Roth vs Traditional 401k

Big IF is right. Traditional 401(k)(or IRA) withdrawals can impact Social Security payments, when half of your Social Security benefits and other income exceed $32,000, your benefits become taxable. So while you plan to be in a lower bracket at retirement, there exists a phantom

46.25% bracket that for a single person can kick in at $30K/yr withdrawal. I haven't done the math for couples, it's my next project. By retiring at 50, I trust you're not counting too heavily on SS anyway?

Roth money is denser® than non-Roth. By that I mean $15,500 in a Roth is worth $15,500, but in the standard 401(k) it's worth as little as $10,000 or less. I'd favor a mix. You did not mention what your employer matches (or what plan your wife has available), but the match will be in a traditional side of your 401(k). I'd say for you to choose Roth, with matching going traditional. You can always change from year to year if you choose or the projected numbers point you the other way.

JOE

Thanks Joe.

My company matches 50% of the first 3% of salary. My wife maxes out her 401k as well and also just received the choice of going Roth. Would you recommend an even split (i.e. 7750 this year) to each for both of us? Or would you suggest one of us goes all Roth and one goes all traditional? My wife does not receive a match at all if that matters.

Combination of both is a good thing.

Consider what you have now as the basis for the IRA/ traditional 401k (which will be taxed at retirement).

I would open the Roth so it grows to more than the 10k you have now. You may also want to consider opening a taxable account because you will need income between age 50 (early retirement age) and standard retirement age (59.5 for access to IRAs).

Agreed, but with the new roth rules, I have moved the taxable brokerage account farther down my list. The Roth contributions can be taken out between age 50 and 59.5 without tax concern and the roth earnings will be tax free after 59.5 whereas the taxable account will not. I cannot say whether the Roth contribs will be sufficient to cover the 9.5 years with the info available. In addition there is also the 72(t) option to access funds pre-retirement.

He could begin make non-deductible IRA contribs for him and his wife and then convert in 2010. This would bulk up the Roth balances available. Even an intelligently shopped variable annuity would provide tax deferral. Of course all of this brings us back around to the "tax now" vs "tax later" argument.

If all of these things are accounted for then perhaps any excess savings should be put into a taxable brokerage account. Hey, its better than the mattress (usually).

To the OP, you mentioned using your wife's account as solely for Roth and your solely for IRA (or vice versa). I would hesitate to do this if inheritance and/or estate planning will ever be a concern. Roths and traditional IRA differ in tax treatment when it comes time to pass them on (even in RMDs before death). Roths can continue on quite easily after death, but IRAs have stretch provisions and distribution rules that may not fit your families plan. Loading up on one type over the other may complicate things after one (or both) of you pass away. The pain will probably go unnoticed until your kids become the heirs, but by then its too late. 401(k)s, whether Roth or not, are largely dependent on the individual plan and can make things even more complicated. What are you goals for your estate?

One last note on your wife: It sounds like there is nothing available to your wife that can compete with the contribution limits of the

401(k). However, because there is no match, pay close attention to the fees, expenses, and investment choices in your wife's plan. Other than high contribution limits, 401(k)s are largely revered because of the match ("free money"). This is not the case for her. Does she have any other income, side job, or hobby that could be income producing?

In my perfect world, the tax structure would be consistent enough so the numbers today could be adjusted for inflation, and I could give you a forecast for your tax bracket that would have some level of accuracy. I do not live in that world.

Since you talk about early retirement, my remarks about the Social Security Trap® can be put aside for the moment. Let's talk about now for a second. See

a couple can have income of $63,700 +$6800 exemptions +$10,700 STD deduction, total, $81,200. To generate this sum with the 4% rule, one would need $2.03M. So, I surmise that you are above that income level (and in the 25% bracket) today. If so, you may be well into the 25% bracket, in which case 50/50 can be good, or you may be on track to save well above the present value of $2.03M, risking a higher bracket at retirement. Not knowing those two figures, present income, and targeted retirement income, I can't complete a response. Just share my thoughts.Retiring today, you'd want the $2M in a traditional account, to stay at 15%, and anything over that to be in Roth or post tax accounts. I hope that helps get you closer to your answer. JOE

See the original post. They live off her income and bank his. I think she's doing fine working, I doubt she needs a hobby. You are right about 401(k) expense impacting the decision on her account, for both of them, the expense is a good probing question. JOE

As you've keyed into, the choice hinges on an unknown/unknowable variable: your tax rate during retirement. A near-retiree at least has a sense of this, but it's very hard for you to even guess.

If you're DQ'd from the Roth your AGI is north of $160k. What is your taxable income, and your marginal tax rate (meaning the combined state + federal tax on your last dollar earned)? In addition to being DQ'd from Roths, do you have other high-AGI effects on your tax return, such as phase-out of your itemized deductions? Did you pay AMT in 2006?

That's a good first step, looking at that stuff, because it tells you the tax benefit for the pre-tax 401k...

-Tad

Thanks again to everyone providing advice. I think I am leaning towards splitting my contributions and my wifes into the Traditional and Roth. I hadn't thought of the estate consequences of doing one or both in total, so this helped.

Some additional information/clarification given some of the questions in this post:

- Present household income is 320k before bonus

- Desired retirement income is 120k in today's dollars

- My company matches 50% of the first 6% (not 3 as previously stated)

- 401k balance around 110k for each of us (220 total)

- We have a taxable account for retirement as well. Current value is around 300k with additions of $4,500 a month.

- My wife will definitely not be picking up another job or hobby. Working 60 hours a week and raising us 3 boys is work enough :).

Take a look at this spreadsheet.

You are well ahead of target. The 4% withdrawal allowed at retirement indicates to replace one's income, 25 times final year salary is needed.In current dollars, you wish to have 3/8 final salary, so if you retired today, 9-3/8 times current income. Plugging in your salaries and current savings balance, along with just 25% savings rate (I think yours is higher, closer to 30%), and assuming an 8% return, you reach that goal in less than 17 years. Given your current high income and tax rate, deep into the 33% bracket, I lean more toward traditional 401(k) and IRA. Don't forget, you can still put $4000/yr, each, into a non-deductible IRA, and can convert to Roth with upcoming tax laws changing in 2009-10, or when you retire.

JOE

I was probing to see if she could convert a hobby into additional income and use that income for a SEP or solo 401(k) in which she could manage fees, expenses, and investment options herself. I wasn't suggesting she take on a new employ. Some people work on computers on the weekend, or tune up cars. If you can find a way to make money at it, you open up your retirement options. I usually wouldn't go that route because of the employer match from the primary job is tough to beat, but that is not the case here.

Agreed. I commend both of you on your success. No additional retirement options are worth burning yourself out for.

What is most tax efficient on way in, is not the tax efficient on the way out.

Being in 33% tax bracket suggests you want to defer taxes as much as possible (the likelhood you will be in 33% tax bracket during retirement is low, IMO, considering you live off a fraction of this now. The 120k per year you "live off of" is in 25% bracket, almost in

28% bracket.

Using traditional 401k saves you 33% now, and costs you 25% later (if tax brackets hold).

Tax efficient going in:

1) 401k/ traditional IRA accounts 2) Roth accounts 3) taxable accounts

Tax efficient coming out**

1) Roth 2) taxable accounts 3) 401k/ traditional IRAs

** when withdrawing, consider capping out tax bracket with withdraws from 401k, converting the excess to a Roth to improve tax efficiency in subsequent years

Using qualified dividends as part of strategy can allow you to have income taxed at 15% as opposed to higher 25, 28 or 33% tax brackets.

My guess is your marginal dollar is taxed at 45% or more, unless you're in a state without income tax -- factoring in both the tax bracket and phase-outs. And you don't have much in the way of pretax dollars in

401ks yet (110k) so aren't facing the "too big an IRA" problem. And you're planning early retirement (50) and have ample nonqualified assets to tap into initially (300k+, and growing).

To me all that leans -- heavily -- towards the deductible 401k, for the known/immediate tax benefit.

And plan on doing partial Roth conversions during the first 20 years of retirement...live off that taxable account initially, and you may be able to do them at zero tax. That should leave you way ahead of doing Roth 401k contributions now (bottom-line, after-tax). It's conceivable you could enjoy both the advantages of the Roth (tax-free growth, no RMD) plus the advantages of the deductible 401k (immediate tax deduction).

One risk of this, which is present with any tax-focused strategy, is a change in tax law. For example, changing rules on Roth conversions.

-Tad

After doing some additional research, and reading through your responses, I have decided to continue maxing out the traditional

401k. I agree with others that it is difficult to imagine a scenario where our tax bracket would be higher in retirement. Regardless, the smart bet would be that it will be lower. I really like Tad's strategy above which should allow us to take advantage of both plans. For what it's worth, I am in Illinois, which has a 3% income tax.

Follow up question: Given that we want to retire before we can tap into the tax deferred money, what have people found in this group is the most efficient way to bridge that gap? I am sure we will have part time work that will cover a majority of our needs during that 10 year period. Is it smart to use the taxable money first, open an immediate annuity, some sort of whole life product, what?

"ChiSaver" wrote

One thought much bandied about by students of the U.S. economy is that income tax rates must go up, in general, to pay for the greater population on Social Security, plus the rising costs of Medicare, added to the burdens of the national debt. While you may presume a lower income in retirement, do not be too sure this means lower taxes.

If you can live off dividends or just the capital gains in a taxable account, that would significantly lower your tax footprint. It would also allow your portfolio to last longer (because you would not be touching principal).

Possibly, but AMT can become a problem. Large cap. gains + one or two deductions and the AMT can beat you like a rented mule. Hopefully, Congress will make changes so that the AMT actually affects those that it was intended to, but until then I would be leary of it.