Roth 401K?

I find myself in a similar decision making situation. I chose to stick with traditional 401k and Roth IRA.

for this discussion, I see 4 types of accounts:

Traditional IRA Traditional 401k Roth IRA Roth 401k

two types of withdrawl rules (more or less): The traditional accounts have one set of rules and the Roth accounts have another set of rules. If you are not aware of the withdraw rules (and the differences), I suggest asking.

In your situation I would look at "how much" will be in traditional type of accounts at retirement age and what the RMD (required minimum distrubution) would be. I would compare this amount to tax tables to see if the RMD is in your same current tax bracket or higher than your current tax bracket.

In my situation I believe my traditional 401k withdraws will still be in my current tax bracket, so taking the tax break now is more important than the other benefits later of the Roth 401k.

Two other questions- do you have any money in a Roth IRA at present time? If you retire, do you plan to withdraw from 401k immediately or do you have other assets you are going to draw down in taxable accounts first?

That's high. In such a high tax bracket, the savings from the traditional 401k is significant (.4 * 15k = 6k). I would count this as a big pro for the traditional 401k.

Another potential pro for the traditional 401k. The Roth is at its best when the money is allowed to sit and compound for a LONG time. That being said, there's no reason you have to spend your Roth dollars immediately upon retirement. If you have enough savings other than the Roth, the Roth could happily sit and compound forever. I believe the Roth is also superior for your heirs (I don't know the details of this; someone correct me if I'm wrong).

This is a pro for the Roth. If you're maxing out your 401k contribution, the Roth option allows you to tax-advantage more money. If you max out a traditional 401k, part of your contribution belongs to the government in the form of taxes. Eventually, you'll have to give that money back (hopefully you give back less because you're in a lower tax bracket). With a Roth, all the money is yours.

Another pro for the traditional 401k (but it's really the same pro as your tax bracket). Your lack of mortgage interest raises your tax bracket, making the traditional 401k more attractive.

Excellent idea. People often discuss diversity among assets and asset classes but sometimes ignore diversity among tax shelters. It sounds like you have significant savings in your traditional 401k. Contributing to a Roth at this point will give you more diversification at the tax shelter level. This is important because there's no way to predict what Congress will do to the tax code.

--Bill

Well, part of the issue is that stuff happens, rates may change.

is where I recommend to view tax brackets. If you're that close to retiring, you likely have a good idea what your taxable income will be, and you can see what bracket you'd fall into. If you are pretty sure the bracket will drop, you would be better off sticking with the 401(k) and its tax savings. Then, at retirement, beginning the process of converting just enough to a Roth IRA each year to 'top off' the bracket you are in. Fully funding for 20 years means you have quite the balance. RMDs have a way of creaping up fast as your balance increases with time, and your RMD divisor drops as you age. The spreadsheets will show that so close to retirement, if there's a tax bracket differential (lower rate at retirement) that the advantage leans toward the regular 401(k). JOE

To be truthful, I think higher taxes (in the future) are on the way. I would go for Roth. Medicare and Social Security are more or less going bankrupt, our government deficit is gigantic an our trade deficit is huge as well. I don't think there's any way that we can expect a lower tax rate in the next several years no matter who is in office.

rg wrote:

Why? It seems that time is immaterial to this decision, all else being equal.

-Will

And so I'd turn to the spreadsheet, only this one I can do on a napkin.

401(k) = G * (1.x)^Y * (1-t) Roth = G * (1-t) * (1.x)^Y

Where Gross is the amount one has available to put in the account, x is the rate of return (whatever you'd like), Y= number of years t is your marginal tax rate. Doesn't matter when you pay the tax, if the rate is the same in and out, there's no difference.

The presumption that favors the 401(k) is that more people will be in a lower bracket at retirement than while working. Of course, this is a generalization that applies to some percent of retirees. 60%? 80%? I don't know, but when I hear of the paltry sums that people have saved who are nearing retirement age, I believe the generalization is accurate. The above napkin math assumes the same expenses in both accounts. JOE

and as taxes rise ... and newer, more aggressive taxation is put in place ... what make you (anyone?) so sure that a Roth will remain untaxed upon withdrawal? When the situation is dire (as Medicare, SS, and Uncle Sam in general, will surely be as the years grind on) -- when it gets bad enough ... are you sure they wouldn't go after the billions (trillions?) currently socked away in Roths?

I expect (although I have no basis in fact) that it will go at least that far, and likely a lot farther.

Hypothetically, think in terms of, say, a wealth tax. Uncle Sam says "You've got a million-er-two saved up ... we need some. We're gonna take 5% of that a year ... just for the privelege of having it when others don't. Give it up or face the FiringSquad(tm)"

It could happen.

Worst case ... the U.S. economy and the Dollar collapse. Your Roth is now completely worthless.

It *could* happen.

My point is, expectations about what may or may not happen in the future with regards to taxation (or anything, for that matter) are nothing more than a guess. Better to have some contingencies in place.

.

Is this a typo? Those two formulas are exactly the same, mathematically.

The answer is pretty simple. Earnings on a 401k/Trad.IRA are tax-DEFERRED, earnings on a Roth are tax-FREE. The longer your investment sits around, the greater the portion of the total which is due to earnings rather than initial investment, hence the greater the impact of the tax-FREE benefit.

Eliminating taxes altogether on one years' worth of earnings is good, eliminating it on ten, twenty, or forty years' worth of earnings is really, really good. I don't care how high or low your tax bracket goes, nor how much you discount future values, zero taxes always beats non-zero taxes.

Like others, I believe there is some chance that the promise of the Roth will someday be broken, so diversify by taxability along with all the other dimensions. After all, the things you buy with Roth distributions will still be subject to sales tax, and it wouldn't take much to tweak the AMT to make earnings in a Roth potentially taxable, at least for higher-income taxpayers.

-Mark Bole

No, it shows the math in order of occurrence. For the 401(k), the tax (1-t) happens at withdrawal, for the Roth, up front. One year, ten, a billion, no difference.

The only difference would be due to a change in tax rates. Follow the math above, and tell me why you would disagree. Keep in mind, Roth deposits are made with post tax money, so while zero is great, my (1-t) appears in both equations. I (only) care about high high/low my bracket goes. Spreadsheets (or in this case, napkins) don't lie. Of course, a bad equation can mess you up. Elle caught the typos I had on my VA analysis. You'd be kind to do the same for me above. JOE

You caught a small error from my POV

If you look- the first formula only raises the first variable exponentially and iss correct as explained the second forumla raises both exponentially in reality (but it not shown)... I think there needs to be a second set of () around the whole thing to show this

401(k) = G * (1.x)^Y * (1-t) Roth = [G * (1-t) * (1.x)]^Y

G = $1000 t=.28 x= .10 Y = 10 years

(1000*.72*1.1)^10 (792)^10 ??

You really want to raise 792 to the 10th?

My equation takes the 720 net and then multiplies by (1.1)^Y for whatever return and years. I admit I shook my head when I ran a spread sheet, and realized what was happening. Take another peek if you would. JOE

Joe, that's not a complete formula in the Roth-vs-regular 401k comparison because depending on your value for G, it either knocks down the Roth contribution below the limit, or allows the 401k to receive more than the allowed annual limit. Even if you don't contribute the maximum you need to factor in a different tax rate, applied to a taxable account, to make it a fair comparison.

Take 2007 - there's a $15,500 limit on the deferral to a 401k. In a Roth

401k you can defer a full $15,500 and receive no immediate tax benefit. Or you can defer $15,500 of pretax money. Either way the account receives $15,500.

In the Roth 401k, assuming say a 35% marginal state + fed tax rate, that represented $23,846 of pretax earnings. You pay the tax, the balance of $15.5k goes into the Roth 401k. If you use the regular 401k instead you defer $15,500 of that pretax, leaving yourself with another $8,346. Which becomes $5,425 after paying 35% taxes. Now you need to throw that $5425 into a side account (taxable) and make some assumptions about annual income, capital gains rates, etc, to run the horse race. After all if in Scenario A you were deferring the equivalent of $23,846 pretax for the Roth 401k you should use the same figure for Scenario B right?

So it's not as simple as just shifting the (1 - t) to the beginning or end of all those (1 + k) years of returns that are applied to G. In effect you have a G' and a k' and a t' coming along for the ride somewhere.

My view is that these tax-rate assumptions, especially if made over long time periods, introduce enough "slop" that this could come down to subjective criteria. Particularly when a comparison relies on a low capital gains rate (remember - Reagan abolished the capital gains rate and it's only slowly returned to its current low level).

I like the "hedge future tax rates" approach of splitting the baby. If someone already has a lot of qualified assets that could mean using the Roth 401k, simply to get money into that form (despite the immediate tax cost).

But I also believe in the assumption "take a certain immediate tax benefit over a potential future one". For someone paying 40% marginal taxes a full $15,500 Roth 401k deferral represents $38,750 in pretax income. Scenario B is...deferring $15,500 of that to a regular 401k leaving $23,250 pretax, or $13,950 post-tax, extra to throw in the taxable side account. The up-front tax hit of the Roth 401k seems a tough pill to swallow there - many retirees (including wealthy ones) aren't in the 40% bracket.

-Tad

Whups! Math post-o in my prior reply, last paragraph should read:

For someone paying 40% marginal taxes a full $15,500 Roth 401k deferral represents $25,833 in pretax income. Scenario B is...deferring $15,500 of that to a regular 401k leaving $10,333 pretax, or $6,200 post-tax, extra to throw in the taxable side account.

-Tad

All your points are valid, and well taken. I agree with the approach to diversify among the tax status of accounts. Of course, to simplify the math, and do apples to apples, I needed to assume a G. If one can put $15,000 into the 401(k), then I assume they will net 15000*(1-t) and put that in the Roth. You are right that the Roth guy has an option to invest more, another 15000*t, but the 401(k) had to pay that in taxes, so doesn't my approach provide consistency?

I agree with your remarks about taxes, but I was replying to Mark who stated the decision had -0- to do with relative tax rates. My point is that the choice would likely be based 'only' on taxes. BTW, t=tax rate, Y=years. Not sure where your k came from.

JOE

You're both correct. Joe's formula is accurate until you approach full funding, after which you must add the tax-savings of the traditional into another account to be fair. So if instead of just subtracting the taxes from the Roth, you also subtract the potential growth from those taxes you get:

401(k) = G * (1.x)^Y * (1-t) Roth = G * (1.x)^Y - G * t * (1.x)^Y * (1-t')

where t' is the effective tax you pay on the non-401(k) account.

If I can find a tax-free account for my saved taxes (t' = 0) then the Roth equation simplifies to the traditional 401(k) equation (Joe's original point).

Roth = G * (1-t) * (1.x)^Y

But if you pay any amount of tax on the Roth (t' > 0), then the Roth beats the 401(k) under Joe's assumptions. Note that t' = 0 when you are contributing less than your max contribution * (1-t).

-Will

This is not correct. Your Roth equation uses the contribution amount as a multiplier against itself. Think of it this way, your equation suggests phenomenal exponential growth for putting my money under the mattress (x = 0). After 30 years I'd have [G * (1-t)]^30 dollars. Too bad it doesn't really work this way...

-Will

This is Joe's point.

It sounds like you are trying to minimize taxes paid rather than maximize after-tax savings.

-Will

Joe, Will - agreed. I was assuming that given the relatively high tax bracket & impending retirement, the OP would be making a full deferral. At lower levels the original formula is fine, you can just mark down the value of the Roth contribution instead of carrying the side account. Though really it would depend on exactly what you planned to do with the $X in pretax dollars.

RE: my (1 + k) - old habits from finance class 20 years ago!

The weakest assumption in all this regards the tax rates. While the math works when you move that tax term from front to back (because a X b = b X a), it's unlikely t today will be the same as t at the end of the pipe. Heck we don't even necessarily know the 07 tax rate -- for several million taxpayers it's hinging on what this year's version of AMT reform looks like. And during retirement there's the side issue of Social Security benefits being taxed, or not, depending on the size of IRA distributions -- one might consider that a further tax on the IRA distribution. So seven years out, during distributions...who knows what the tax rate will be? Hence the fallback to subjective criteria like "favor immediate tax benefits."

-Tad

Not sure that isn't the same thing... But as one who was a math major, financial modeler, computer programmer, etc blah blah, I like the challenge of trying to put this into words rather than equations. (Kind of like something that vos Savant person in the Sunday newspaper insert would write...)

In the "normal" case where there are non-zero taxes throughout the investment period, the Roth would still be better in the end, and the longer your period, the "more better" it is. This is the original point I was responding to, namely a Roth investment for a 20-yr old is much more likely to be a winner than a Roth investment for a 50-yr old, because the 20-yr old will have thirty additional years of tax-free earnings. I was agreeing with Bill Woessner's original comment, which Will Trice was questioning (whew...)

But in an extreme case -- say, your first-year tax rate is 30%, and then it drops to zero for every year thereafter -- then the trad. IRA/401k ends up looking a lot like the Roth, and the little extra tax-deferred (or in this extreme case, tax-free) sweetener from the trad. plan in the first year makes it overall the better plan. If I were doing a graph, I would see that as the future tax rate approaches zero, the trad. IRA/401k approaches the Roth. There will be low enough rate somewhere out on the graph where the first year "bump" from traditional actually overcomes the normally better deal of forever tax-free earnings.

After all, when doing these types of analysis, shouldn't regular tax-free investments be thrown in for comparison as well? With municipal bonds, the tax benefit has been given to the borrower (state government), since they pay interest comparable to after-tax interest on regular investments. With the Roth the tax benefit has been given to the lender (investor), since they can earn before-tax interest rates but without ever paying tax on it. With the trad. IRA/401k, it seems to me one is merely given the ability to treat earned income a lot like a capital investment, with taxes deferred until the time of "sale" and hopefully at a lower rate by then.

-Mark Bole