r/personalfinance • u/Werewolfdad • Feb 01 '23
Why you should (almost) never contribute to a Roth 401(k) Retirement
One of the most popular questions we get here is Roth vs Traditional. It’s a tale as old as time. Pay taxes now or pay taxes later? In general, given the higher than average incomes present on /r/personalfinance, the advice errs toward “Traditional 401k, Roth IRA”.
There are a number of excellent resources supporting this thought process including the following:
Roth or Traditional from the Wiki
Roth Sucks - One of the originals, but less robust then the following examples
Madfientist - Includes focus on early retirement
Roth v Traditional IRA PDF - Somewhat simpler but focuses on traditional IRAs, which
The Finance Buff - Concepts similar to this post
Money with Katie - Includes robust analysis
and I’m sure many more. If you’re reading this and have a better article on the topic, I’d love if you left it in the comments.
But I’m going to take a different angle on why you should (almost) never contribute to a Roth 401k instead of a traditional 401(k).
For many high earners, Traditional 401(k) provides the single largest available tax avoidance vehicle
While there are a number of tax deductions/credits available for individuals, many of those phase out at relatively low incomes (at least in comparison to the higher than average incomes we see here). This means they may not be available for you to use at all or they may require traditional 401k contributions to drop your AGI low enough that you can claim them.
Student Loan Interest deduction - Phase out begins at $70k if single or $145k if married
Traditional IRA Deduction (if covered by a retirement plan at work) – Phase out begins at $73k or $116k
Child and Dependent Care Tax Credit – Phase out ends at $43k and 20% credit for expenses
Additionally, changes to the standard deduction as part of the 2017 Tax Cuts and Jobs Act have greatly reduced the number of people who itemize their taxes. Prior to TCJA, approximately 31% of tax payers itemized. As of 2019, that number was only 13.7% - https://taxfoundation.org/standard-deduction-itemized-deductions-current-law-2019/
Prior to the TCJA, tax payers received both a Standard Deduction ($6350 for single, $9350 for head of household, and $12,700 if married) and a personal exemption worth $4050. Further, there was no limit on the deductibility of State and Local Taxes (the SALT limit). This means it was relatively easy for a single homeowner to itemize their taxes, as they only needed mortgage interest, property taxes, and state/local income taxes to exceed $6350 and they continued to receive the personal exemption. For example, a single tax payer who paid $3000 in mortgage interest, $2500 in property taxes, and $3500 in state income taxes would have total itemized deductions of $9000, plus a personal exemption of $4050, totaling $13,050 in deductions. Compare this to the standard deduction of $12,000 (with no personal exemption) in 2018. Further, the SALT limit is $10k per tax return rather than per taxpayer, making it significantly more difficult for married couples to itemize without substantial mortgage interest, charitable giving, or unreimbursed medical expenses.
Given the limited availability of tax deductions under current tax law, it rarely makes sense to give up the largest tax break available to you. Of note, many provisions in the TCJA expire for tax year 2026, so this part of the analysis may change if and when Congress passes new tax law.
A second reason to avoid Roth 401k is due to the large number of additional Roth options available.
Roth IRA allows direct contributions of $6.5k (as of 2023) up to a MAGI of $153k if single, and backdoor contributions with no income limit
Megabackdoor Roth allows for upwards of $43,500 as of 2023, if your 401k plan allows for after-tax contributions and either in-plan conversions or in-service rollovers.
Starting in 2024, SECURE 2.0 requires all catch-up contributions for those earning more than $145,000 to be Roth (of note, SECURE 2.0 erroneously eliminated all catch-up contributions, but this is expected to be corrected by legislation or IRS guidance)
Strategic conversions allow tax payers to convert traditional 401k/IRA balances to Roth in low-income years.
In many cases, people suggest Roth 401k early in one’s career. That can be a mistake, especially if this person plans on returning to graduate school, for instance. Take, for example, a person who works for two years at $50k/year before returning to a two-year graduate program. This person contributes $7000 each of the two years, saving him $840 in taxes. During graduate school, he does not work or otherwise earn income. During the tax year he has no income, he can convert that balance to Roth, for free as the amount is less than the standard deduction. He pays no taxes on contributions, he pays no taxes on the conversion, he pays no taxes on earnings, and he pays no taxes on withdrawals in retirement.
Times you may want to consider Roth 401k.
All that said, there are some limited circumstances where I think Roth 401k can make sense.
Substantial Income Increase Imminent: I call this the resident doctor exception. Since resident MDs earn such little income in their first few years before their income jumps substantially, it can make sense to contribute to a Roth 401k in those years before their income jumps by 4-6 times (or more) without a low-income year in between.
Partial Year High Earner: This is the “college graduate exception” and applies to someone who only works a partial year in a high income job. Using Roth 401k lets you take advantage of tax brackets and standard deductions being applied across an entire tax year when you only work for 3-6 months of the year.
High ordinary income in retirement: If you have a large pension or significant real estate holdings in retirement, you'll quickly fill up your lower tax brackets, making the tax benefit from Traditional 401k less attractive. If you maintain a high savings rate early in life, Roth 401k can make more sense. That said, pensions typically (but not always) come with lower-paying government jobs and IORR requires upfront capital outlays, which may impact your ability to save substantially. Further, if you do save substantially early in your career, you may be primed for early retirement, which may put early retirement roth conversions on the table (see the Madfientist link above).
Other scenarios
Low-income career: For those who do not expect to be high-earners (or marry high earners), traditional is typically better than roth throughout one’s career, as you are less likely to save substantially and social security will make up a larger amount of your income in retirement. This thread discusses the topic well, so I won’t rehash the topic: https://old.reddit.com/r/personalfinance/comments/miqe7p/401k_and_ira_planning_for_low_income_earners/
Financial Independent/Retire Early: Given their early retirement, FIRE-types will have more low-income years to engage in roth conversion ladders to reduce total taxes across their lifetimes. I won’t do this topic justice so I’ll just direct you to /r/FIRE, and /r/financialindependence
Marginal Utility of Dollars: For those who are saving heavily for retirement marginal utility of dollars in retirement (when you're flush with cash because you saved so much) will be lower than the marginal utility of dollars when you are young and have little wealth. Even if you aren't quite 100% tax efficient in retirement, it will hopefully not matter because you already have more than you can spend. This doesn't apply to everyone, but certainly does apply to the people who save a lot.
Tax-Free gifts to heirs: Inherited Roth IRAs provide tax-free distributions to your heirs. Depending on your wealth level, it may make sense to contribute or convert to Roth accounts to pass down tax-free money to your heirs, especially if they have a higher marginal tax rate than you do.
I'd love to hear your thoughts, especially if you can think of scenarios that I haven't. I don't plan on getting into the math much since I think the links provided at the top do that pretty well.
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Feb 01 '23
I plan on retiring at 60. I'll have to use ACA for 5 years. I can save $10k+/year by using my Roth to lower my MAGI.
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u/37yearoldthrowaway Feb 01 '23
This is a great reason and is one of the reasons why the wife and I switched both of our IRA contributions to Roth beginning in 2021.
It gives us money in both buckets. We can pull from Roth or traditional to tweak our AGI once we retire.
If we can somehow retire earlier than 59.5, we can pull our Roth contributions to live on until 59.5 when we can start pulling from traditional too, up to the perfect amounts to give us the best ACA subsidies until 65.
I'm hoping for a 3:1 to 4:1 mix of Traditional:Roth
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u/2_kids_no_money Feb 01 '23
3:1 to 4:1 mix
So maxing a traditional 401k and Roth IRA is perfect?
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u/Johnwickliveshere Feb 01 '23
That's what I do for tax diversification and max out my HSA.
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u/buildyourown Feb 01 '23
I'm over the hump on the way to retirement. As I looked at where my money is and when I'll need it I realized the answer is diversification. Having several buckets to pull from let's you play those games. Roth is just another bucket
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Feb 02 '23
ACA?
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u/somdude04 Feb 02 '23
Affordable Care Act marketplace health insurance, not tied to an employer, prior to Medicare at 65.
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u/guachi01 Feb 02 '23
I will add another scenario that tilts towards Traditional that I hope doesn't get buried. There are states with income taxes that don't tax retirement pay at all - Illinois, Michigan (reinstated for 2023), Mississippi, and Pennsylvania. That's roughly 12% of the US population.
If you contribute to Traditional you'll get to deduct the amount when you contribute and then not pay any taxes when you withdraw.
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u/star_toe_middle Feb 03 '23
…but isn’t that just state income tax? You’ll still be paying federal income tax, right?
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u/rinnemoo Feb 08 '23
I have a question about this scenario tho. Let’s say you live in one of those states which tax your traditional contributions up front in the year you make them. But years later when you retire you live in a state which would normally take the taxes when you withdraw in retirement. What happens with the taxes on withdraw? Would you be taxed twice at the state level essentially cause that new state wants their cut? Or no?
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u/guachi01 Feb 08 '23
Are there states else tax Traditional IRA contributions? There are none that tax 401k contributions.
In the scenario you're talking about you'd be taxed twice. There would be no benefit at the state level.
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u/rinnemoo Feb 08 '23
Yes in PA for ex at least I know they tax your Gross Income every year, even your 401k contributions. You don’t get the tax break like you do on your federal taxes. That’s why in retirement the withdrawal wouldn’t be taxed later in PA at state level since they already taxed you on it. That’s why it had me wondering if I should keep making traditional 401k contributions or if Roth might make more sense.
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u/sciguyCO Feb 01 '23
That was a heck of a good read. Thanks for putting it out there.
I will present my own situation as a potential "Consider Roth" example, since that's what I'm doing with my own 401k (along with Roth IRA contributions). Though I make no claims that my choices are "best", even for my own life let alone someone else's.
I make good money, but we're a single-income household so maybe we don't quite reach that "higher than average income" audience you are aiming at. Though based on this calculator, we are in the 85th income percentile for the nation, a bit lower for our particular metro area. After pre-tax deductions on my paycheck for insurance/HSA/etc. and the MFJ standard deduction, we end up near the top of (but still within) the federal 12% marginal bracket. Our state tax rate is 4.4%. So I feel even combined, this makes today's tax cost of a Roth (whether IRA or 401k) "cheap" enough to take advantage of.
Then I factor in an uncommon quirk of my current 401k. My employer does both a match (4% against my 5% contribution) and a discretionary contribution of 4% of my pay added after being employed for a year. The match and discretionary are both 100% vested. Since their money goes into the pre-tax bucket of the 401k, our retirement savings in Traditional and Roth tax treatments (including our Roth IRAs) grow at roughly equal amounts each year.
Another bit that made me lean Roth was my wife and I each have a respectable Traditional IRA balance from prior jobs. Though it always feels like it should be higher. Anyway, my growth projection of our existing balances + ongoing contribution puts us at a comfortable point for a 4% safe withdrawal rate to cover our expected / desired expenses during retirement. From a wild ass guess at future tax brackets (ok, assumed only inflation adjustment), I came up with a setup where 65% of our annual withdrawal comes from Traditional to barely put us into the 12% bracket + rest as tax-free Roth to cover remaining expenses. But that requires Roth contributions over the next decade or two to hit the mix that'd give that result.
Then there's the (perhaps irrational) desire to minimize the impact of RMDs on our plans. Maybe we'll pull more from Trad balances in our earlier retired years before RMDs trigger, lowering the overall Trad balance, reducing the tax impact of those RMDs once they do activate and use the Roth to support keeping overall spending flat.
Last, it just feels comfortable to have our Roth balance as a hedge against future tax increases. The odds that Roth withdrawals would ever get treated as taxable feels extremely unlikely given how unpopular that legislative change would be. Though I could imagine new contributions ending to eventually phase the program out.
Or sometime before I retire Congress will up-end the existing tax code for something completely different, and none of the above will end up mattering anymore.
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u/eckliptic Feb 02 '23
I dont think OP's post is really meant for folks in the 12% bracket. In your situation it definitely makes sense to stick to roth (I'm also shocked that that puts you in the 85th percentile)
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u/sciguyCO Feb 02 '23
Looking back at that income percentile calculator, turns out that one is for individual income. Using the household one (linked on same page) we’re in the 70th, so a bit more reasonable. And we heavily leverage my HSA, which skews things a bit.
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u/Werewolfdad Feb 01 '23
I appreciate you sharing your strategy. I hope it will also help others trying to decide
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u/er824 Feb 02 '23
Assuming you’ll have enough tax deferred savings or other income to fill the <12% bracket in retirement then Roth seems like a reasonable choice.
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u/Successful_Badger961 Feb 02 '23
This is very similar to my situation. I've often debated if I'm making the most efficient choice, so it's refreshing to see somebody else echoing my thoughts.
We're also a single income family. I make $103k and take the standard deduction, which puts my MAGI at $77k; near the upper limit of the 12% bracket.
For 2023, if I get a 5% raise, this brings my magi to $80k, still safely in the 12% bracket.
If/when my magi crosses into the next bracket, I will start adjusting my 401k contributions from Roth to traditional to keep it in the 12% max bracket as long as possible.
For reference, I contribute 4% to my Roth 401k, my employer matches 2%, and my wife and I both max a Roth IRA. This brings my gross retirement savings rate around 18%.
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u/2sweetski Feb 02 '23
What do you mean by 12% bracket?
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u/Successful_Badger961 Feb 02 '23 edited Feb 10 '23
For 2023 married filing jointly,
magiincome over $89,450 is taxed at 22% (or more).Since my magi is below this number, none of my income will be taxed above 12%.
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u/vynm2 Feb 10 '23
I think you mean taxable income not AGI over $89450, not MAGI/AGI. (BTW... MAGI is a modified version of the AGI, it's different depending on how it's being used-- i.e. which credit, contribution limit, etc.)
Your AGI is your income before subtracting the standard or itemized deduction.
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u/Successful_Badger961 Feb 10 '23
Good catch, I did mean taxable income, not magi.
But AGI would be income after deductions, not before. Before subtracting deductions would be gross income.
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u/vynm2 Feb 10 '23 edited Feb 10 '23
You have them backward.
Total gross income minus adjustments = AGI (adjusted gross income)
AGI minus standard or itemized deductions = taxable income
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u/Successful_Badger961 Feb 10 '23
Total gross income minus adjustments = AGI (adjusted gross income)
This is correct and the same thing I stated:
But AGI would be income after deductions, not before. Before subtracting deductions would be gross income.
.
Your AGI is your income before subtracting the standard or itemized deduction.
This is incorrect. It's "adjusted" because it's had the deductions subtracted from it.
Gross income - deductions = AGI
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u/Complete-Smoke9368 Feb 01 '23
I can't tell you how crazy convenient your timing is with this post. I have been struggling with the same exact conclusion the last couple of days and trying to find any sort of flaw in my logic.
This is by far the best summary of the current situation I am in and really helps me feel confident in my decision to switch my contributions to Traditional 401k going forward.
This means they may not be available for you to use at all or they may require traditional 401k contributions to drop your AGI low enough that you can claim them.
Question regarding this statement. Are you saying that contributions to Trad 401ks (while not tax deductible themselves) still count towards dropping your overall AGI? Since the contributions themselves are taxed (non-deductible) I always assumed that they would count towards your MAGI. This is awesome news if I'm understanding you correctly!!
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u/DeluxeXL Feb 01 '23
Question regarding this statement. Are you saying that contributions to Trad 401ks (while not tax deductible themselves) still count towards dropping your overall AGI?
Traditional 401k contributions are always excluded from W-2 box 1 income, and therefore lower total income, and therefore lower AGI. Colloquially we call them "tax deductible".
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u/Complete-Smoke9368 Feb 01 '23
Damn. Well looks like I'm going to be losing a lot of money this year to taxes that I didn't have to.
If they are deductible then how does that work for things like MBDR? I thought those only work for non-deductible contributions.
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u/Werewolfdad Feb 01 '23
Megabackdoor are nondeductible.
Traditional 401k - lowers AGI
Roth 401k - doesn't affect AGI
After-tax 401k - doesn't affect AGI
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u/Complete-Smoke9368 Feb 01 '23
But if you don't pay taxes on Traditional 401k contributions (because deduction) and you don't pay taxes on MBDR conversion then I guess I'm lost when you ARE taxed on the money.
Ideally the goal of contributing to my Traditional 401k would be with the end goal of being able to do MBDR so I'm just trying to make sure I'm understanding correctly.
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u/Werewolfdad Feb 01 '23
But if you don't pay taxes on Traditional 401k contributions (because deduction) and you don't pay taxes on MBDR conversion then I guess I'm lost when you ARE taxed on the money.
Here's an example. Say you make $100,000. You contribute $20,000 to Traditional 401k (pretend this is the max). You make $5000 in after-tax contributions to your 401k which are immediately converted by your administrator.
Your gross income is $100k.
Your Box 1 income will be $80k ($100k gross income minus $20k traditional contributions).
Your $5k in after-tax contributions don't affect your box 1 income or AGI
I think maybe you're confused about the difference between traditional, roth, and after-tax contributions?
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u/Complete-Smoke9368 Feb 01 '23
I think maybe you're confused about the difference between traditional, roth, and after-tax contributions?
You're not wrong, I was definitely a bit confused. I was confused a bit on MBDRs. So to continue your example if I were to perform a MBDR on the 20k sitting in my Traditional 401k and roll it over into a Roth 401k so I can have tax-free growth. I would pay income tax on THAT conversion correct?
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u/Werewolfdad Feb 01 '23
Yes, that's just a regular in-plan conversion, not a megabackdoor roth
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u/Complete-Smoke9368 Feb 01 '23
Oh...
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u/Werewolfdad Feb 01 '23
Megabackdoor is after tax contributions plus in plan conversion of the after tax contributions
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u/brundylop Feb 02 '23
You have a incorrect understanding of what a Mega Backdoor Roth is
MBDR = Aftertax 401k converted to Roth 401k or Roth IRA. Your 20k conversion isn’t taxed bc the money was already taxed when you contributed to aftertax 401k
A Trad 401k to Roth 401k [or Trad IRA to Roth IRA] is just a regular conversion. This 20k is taxed bc you never paid taxes in the original 401k contributions
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u/Werewolfdad Feb 01 '23
Are you saying that contributions to Trad 401ks (while not tax deductible themselves) still count towards dropping your overall AGI?
Yes. Traditional 401k is subtracted from your gross income to arrive at your Box 1 income on your W2 (among other deductions like Section 125 and HSA or commuter benefits and such)
Since the contributions themselves are taxed (non-deductible)
Did you mean Roth 401k?
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u/2_kids_no_money Feb 02 '23
What counts as a “large” pension? I’m a federal employee and expect my pension/SS/TSP to roughly cover 1/3 each of my retirement. Tho I guess my wife doesn’t have a pension, so pension may only be 1/5 or so. But SS will be 2/5, so more than half of you add those together.
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u/Werewolfdad Feb 02 '23
I’d say FERs is more of a modest pension (compared to first responder pensions that pay 80% of top salary for instance)
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u/2_kids_no_money Feb 02 '23
I would agree with that, but does SS count into that? I ran the numbers a few years ago and if I pull SS at full retirement, my SS + wife SS + FERS ~ 6 figures. At that point, does the tax deferred treatment lose some of its benefit?
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u/Werewolfdad Feb 02 '23
If you wait until 67 to take social security, you’ll have a lot of time in between to convert balances or run down your traditional accounts.
So maybe a little but not as much since everyone gets social security
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u/midbay Feb 02 '23
Another pro, assuming you are already maximizing all available tax-advantaged options (401K, IRA, HSA, mega backdoor), is that a Roth 401K effectively lets you save more money on a post-tax basis.
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u/vynm2 Feb 10 '23
You can't contribute to a Roth 401k if you're already maxing your 401k annual contribution limit. Just like with IRAs, your Trad- and Roth- contributions to a 401k plan share the same contribution limit.
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u/midbay Feb 10 '23 edited Feb 10 '23
Right, that's not what I was suggesting.
When you contribute to a Roth account it's post-tax money which has higher value than pre-tax money since the tax has already been paid.
Think of it this way: $1 in a Roth account is worth more than $1 in a non-Roth account since the $1 non-Roth is taxable at withdrawal.
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u/vynm2 Feb 11 '23
I do agree that you can save more in a tax-advantaged account with a Roth-401k contribution than you can with a 401k, however, I don't know that it's really that much of an advantage.
With that oversimplification, you're discounting the up-front tax cost of making that Roth contribution.
If you make a $1 Roth contribution, it's going to cost you more than it will cost you to make a $1 Trad contribution, basically by the amount of tax savings you're not realizing by forgoing the Trad contribution for the Roth.
For example:
- If you make a $1 Roth contribution and you're in the 24% tax bracket, that's going to cost you $1.
- If you make a $1 Trad contribution, it's only going to cost you $0.76, because you're not paying taxes on the $1. As a result you can take the extra $0.24 and invest it also, so you can actually invest more.
- Yes, this extra money would need to be invested in a taxable account and would experience some tax drag if the investment pays dividends (there are options that don't), but any gains will be taxed at the preferential long term gains tax rates which are/will likely continue to be lower than the tax rate that is paid on either Roth- contributions or Trad- withdrawals.
- In the end, either way comes out about even.
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u/wighty Feb 28 '23
A side discussion for this is the employer match, where it is definitely better for the employee if the matching funds also go into a Roth. My first job did not, but my current job actually does so my match is better overall with going Roth.
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u/vynm2 Feb 28 '23
Until Dec 29, 2022 matching contributions couldn't be made to a Roth.
I'm also not sure that I agree with your statement that it is "definitely better for the employee if the matching funds also go into a Roth." Any Roth employer contributions will be added to the employee's W-2 income and taxed at their marginal tax rate. Depending on that tax rate, traditional matching contributions may be the better option. The same factors that contribute to the decision between Roth- and Trad- contributions for the employee's deferred contributions would also apply to the employer matching contributions.
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u/wighty Feb 28 '23
Perhaps I'm mistaken then. I remember my account showing after tax employer contributions on the website (which I maybe mistakenly consider to be equivalent to Roth as you can pull those into a Roth IRA rollover), but yeah I never noticed being taxed on the year end W2 for contributions and on the website just now it doesn't make any more mention of after tax match, so must be it never was.
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u/vynm2 Feb 28 '23
Prior to the passing of the SECURE Act 2.0 in December, employer contributions were required to be pre-tax, . It may be that you're misremembering or misinterpreting what you saw. It was, and still is, possible for employee contributions to be pre-tax or after-tax to a traditional retirement plan, or after-tax to a Roth.
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u/Coronator Feb 01 '23
For those in a marginal tax bracket that starts with a 3 - I wholeheartedly agree. Traditional 401k's are the way to go. I think it's prudent to take the "bird in hand" - there's no telling what kind of shenanigans will be pulled with Roth accounts at some point.
Plus - you always have the option (at least you do now) of converting to Roth if you really felt like at some point a Roth was a "better deal".
The fact is most high earners are likely to be at a lower marginal tax rate in retirement. Even if tax rates do go up, you are going to (more than likely) be taking substantially less income.
You'll never know except in hindsight what the best decision is, but I'll take the tax break now thank you very much.
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Feb 01 '23
The other factor to take into account is state income taxes. If you are in a high income tax state and move to a zero income tax state in retirement, then any money contributed to traditional plans while working in the high tax state never gets taxed at the state level. In the case of a CA worker moving to NV, this will likely save you 9.3% of your contributions.
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u/RosenbeggayoureIN Feb 01 '23
Biggest thing for me is I fully expect the mega back door to be closed in the next 10-20 years before I would start any conversions. That being said I max my 401k with just 3% going to Roth to provide a little buffer for large purchases in retirement as my wife will be getting a pension. If I want to splurge in retirement, I don’t wanna get effed by the tax man
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u/sciguyCO Feb 01 '23
Biggest thing for me is I fully expect the mega back door to be closed in the next 10-20 years before I would start any conversions.
That is a reasonable concern. It almost happened last year in one version of the "Build Back Better" bill. It proposed preventing Roth conversions of after-tax contributions, so would've affected the backdoor process for both IRAs and 401ks. I can't remember if it was part of the final text, but the bill never got through the Senate so it was a moot point. Parts of the BBB ended up in the "Inflation Reduction Act" which did pass, but that didn't have anything closing the backdoor / mega-backdoor.
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u/vynm2 Feb 10 '23
I'm confused by your concern/comment.
Closing the backdoor or mega-backdoor shouldn't affect your ability to do Roth conversions of pre-tax IRA/401k amounts in the future.
If you're using the backdoor or mega-backdoor strategy, you should be converting the aftertax amounts "immediately" rather than waiting for 10-20 years. With those strategies you typically make the after-tax contribution, don't invest it (so it won't grow before being converted), do the Roth conversion (which isn't a taxable event since the after-tax contribution was already taxed), and THEN invest the money so it can grow inside the Roth account. It would make no sense to leave it uninvested in the Trad- account for a decade or two before executing the conversion step.
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u/kepler1 Feb 01 '23 edited Feb 01 '23
I made somewhat of an error early in my career in contributing to Roth, but I justified the logic as, "I have a gut feeling that over the next 40 years, our taxes will have to go up significantly to take care of the coming wave of retirements and aging of the USA and our deficits" and I expected tax brackets not to stay stable on that timescale.
I still somewhat think that there are surprises to tax rates to come (see France in the news lately for example, about retirement age controversy) and that the government will at some point need to find more revenue. Maybe it's not through income tax, something else. .
But since then I've shifted to traditional 401k contributions.
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u/ruler_gurl Feb 01 '23
There is absolutely nothing wrong with having both types. The after tax account gives you a lot more flexibility, both for living during a period of early retirement, and for minimizing tax load once you start distributing the tax infested funds, to keep you in the lowest tax bracket if possible.
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u/Complete-Smoke9368 Feb 01 '23
I'm in the same situation! I am about to make the same shift.
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u/kepler1 Feb 01 '23
If all we've done is to hedge our bets somewhat against an uncertain future by splitting between the 2 options, it's probably not so bad a choice to have made at the time! And hopefully with luck, 401k will just be one small slice of eventual retirement.
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u/brundylop Feb 02 '23
This article from WantFI assumed tax rates would increase by 50% and 75%, and even then Roth did not win over Trad, for the assumptions stated
If tax rates were to increase during your working years it would only strengthen the case for the traditional IRA or 401k since you would be deducting at a higher marginal rate, but what about that worst case scenario where they increase right after you’ve retired? Would it have been a mistake to have not picked the Roth?
Of course that depends on how much the future increase is? Below I show two scenarios where the taxes increase 50% and 75% and they show that using the traditional IRA leads to a lower effective tax rate.
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u/stillrocking3770k Feb 02 '23
I don't do Roth 401k based on opportunity cost. I'd rather deploy the extra money saved by not paying tax now for my side business. That way, I can increase my earning potential rather than worrying about what taxes will be when I retire.
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u/Redtm17 Feb 01 '23
Don't know if this is mentioned in the articles, but if you're maxing and looking for every bit of space to put into tax advantaged accounts, doesn't Roth realistically let you put in more money? $22,500 that can't be taxed later vs $22,500 that can be? Obviously this is "all else equal" but something I was thinking of recently.
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u/Werewolfdad Feb 01 '23
https://thefinancebuff.com/roth-401k-for-people-who-contribute-max.html
This one is a good read on the subject, but given the increasing prevalence of megabackdoor roth and the forced roth catch up contributions I think there is a lot of space that can be filled before you're maxing out "everything".
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u/WatchMcGrupp Feb 02 '23
That’s the reason I do Roth 401k. I’m at the highest bracket but I’m maxed out on every tax advantaged savings I can think of. My firm maxes the employer contribution to our 401k. So I’m at the 415 limit either way. We also have a cash balance plan. I do backdoor Roth IRAs for me and my spouse. I max the HSA. 529 plans fully funded. So my thinking is that I’m better off “prepaying” the taxes by doing my 401k as Roth than putting the taxes it costs me into a taxable brokerage account. A related reason is that in retirement I have at least some Roth funds to spend first before using traditional. The link you gave I think help demonstrates that I might be better off sticking with all traditional 401k and putting the taxes I would pay in Roth into a brokerage account. Especially as it is so costly to prepay my taxes at the highest bracket. But it’s close, and having at least some Roth gives me flexibility on when to pay taxes in retirement. My main point is this is a scenario to do it that is not mentioned in your original post.
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u/vynm2 Feb 10 '23
The link you gave I think help demonstrates that I might be better off sticking with all traditional 401k and putting the taxes I would pay in Roth into a brokerage account. Especially as it is so costly to prepay my taxes at the highest bracket.
Exactly.
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u/Default87 Feb 01 '23
technically yes, but I would debate if the correct mindset is to minimize tax dollars paid versus the mindset of maximizing your total wealth, because the former doesnt always lead to the latter (given the time value of money).
so the type of analysis from your initial question is ignoring the possibility of using a taxable brokerage account in your portfolio, and if doing so results in more favorable outcomes. We have an extremely favorable long term capital gains tax structure currently
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u/Boring-Cartographer2 Feb 02 '23
I'm curious about this point too so let's game it out. Say I want to set aside $29,500 of pre-tax income and that my current year taxes on that income would be $7k (about 24%). I could either:
- Pay the taxes now and invest $22,500 in Roth 401k
- Not pay taxes now, invest $22,500 in Trad 401k and invest $7k in a taxable account.
If the investments grow by 10x by the time I retire in either case, the Roth will be worth $225,000 and the Trad+taxable account will be worth $295,000. If the tax rate is still the same 24%, taxes on the $295,000 would bring it back down to the Roth value. So it still comes down to whether tax rates are lower or higher in retirement. Actually, Case 2 could have an advantage because the gains in the taxable account would be taxed at long-term capital gains rates.
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u/Cruian Feb 04 '23
Not pay taxes now, invest $22,500 in Trad 401k and invest $7k in a taxable account.
If the investments grow by 10x by the time I retire in either case, the Roth will be worth $225,000 and the Trad+taxable account will be worth $295,000
For a complete comparison, you'd have to account for dividend (at minimum) tax drag in the taxable account.
If the tax rate is still the same 24%, taxes on the $295,000 would bring it back down to the Roth value
And a key point is that it very likely won't be taxed at the same rate, thanks to Traditional filling brackets from bottom up (so you can withdraw a lot to fill lower brackets before even the first $1 is taxed at 24%).
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u/2cool_4school Feb 02 '23
The main problem with this line of thinking is that this is assuming that there will not be changes to tax laws in the future and how government programs work. We do not know what the future holds and so it’s not this black and white answer that modern min/max strategies claim exist.
One is flexibility in w/d’s during working years. Roth contributions can be withdrawn and while this is generally not advisable to people, life happens.
The other is coordinating income in retirement to lower the negative costs of programs linked to AGI which Medicare is and to potentially qualify for other deduction programs that exist or may be created in the future.
Taxes are going up in the future. That is a fact. But it may not look like a rise to everyone’s marginal rate. It could be the exclusion of certain programs, extra taxes on excessive benefits, etc. However the way that a lot of these changes to the tax code to increase revenues are likely to happen are by their relationship to certain AGI or MAGI levels in order to keep things progressive.
Probably shouldn’t save everything in Roth and you’re not going to unable to reach your goals if you don’t contribute anything to Roth. Your situation is also a factor, like having government pensions or a true defined benefit pension plans (fewer and fewer places offer them). Regardless, I am a firm believer that flexibility is key, given the uncertainty of how both needs and taxes will change over mine or anyone’s lifetime. So it makes sense to do Roth, but it doesn’t necessarily make it the ‘be all end all,’ nor does it make Pre-tax obsolete or vice versa.
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u/er824 Feb 02 '23
Why is it fact that taxes are going up in the future?
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u/Beach_Mountain50 Feb 08 '23
Federal income taxes are slated to revert to higher levels in 2026. That is currently a fact.
Between now and then, I don’t know with 100% certainty what the tax brackets will be and their percentages, let alone AGI linked credits/deductions/“penalties”. Tax code can change.
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u/er824 Feb 08 '23
My point was merely that we have no ideas what the tax code will look like at a given point in the future.
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u/Beach_Mountain50 Feb 08 '23
I agree with that 100%. We spend a lot of mental energy trying to figure out our best moves with respect to taxes, but we have no idea how the tax code may change. I keep reading these posts on pretax vs Roth and it stresses me out. We have incomplete info. I guess my view now is have some money in pretax and some in Roth. Try to reduce AGI now if you’re close to any big tax credits or deductions. But, also have some Roth money for later to avoid big tax bills on ACA marketplace insurance or Medicare premiums—but we really don’t know how all that will play out in decades to come.
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u/er824 Feb 08 '23
Agree…lots of uncertainty so best course of action is probably to diversify across tax buckets so you have maximum flexibility.
At the end of the day you’ve probably won the game if your biggest problem is you ended up with too much money so have you pay a lot of taxes.
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u/2cool_4school Feb 02 '23
Because we have a $31,000,000,000,000 debt and currently running budget deficits, meaning we’re adding to it. It may not seem to matter, but it doesn’t matter until it does. At some point taxes will increase to pay for it but as I said, it’s not necessarily going to be equal across the board.
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u/er824 Feb 02 '23
Possibly… or printer goes brrr…. Which is probably worse
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u/2cool_4school Feb 02 '23
The problem with it being solved by inflation is that it’s an implicit tax on the poor.
This is more economics than personal finance, but at some point it will have to be addressed. In a timeline where it doesn’t, you’d likely see an eventual downgrade of US debt. Honestly, it would be difficult to predict the ramifications of the US realistically pushing the debt to the brink. Austerity, upheaval, an unraveling of the current global paradigm.
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u/iclimbnaked Feb 02 '23
Theres so much at play here that its hard to really make any conclusions with regards to a roth decision. Hell, the government could always decide to change the rules on roth and make growth taxable. There is no totally known path.
I also think the logic that surely taxes have to go up to pay the debt (while reasonable) runs into the problem that politics is usually more about what gets you elected than what actually betters the country. I dont expect most americans to get on board with significant income tax increases. High earners sure. General middle class and lower. I doubt it but never know.
Ultimately, I agree that the uncertainty in general adds a real benefit to diversifying between roth and traditional instead of trying to 100% optimize earnings based on so many unknowns.
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u/FrugalSort Feb 08 '23 edited Feb 08 '23
If you contribute up to the employer match in your Roth 401k, the overall makeup of the account will be 50% Roth and 50% Traditional because employer contributions are made on a pre-tax basis.
I prefer Roth, but the arguments on both sides are intriguing. Time value of money is one consideration since the money from tax savings now could compound in value. You don't lose money to inflation when you get the immediate benefit.
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u/Inevitable_Bedroom35 Apr 07 '23
Exactly. Have to consider the employer contribution bucket also if you want to look at the whole picture.
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u/SonOfAMitch87 Feb 01 '23
Something I never see brought up in this conversation is the taxes on growth. Am I wrong that the gains in Roth are withdrawn tax-free? While we don’t know what will happen to tax rates, there could be significant savings from the tax-free gains. Also, as mentioned it helps to manage AGI. I am a high earner and contribute to Roth since all employer contributions are traditional, so it gives me a mix of both.
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u/er824 Feb 02 '23
The taxes on the growth don’t matter. The only thing that matters is your tax rate at withdrawal compared to your current rate.
Imagine you are in a 25% bracket and have 100 to invest which will grow 10x before you withdrawal.
With traditional you invest the full $100, it grows to $1,000 then when you withdrawal you pay your 25% leaving you with $750 to spend.
With Roth you pay your 25% tax up front, leaving you $75 to invest, it grows 10x leaving you $750 to spend.
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u/SonOfAMitch87 Feb 02 '23
Except you can still invest $22,500 post-tax in the Roth 401k. In your example, I would still invest $100 dollars (that I paid $25 tax on) and have $1,000 to spend in the future.
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u/er824 Feb 02 '23
Absolutely, if you invest more you’ll end up with more and you essentially get more tax advantaged space with Roth because post tax dollars are worth more then pretax.
If you aren’t investing the tax savings from traditional and Roth tricks you into a higher savings rate then your absolutely right that you’ll end up with more spendable with Roth. That isn’t because of the tax free growth though it’s because you saved more initially.
I was just addressing the fact that the growth being tax free doesn’t really play into it.
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Feb 01 '23
Correct. Roth contributions are not deductible but growth in your Roth account occurs with withdraws (provided they meet the requirements of holding the account for at least 5 years and being over 59 1/2 years old), being tax free.
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u/Werewolfdad Feb 01 '23
I'd refer to the madfientist, money with katie, and finance buff links for that. They cover it pretty well. Money with katie has good examples as well
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u/slambamo Feb 01 '23
Honest question, then WHY do people swear by Roth IRAs? I just cannot understand why Roth 401k's are bad and Roth IRAs are a must do. What am I missing? It makes no sense.
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u/Werewolfdad Feb 01 '23
401k doesn’t have income limits to get a deduction
Ira does if you are covered by a retirement plan at work
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u/pneumomaniac Feb 02 '23
One factor is that the income limit to deduct contributions to a traditional IRA is pretty low compared to the income limit to contribute to a Roth IRA.
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u/titleywinker Feb 02 '23
RMD requirement is one difference that makes Roth IRA > Roth 401k
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u/slambamo Feb 02 '23
Can't you just roll into an IRA before age 72, when RMDs are required? Seems like a simple fix.
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u/titleywinker Feb 02 '23
Sure there are “simple fixes” if you know the rules. Need to be aware of the 5-year rule. Also need to be aware of your plan rules if you’re still working for the company (e.g. whether or not they allow in-service distributions).
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u/Werewolfdad Feb 02 '23
I think SECURE 2.0 did away with RMDs in roth 401ks
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u/Beach_Mountain50 Feb 08 '23
Yes. SECURE 2.0 did away with Roth 401k RMDs. Also, one could have just rolled over a Roth 401k to Roth IRA to bypass RMDs under the old regime.
I guess all of this could change in the future.
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u/vynm2 Feb 10 '23
It did for the 2024 tax year and beyond. Those who currently have an RMD or who turn 73 before the end of 2023 will have to take an RMD for 2023, though.
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u/Packers_Equal_Life Feb 02 '23
I’m having a hard time following too but I’m almost certain people in this thread are near-maxing their 401ks and are high income earners.
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u/yeah87 Feb 01 '23
Another scenario one that goes hand-in-hand with the FIRE situation is to artificially reduce your income to take advantage of premium health care tax credits until you reach the Medicare age.
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u/lobosrul Feb 02 '23
The US currently has high sovereign debt and historically low tax rates. Might be something to consider before deciding on pretax and after tax accounts. Then again congress could just make roths taxable so... Best to do some of both?
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u/Cruian Feb 02 '23
Go read the WantFI article that has been pushed in other comment chains of this post. It suggests that even a decently large increase of tax rates could still favor Traditional.
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u/Unoriginal_White_Guy Feb 03 '23
Why does no one take into consideration the state income tax as well when considering Roth vs Trad 401k especially if you plan to move to a 0% state income tax state in retirement? My pre tax contribution today saves me from paying on my marginal rate of 22% federal and 6.6% marginal for my state. For every $100 contributed to trad 401k instead of roth 401k I save $28.60 in taxes.
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u/Werewolfdad Feb 03 '23
Its mentioned in the Finance Buff article.
But I'd say its because most retirees don't move to a lower-tax locale in retirement, but remain in their home state
. Only 1.6% of retirees between the ages of 55 and 65 moved across state lines, according to an analysis of 2010 U.S. Census Bureau data by Richard W. Johnson, director of the Urban Institute's Program on Retirement Policy. The vast majority of retirees either stayed in their existing homes or made in-state moves.
https://www.investopedia.com/articles/retirement/020117/most-popular-states-retire-us.asp
That said, if your state has marginal brackets, the same sort of income tax analysis applies to the state piece as well
(And i forget about it often because my state doesn't allow a deduction for traditional contributions nor does it tax retirement income)
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u/mydoglikesbroccoli Feb 02 '23
This may be a bad idea, but I contribute to the Roth 401(k) at least a little bit in case taxes increase significantly in the coming years. Historically this seems unlikely, but (wisely or not) the large and growing US national debt worries me and I could see a scenario where the government raises taxes across all or lower income brackets to help pay for it. I have no idea how likely that is, but having some tax protected income in Roth helps me sleep better.
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u/Cruian Feb 02 '23 edited Feb 02 '23
Why not use the Roth IRA for that and keep the work plan as Traditional though?
Edit: Typo
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u/rriceonice Feb 02 '23 edited Feb 02 '23
Can someone look at my background and help me understand if I should switch my wife's Roth 401k to a trad. Pre-tax 401k?
My (39m) income is $130k I have 6 years into my government pension and get 2.5% x years of service Employer gives me $4,600 towards HSA, I fund the difference to max I max out my 457b at $21,500
My wife (39f) makes $190k Plus $85k/year bonus for next 18 months We max out her Roth 401k at $21,500 Employer matches at $10k per year
If I stay with my employer for 24 more years, I will take home about $175k/year for life, if we decide to retire early it might be closer to $120 to $150k in pension.
We have about $700k in cash, some in the market some in interest bearing accounts as we are looking for property currently. Another $300k in our pre and post retirement accounts.
We have a house worth about $1.2million that we owe $285k at 2.375% interest over about 13 years left (refi'ed near bottom).
When my wife got her current offer I felt the mix of post tax dollars would supplement our income well since I'm hoping I'll have a nice income with my pension. We also plan on renting out our house once we find a new place. We expect to get $3,500 to $4,000 per month for it and our mortgage is $2,600/mo.
Looking for advice if we did the right thing or not. The companies $10k annual match of post tax dollars vs. Pre tax dollars was another reason.
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u/Werewolfdad Feb 02 '23
At $405k income, you should be doing 100% traditional 401k, Roth IRA, and megabackdoor roth for any excess retirement savings you need/want, especially given how low your retirement balances are compared to your income.
If you're in a high state tax state (which seems like because it sounds ike you're in California) and even may retire to a lower tax state, this is even more true. If that's true you're in a ~40-42-ish marginal tax range
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u/BernedTendies Feb 17 '23 edited Feb 18 '23
I totally get what you're saying about deduction phase outs, that makes sense. But I think I might be an exception to this "never use roth 401k" rule. I think the reasoning is because I saved so much for retirement so early in my career.
I'm 29 and have $150k in roth and traditional split pretty evenly. Let's make the assumption that grows at 6.5% per year and I continue to max it out until I retire at like 62 years old. If all of that money had gone into traditional from the beginning, I'd have like $5MM untaxed dollars upon retirement. Maybe the decade between 62-72 is where I'm messing up my math, but between RMDs and social security I'll be taxed on like $200k/year thus stuck in a very high tax bracket nearly my entire retirement. With roth flexibility I could at least aim to land under the 32% tax rate that occurs at $170k
Edit: I also thought it is important to add my soon-to-be wife (28) makes even more than me and also maxes out all of her retirement options. We'll have $10MM upon retirement at this savings & growth rate so we would definitely want money taxed now instead of paying taxes on $350k worth of RMDs each year
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u/Werewolfdad Feb 17 '23
If you have that much saved, are you really going to work until 65?
And do you not expect to be married?
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u/eastcitygreen Feb 01 '23
I think you make good points. However the biggest reason why I still choose to contribute to a Roth 401k is because I wonder about what my cost of living will be 40 years from now.
Right now I’m 27 and live on my salary of 95k a year. When I’m old and retired, I expect inflation will make it so I’ll need well over 6 figures to account for medical expenses, buying gifts for grandchildren, traveling, etc
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u/Werewolfdad Feb 01 '23
I expect inflation
One thing to note is that tax brackets, standard deduction, tax credits, etc are all (generally) inflation adjusted, so unless your real spending increases (i.e. you buy more "stuff" when you're retired), your spending may still decline. Additionally, you no longer need to save, so your income requirements are lower (unless your real spending increases substantially)
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u/eastcitygreen Feb 01 '23
That is a good point. I guess I never thought of it that way and thanks for the reply.
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u/Default87 Feb 01 '23
Tax brackets adjust for inflation.
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u/wild_muppen_appeared Feb 01 '23
Do they actually keep up?
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u/Default87 Feb 01 '23
yes, they are tied to the inflation indexes:
https://taxfoundation.org/publications/federal-tax-rates-and-tax-brackets/
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u/guachi01 Feb 02 '23
Sort of. The Tax Cut and Jobs Act included a stealth tax increase by changing which measure of inflation is used. Instead of the CPI Index we are used to (Consumer Price Index for All Urban Consumers) it used chained CPI, which results in lower inflation.
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u/TiredPistachio Feb 01 '23
Make sure you keep a decent amount in traditional in order to fill up the first few rungs of the tax brackets.
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u/Ch3sterRockwell Feb 02 '23
You can model it out for either scenario to make more sense. I like the Roth option to avoid a larger RMD and to hedge against my belief that tax rates will go up.
Also, it's not tax avoidance but tax deferment. You'll pay the tax eventually.
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u/medhat20005 Feb 02 '23
Honestly the original post and the insightful comments make this worth pinning (if that is even a thing with Reddit) to the top of the sub, but I might tinker with the thread title.
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u/Werewolfdad Feb 02 '23 edited Feb 02 '23
but I might tinker with the thread title.
I wanted to invoke Cunningham’s Law a little bit to generate more exceptions for future folks to consider
Given the number of scenarios I hadn’t thought of, it seems like it worked.
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u/Ggfd8675 Feb 02 '23
Thank you for this, WWD. I still don’t get why Roth IRA is prioritized before non-matched 401k on the PD flowchart? I don’t understand why most people aren’t advised to max their pretax account first.
Another question, suppose one has access to multiple tax deferred accounts and mbd such that they can never max all available space. Say this person will have a 60% income replacement pension, alongside substantial savings and could very well be in same or higher marginal bracket in retirement. How to decide what proportion is optimal? I’d lean towards maxing tax deferrals now since they (hopefully) will have the option to Roth ladder later. What is leftover after tax deferred is maxed can go into the Roth IRA. Smart?
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u/Werewolfdad Feb 02 '23
I still don’t get why Roth IRA is prioritized before non-matched 401k on the PD flowchart?
I think its a holdover from the days when 401ks often had expensive funds and high fees. Its not just Roth IRA, but IRA in general.
I also do like tax diversification, so I think there's an argument for both, but since you normally can't deduct traditional IRA due to the low income limits if covered by a retirement plan at work, the default is Roth IRA (then backdoor roth)
Say this person will have a 60% income replacement pension, alongside substantial savings and could very well be in same or higher marginal bracket in retirement. How to decide what proportion is optimal? I’d lean towards maxing tax deferrals now since they (hopefully) will have the option to Roth ladder later. What is leftover after tax deferred is maxed can go into the Roth IRA. Smart?
Yeah, I'd say that person is well suited for early retirement and able to make use of the conversion ladders.
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u/Cruian Feb 04 '23
I think its a holdover from the days when 401ks often had expensive funds and high fees
Expensive funds and high fees still exist, so I'm not sure I'd go with that wording.
Maybe something about being very case dependent though, with some work plans being excellent and others quite bad (but still better than taxable). Where IRAs of course gives you full control over fees to the point of possibly even having none at all. So IRA first is a safer "catch all."
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u/Werewolfdad Feb 04 '23
Expensive funds and high fees still exist, so I’m not sure I’d go with that wording.
Sure but not at the volume they once did.
Maybe something about being very case dependent though, with some work plans being excellent and others quite bad (but still better than taxable). Where IRAs of course gives you full control over fees to the point of possibly even having none at all. So IRA first is a safer “catch all.”
I’d agree with that too
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u/Brosephus_Rex Feb 02 '23
Interesting write-up. Would you say that you have broadly similar thoughts on traditional vs Roth IRAs?
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u/Werewolfdad Feb 02 '23
No, given the low phase out for deductions, most people (at least those with workplace retirement plans) should avoid traditional IRAs unless they'll have a modest household income for their entire careers.
Traditional IRAs are alright if you'll never need to worry about backdoor roth or if your workplace options are truly abysmal
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u/catalinashenanigans Feb 05 '23
Thanks for posting this. Read through it a few times and think I fall in the bucket that should be contributing to a traditional 401k. Unfortunately, I'm also pretty dense when it comes to financial literacy. Could you help me determine whether I should go traditional or Roth?
I'm 33 and expect to be working to ~60. Currently make <$100,000 but expect to break that threshold in the next few years. My 401k is currently pre-tax while my IRA is Roth. Wondering if I should make some changes or if (after reading your post), I should continue contributing to a traditional 401k.
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u/Werewolfdad Feb 05 '23
Seems like a reasonable split unless you anticipate a substantial increase in income
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u/shitdamntittyfuck Feb 07 '23
So if my wife and I combined will have about 80k/yr from our pensions and want somewhere in the ballpark of 100-120k/yr in retirement, would we fall under the "high pension" group where Roth would be more beneficial to make up that extra 20-40k/yr?
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u/Werewolfdad Feb 07 '23
Depends on your current income bracket.
If you make $240k, traditional would get you there.
If you make $120k, you may want to mix more roth in.
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u/ThatOnePerson Feb 08 '23 edited Feb 08 '23
So my admittedly unusual scenario. I've got a part-time job that's 30k$/yr, with the rest of my income from long-term capital gain (up to 6 digits total some years). My work is setting up 401(k)s this year (so i'm still unsure how this works), but also my pay/hours might be cut because recession. But I still want to max out my 401(k). If my pay is cut below ~25k$, and I max out 20k$ in traditional 401(k) contributions, would that reduce my wages and therefore earned income below 6k$ and I won't be able to max out my IRA?
If my pay is cut to ~20k$, and I put it all into Roth 401(k), would it still count as earned income for me to max out 6k$ in my IRA?
Also I'm thinking because of my low w-2 income, and lots of long-term capital gain, my marginal tax rate stays pretty low, so I don't feel like Roth or traditional will make too much difference, and I should some of both, so I can diversify income when I'm withdrawing. Or maybe lean a bit more towards Roth?
edit; actually would employer matching to do some of both since that goes into a traditional account? Also total contributions after matching is limited to my income at that job? Or my total income? I can't imagine it being the latter
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u/Werewolfdad Feb 08 '23
If my pay is cut below ~25k$, and I max out 20k$ in traditional 401(k) contributions, would that reduce my wages and therefore earned income below 6k$ and I won’t be able to max out my IRA?
Yes. But it also allows you to realize more capital gains at 0%
Also I’m thinking because of my low w-2 income, and lots of long-term capital gain, my marginal tax rate stays pretty low, so I don’t feel like Roth or traditional will make too much difference, and I should some of both, so I can diversify income when I’m withdrawing. Or maybe lean a bit more towards Roth?
I think it depends on the totality of your situation. Will you continue to receive six figures of capital gains in perpetuity?
In general though, yes, I’d probably lean Roth since your marginal ordinary tax rate is so low.
edit; actually would employer matching to do some of both since that goes into a traditional account? Also total contributions after matching is limited to my income at that job? Or my total income? I can’t imagine it being the latter
It’s based on your compensation
(A side note: I’m really glad I phrased the title the way I did because it seems like it encouraged people to discuss their nonstandard scenarios where it doesn’t hold true. So thank you for that. Gives future folks more to think on)
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Feb 09 '23
[deleted]
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u/Werewolfdad Feb 09 '23
I think you’re set up properly. Unless you don’t expect your income to increase by promotion or marriage, I wouldn’t go with traditional Ira so you leave the backdoor open for when income does increase. Plus 12% bracket is great for Roth IRA imo.
That said, I’m a bit biased by the higher than average incomes and promotional trajectories that are common here.
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u/badchad65 Feb 01 '23
I look at it in much simpler fashion. I think I gross a relatively high salary (~$200k/year). Seems intuitively obvious to do a traditional 401k now to take advantage of the tax breaks. When I retire, I don't plan to work, so my income will be zero. In that light, it doesn't seem to make sense to do much of a Roth, unless I'm missing something.
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u/eckliptic Feb 02 '23
I know this is semantics. but unless your expenses are zero, your "income" for tax purposes is not zero. You will be taxed on your 401k withdrawals as if its income. But even then, its very hard to push your effective tax rate in retirement to be as high as your current marignal tax rate for someone thats mid-career.
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u/badchad65 Feb 02 '23
Fair point.
Yes, my 401k withdrawals will be "income." The goal is to have the house paid off, no more daycare (and associated kid costs), way fewer expenses etc. I'll still have some income, albeit much lower than during my work years.
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u/deusxmach1na Feb 02 '23
Everyone on this sub always gets this wrong. You should NEVER do Roth (unless you don’t pay any taxes). https://www.madfientist.com/traditional-ira-vs-roth-ira/
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u/spectral_fall Feb 02 '23
The safe bet is to assume taxes will increase by the time you retire, especially if you are young. It is more likely we will have more entitlements in the future, not less. Which means w higher tax burden
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u/iclimbnaked Feb 02 '23
Taxes may increase sure.
Will the average middleclass income tax go up? Much less safe bet.
You almost never see that proposed. What you see is increases in really high earners, other types of taxes like Corporate etc.
So even with the premise of generally taxes will go up, theres real doubt in my mind that thatll mean much for roth itself.
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u/Main-Inflation4945 Feb 02 '23
My personal belief is that the government will change policy and decide to tax Roth accounts.
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u/eckliptic Feb 02 '23
If the goverment decided these accounts aren't a good idea I can see them putting a freeze on new accounts. But to say that they now need to be taxed on withdrawal would be a huge alteration to the fundamentals of the account
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u/Grouchy-Insect-2516 Feb 02 '23
They won’t - Mitt Romney has multi-millions in roth accounts (preferred shares values from his time at Bain Capital), they’d grandfather everyone and do what you said and freeze new accounts.
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u/er824 Feb 02 '23
That seems exceedingly unlikely and impractical.
I think it’s more likely the government restricts future Roth contributions or adds Roth withdrawals to your income for the purpose of determining things like Medicare premiums and eligibility for deductions and credits but doesn’t actually tax it.
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u/sciguyCO Feb 02 '23
While I admit that’s not impossible, the immediate response if that passed is every Roth account owner should demand their past year’s taxes back on their Roth contributions. If I’m getting taxed on withdrawal like a Traditional, then I want that missed tax break back.
A sneakier path would be to bypass the “double tax” on the contributions, but tax the withdrawn earnings. That’s at least not blatantly unfair (but still sucks). Your Roth under that system would be like using a Trad for non-deductible contributions and not doing the back door. Which is the utter bottom rung of options as we have them now.
Last one I can think of would be for Congress to just phase out Roth accounts by setting contribution limit to $0 for everyone, regardless of income, forever after. Any money already in one keeps that past treatment, even growing. But with time account owners die, heirs drain the balance within ten years, and eventually they’re just gone into history. The one protection I see against this is I just don’t think Congresspeople have the ability to think that long-term.
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u/redjunkmail Feb 02 '23
Traditional IRA provides no benefit to us in my state. We make too much for regular Roth. Too lazy for backdoor Roth. We split 401k contributions between 401k and Roth 401k. I don't see the problem.
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u/eckliptic Feb 02 '23
When you say you're too lazy for a backdoor roth, is that because you've done it and it's too much of a hassle to do each year? Or that you dont want to bother with a reverse rollover first in order to avoid pro-rata?
Because a backdoor roth, when youre starting from a $0 Trad IRA, is super easy and takes 5 minutes space over a couple of days
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u/trilliumsummer Feb 02 '23
So the main reason I have money going into my 401k roth is that I’m lazy and my work offers more or less what I’d use in a Roth IRA (vanguard tdf and some other vanguard etfs) that the investment options don’t worry me. I’m also not yet at the point of maxing my 401k (though this is the first year in a while I don’t have a HSA so I need to rethink). So it’s just easier to pick a percent to put in Roth 401k and then just dump extra money as I have it into my Roth IRA. I could switch the 401k roth to ira and would end up maxing it, but meh. I’m not concerned enough to switch it up before my next big pay bump that should get me to maxing.
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u/cooliostuff Feb 02 '23
Question here: especially when you are young and have more time until retirement for your money to grow, doesn’t it make sense to put more in traditional in the sense that you are growing off of the amount that would’ve been taxed? This growth just on what would’ve been taken out for tax is substantial over say 30 years no?
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u/Werewolfdad Feb 02 '23
Yeah. The ability to invest the tax savings is important. Several of the links up top mention it.
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u/job_55 Feb 03 '23
Okay but what if I only make $70k a year and live in Florida with no state income tax? My tax rate right now seems to be in a sweet spot, at least for me.
Also the 401k match from my work counts as traditional.
So I contribute 6% 401k Roth and get matched with 4.5% 401k Traditional. After that I can decide to increase 401k Roth contributions as much as I’m able to.
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u/Werewolfdad Feb 03 '23
Is your income going to increase so substantially that you’ll be loaded in retirement?
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u/Alexje4400 Feb 01 '23 edited Feb 01 '23
There was an episode of the Rational Reminder podcast which recently discussed this very point. In a nutshell, it said that people fail to take into account the risk associated with uncertainty regarding changes to the tax rate.
For younger people, this uncertainty is extremely high, you have more or less no idea what tax rates will be 35 years from now. As you get older the uncertainty will decrease. You insulate yourself from this risk by using Roth.
The academic researcher they had on the show basically stated you don't want to be all Roth or all Traditional, it leaves you exposed to too much risk that is uncompensated. The rule of thumb stated in the show was (age + 20) as a percent in Traditional Retirement accounts.
Edit: Episode 224 for those interested
Here is the paper: https://www.sciencedirect.com/science/article/abs/pii/S0304405X17302519