Change from Roth 401(k) to pre-tax 401(k) to get back full child tax credit and avoid AMT?

Feb 17, 2011 1 Replies
J

Lucky for me, my income is sufficiently high that I lost a good chunk of the child tax credit on my 2010 taxes and also had to pay around $500 in AMT. D'oh! I'm trying to figure out how to take some of the bite out of both of those when tax time rolls around next year.



Right now all of my 401(k) withholding at work is going into a Roth 401(k), i.e., it's post-tax and added to my AGI.



I'm thinking that for each $1,000 that I contribute to a pre-tax 401(k) instead:


  • My AGI is reduced by ,000, so I get back of the child tax credit.


  • My AGI is reduced so I pay less in AMT.

  • The taxes that I don't have to pay as a result can go toward paying down my debt, and thus reducing the interest I'm paying on it.

Now, if I'm understanding correctly, the biggest risk in doing this is that if my tax rate when I retire ends up being higher than my current tax rate, I'll end up paying significantly more in taxes when I withdraw money from the pre-tax 401(k).



I've been working under the assumption that my tax rate under retirement would, in fact, be higher, since I will (I hope) no longer be paying interest on a mortgage, will have only two exemptions (wifey and me), and won't have any kids to take a child tax credit for.



However, when I look at what the SSA says my monthly benefits will be, combined with what I'll be likely to afford being able to take out of my retirement funds every year, it seems to me that (a) I probably won't be living the high life (although God willing I won't be poor), and (b) the tax brackets are progressive, so I'll only be paying the higher tax rate on the top end of what I take out of my funds.



Taking all this into account, I'm feeling like I should probably be switching from Roth 401(k) contributions to pre-tax 401(k) contributions. I'm interested in hearing from the readers of this newsgroup whether my thinking on this is sound.



(I realize that would be an easier question to answer if I gave more details about my financial situation, but that's not something I feel comfortable doing in a public newsgroup posting, so please answer as best you can given the available information. Thanks!)


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J

First, this is one of tax code results that I call "phantom rate." Regardless of what the marginal rate looks like (you seem to be in the

25% bracket) a difference of +/- $100 in income results in a tax change of greater than that rate. The child tax credit of $1000 phases out over a $20K income range creating a 5% surcharge to your bracket. Unfortunately, If read pub 972 correctly, the math results in a sawtooth, not a step function. $1000 of income reduces the credit by $50, but the form tell you to round to next thousand, so (to quote the form) "increase $1025 to $2000" thus losing another $50 credit for $25 in income. If I misread, I hope to be corrected here.

You are right to observe that the retirement account impact is right up top, at the margin, but withdrawal start at $0.

In an article I wrote in '09

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walk through the math of how your first $467,500 in pretax funds results in staying within the standard deduction and exemptions. Another $417,500 to fill the 10% bracket. So, until you have nearly $1M in pretax savings, you're not close to having an issue with rates during retirement. There's a phantom rate structure that kicks in when you are taking Social Security benefits, something to note, but not a deal breaker on this advice as (a) who knows if it will be around when we retire, (b) you have the years between retiring and starting SS in which to convert, filling the 15% bracket and reducing the RMDs and taxes further down the road.

By the way, your employer may offer in-service conversions, the ability to go pretax 401(k) but convert at will. Nice way to do a 11/30 dry run, and nail down an exact amount you want to Roth.

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