Comments on: Roth 401(k) vs. the Traditional 401(k): One Reader’s Thoughts

By: partgypsy

partgypsy — Thu, 03 Jul 2008 16:57:52 +0000

I am still confused. I don’t make alot of money. Currently I put 10% (5900) away per year in 401K (plus half of that is matched). In the near future I want to start to save an additional 3K a year. It would be psychologically easier for me simply to up my percentage in my 401K (I am nowhere near my maximum), but I keep hearing about Roths. What would you do in my situation? Diversify (by putting it in a Roth), or is it really not worth it considering my financial situation?

By: steve

steve — Mon, 31 Mar 2008 19:13:19 +0000

Finally, I read a comparison that gets this correct. I have emailed may “financial experts” clamering for the ROTH is better. Kiplinger.com has a quiz that says a Roth 401k is better. Sometimes it is some times it is not. The mistake is when you contribute to a 401K you save (or can invest an extra) is at you marginal tax rate. When you withdraw, you are taxed at your effective tax rate.
The calculation can be done 2 ways 1 you do not max out your 401k and 2 you max it out.
1. You can figure you make 50k and invest 10K a year in a 401k, or $8500 a year in a roth (assuming 25% tax rate). After 30 years with a 5% return over inflation the Roth will have 500K the traditional 660K in todays money. Lets say that is 36K to 48K. Subtact taxes out todays rate will lead to about 7K + 2k(added ss taxes). you are left with 39K traditional, and 36k Roth. This way the traditional usually has a slight advantage due to lower retirement income. (most experts figure taxes 48K *.25=12K, so you get 36K to 36K.) That is not how our tax system works. Even if taxes are raised 10%, it is still 38 to 36.
2. You contribute 15k to each. Plus an additional 3750 to a taxed account for a traditional. The taxed amount will only earn 5*.85 or 4.25%. From this we have roth 72K a year, compaired to 87k. The income will be about 65K a year for a traditional to 72 for a roth. The Roth has a slight advantage. For this calculation.(Which all experts do).
I tend to envoke a balance 60-80% traditional, 20-40% Roth. The reason to lean more on traditional is for two reasons. The first is currently you pay no taxes on the first 8.5K for each person a year. That means about a 120K balance in the traditional is not taxed for a single person, and 240K for a couple. The medium balance for a Boomer is 50K, and I believe 100K for those who invest. The second is the Roth helps the more you have for retirement. Until you can see you are going to be someone who is well off, that 3K in senerio 1. is more valuable than that 7K in senerio 2. Plus even in senerio 2, after 15 years and good growth is seen, they can contribute only to a roth, and come out with about the same 72k. Also for most Americans 27-50 a roth is slightly more atractive do to child tax breaks.

By: JLP

JLP — Wed, 27 Feb 2008 16:23:40 +0000

Aardvark,

Sorry for the confusion.

Roth IRA withdrawals ARE NOT taxed (as long as you have had the account at least 5 years and are at least 59 1/2 when you start withdrawing).

By: aardvark

aardvark — Wed, 27 Feb 2008 16:18:31 +0000

Can someone clarify taxing of Roth IRA withdrawals after retirement age? I’ve always had the understanding that Roth IRA money has already been taxed and withdrawals, after retirement age, will not be taxed. To clarify my question, imagine my wife and I earn $80,000 a year today and our earned income is taxed at 35%. We retire tomorrow and our only retirement “income” is from Roth IRA withdrawals. Can we withdraw $80,000 a year from our Roth IRA savings and pay no “income” taxes? After all, we paid 35% on the money just prior to depositing it.

By: CiaranFromChance

CiaranFromChance — Wed, 27 Feb 2008 15:49:18 +0000

It seems this debate will rage on. I guess the good thing is if you’re diligent towards putting money away for retirement (however you do it) you’re on the right path and can’t go too wrong in the end.

A couple quick points:

If they change the rules for Roth’s you will be grandfathered or fairly compensated in some other way (anecdotally speaking). It’s unfathomable to me that everything you would have done properly is taken away (this isn’t Checnya)… you will be grandfathered.

With that said, regardless of future tax rates nothing beats a 0% rate. With that said, I think Jeremy has it right, you can spin it any way you want with a financial calculator… but from my experience, what can’t be quantified are the positive psychological benefits of controlling your future tax situation, knowing somewhere in your future you won’t have to pay taxes. That’s a big deal! that motivates investors to stay with their yearly and systematic contributions and be more proactive with their investments in general, which is a big part of it.

Also, as mentioned somewhere above, another major benefit of the Roth is no forced RMD’s and estate planning possibilities, these are huge. If we’re talking about the kind of person that can follow this thread… than chances are they will have done pretty well from the planning (for retirement) standpoint, and may want to have the option of using their retirement assets for purposes other than taking distributions.

I have quite a few clients that are pissed off because they are forced to take RMD’s each year from traditional IRA’s, raising their taxable income.

This is getting long so I’ll wrap… I think tax diversification is wise (just like investment diversification is numero uno) but when it comes to prioritizing your contributions I think its obvious where I stand, where I think the first contributions should be made and what should be the cornerstone of your future plans. (of course after taking advantage of any employee match in a traditional 401K, 403b etc

By: Foobarista

Foobarista — Wed, 27 Feb 2008 10:53:51 +0000

In general, the more you make, the better the Traditional 401K works out, especially if you plan to arrange your life so that you pay lower tax in retirement (move to a no-income-tax state, overseas, etc). Another factor: for two years, my wife and I were able to fund Roth IRAs because our (maxed out) 401K contributions got our MAGI under the max for Roth IRA funding. If we’d been funding Roth 401Ks in those years, we couldn’t have funded Roth IRAs.

Given the vast uncertainties regarding the tax code, a mix of Traditional instruments, Roth-type instruments, and after tax investments is best. Traditional ones will likely do best if we, for example, go to a consumption tax – which will nail Roths.

By: Future Millionaire

Future Millionaire — Wed, 27 Feb 2008 03:35:28 +0000

I have to agree with Andy. Personally I divide up my 401k contributions as 66% to my traditional 401k, 34% to my Roth 401k, and max out my Roth IRA. I don’t have a crystal ball and it is way to complicated for me to try and predict the future as far as tax rates, tax breaks, future earnings etc etc etc (trust me I’ve tried to run all the numbers but there’s not real conclusive data to base a decision upon).

Since no one can predict the future my thought is its best to diversify.

By: Andy

Andy — Tue, 26 Feb 2008 23:14:18 +0000

The best approach is to have both types of accounts. Then you can withdraw from your traditional 401k/IRA until you hit some marginal tax bracket (e.g. withdraw up to the whole 15% bracket) and then withdraw from your Roth 401k/IRA for the rest of the money. That way you maximize your tax savings. Generally taxable investments should be taken last because if you die your heirs won’t have to pay any capital gains.

By: Andy

Andy — Tue, 26 Feb 2008 23:11:56 +0000

They might tax Roth contributions. There’s no principal reason why they couldn’t. But I suspect it would be easier to raise tax rates on regular income, since they are so low right now. That would hurt the traditional 401k/IRA contributions much more.

And the “ex post facto laws” provision of the Constitution has no effect on taxing Roth contributions, since the *withdrawal* takes place after the law. Similarly if there is a higher capital gains tax you can’t avoid paying it because when you invested the taxes were lower.

By: broknowrchlatr

broknowrchlatr — Tue, 26 Feb 2008 22:23:25 +0000

I have another variable to throw in. Your tax bracket while emplyed will likely not likely be lower than it is new because of inevitable pay raises. As such, you may want to get more in ROTH accounts now. Say you are at 15% bracket now and are at a 25% in 10 years. If you max out a ROTH now and then max out a traditional then, you will save the most. In addition, you could convert some ROTH ammounts to traditional in future years and deduct the ammount from our taxes.

As a simple example, say your funds double every ten years, you contribute $10k one time at 25 and are in a 15% bracket till age 35 and 25% thearafter.

If you go 50/50, you will have $10k in roth and $10k traditional at age 35.

If you contribute 100% to ROTH, it will cost you an extra $750 in the first year because of taxes. At 10 years, you have $20k in a roth 401k. Now, say you convert half to a traditional 401k and deduct tht from your taxes. You end up with the same $10k roth/$10k traditional, but you save $2500 on your taxes. Doing this, you get a return of $2500 from $750 over 10 years. Thats a 12.8% return when the market returns 7.2% over the same period. Of course the numbers chagne with different market returns.

Bottom line, It is good to get as much as you can in a roth when you your marginal rate is lower and to level out your balances when you can do it at tax savings.

Note: I agree with the point that you are really getting mroe invested when you max out with roth vs traditional, but the math on that is harder:)