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401k part 2 – Traditional VS ROTH 401k

by retirebyforty on November 3, 2010 · 12 comments

in retireby40's investing fundamentals

If you don’t have a Roth IRA account, you should open one to give yourself the more options in the future. Open an E*TRADE Roth IRA. No Fees. No minimums and get up to $600 when you rollover or transfer.

Roth 401k  first became available in 2006, and many companies slowly rolled out the plan over the next few years.  The key difference from the traditional 401k is:  The contribution to ROTH 401k is taxed at your current rate and the withdrawal will be tax-free in retirement (after 59 and a half.)

Let’s go through the ROTH 401k.

This is actually quite complicated.  The current tax rate is at a historic low and will likely go up in the future because the government will have to pay for the budget deficit, social security, health care, wars, and more. So there maybe some advantages to paying tax now rather than later.

Your top tax rate is 15% to 25%:

You should consider going with the ROTH 401k plan if you already contribute the maximum.  For example, you contribute $5,000 to the traditional plan this year and your tax rate is 25%. Then if you choose ROTH 401k next year and keep the take home pay the same, you would be contributing only $3,750 (5,000×75%).  It is better to have the larger sum in the 401k so it can compound. If you are already contributing the max and can handle the smaller take home check, then it is a good idea to max out on ROTH 401k. If you  max out, the total amount in the account is the same in both cases, but the ROTH 401k is worth more because you won’t have to pay tax in the future. If you are not maxing out, then go with traditional 401k and contribute to ROTH IRA.

Your top tax rate is 33% or higher:

If your income puts you in the high tax rate, then ROTH 401k is probably not for you. The contribution comes off the top bracket and if you are discipline, you can invest that tax deduction in an individual investment account. The exception is if you want tax diversification and your income disqualify you from ROTH IRA. In this case, ROTH 401k maybe the right fit.

Another option is to split the contribution and put some money in traditional and some in ROTH 401k as you see fit.

When you retire, the advantage of ROTH 401k is TAX diversification. When you are ready to withdraw the money, you can withdraw from a taxable account up to the top of a bracket and then withdraw more from the ROTH accounts.

Example – A 2010 retiree can draw 34,000 from traditional 401k account and pay up to 15% tax.  Then he/she can withdraw $15,000 from ROTH accounts and avoid the 25% bracket.

The last advantage to ROTH 401k is the distribution option.  If your 401k is large, say $400,000, your inheritance would be taxed up the wazoo if the unthinkable happens.  With ROTH, the beneficiary will keep the whole amount.

retirebyforty’s take on ROTH 401k -

ROTH 401k – for people who are in the 15% or 25% tax bracket and already maxed out.

ROTH 401k – for high income earner who can’t contribute to ROTH IRA and want TAX diversification.

ROTH 401k – for people who can’t keep their paws off the extra money in the bank (tax refund from traditional 401k.) You won’t have to deal with temptation once you set up ROTH 401k auto deduction.

Traditional 401k – if you are not maxing out.

Traditional 401k – if you hate paying tax and want to put it off as long as possible.

If you don’t have a Roth IRA account, you should open one to give yourself the more options in the future. Open an E*TRADE Roth IRA. No Fees. No minimums and get up to $600 when you rollover or transfer.

Am I missing anything? Are you contributing to the traditional or ROTH 401k? Hopefully you read part 1 and is working toward max contribution.

Note: ROTH IRA Eligibility for 2010 phases out between $105,000 and $120,000 for single filers and $167,000 to $177,000 for those who are married and file jointly.

part 1 – The Low Down on 401k

Part 3 – mistakes and pitfalls, retirebyforty’s 401k portfolio

{ 10 comments… read them below or add one }

Jessica07 November 4, 2010 at 3:31 pm

Great analysis, and I think you’re right about the likelihood of taxes increasing (making it reasonable to pay them now, rather than when they’re higher).

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retirebyforty November 4, 2010 at 6:30 pm

Thank you. I think I will have to rewrite this at some point. There are way too many ifs in this post. It was a tough day at work.

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learner January 8, 2012 at 8:48 am

Can you please clarify what you mean by the top tax rate? Is it the Federal tax rate or Federal + State? Thanks.

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retirebyforty January 9, 2012 at 8:49 am

I’m just talking about Federal tax rate because the state tax rates are so diverse.

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learner January 9, 2012 at 6:13 pm

Thanks, helpful article!

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Eric October 23, 2013 at 5:45 am

I like the fact that my Roth distributions in the future won’t contribute to kicking my social security payments into higher taxability. That is a major downside to regular IRA or 401(k) distributions, especially when you get over age 70.5 and are required to take minimum distributions. It gets tough to avoid being forced into Social Security taxability.

Roth distributions also avoid any impact from the new 3.8% net investment income tax under the Affordable Care Act. Regular IRA or 401(k) distributions, while not directly taxable as investment income, do affect the calculation of modified adjusted gross income in relation to the threshold amounts and could possibly kick more income into being taxed.

Full retirement is probably 10 years away for us, and we are betting heavily on Roth IRAs and Roth 401(k)s for these very reasons. If it turns out that we have so much investment and passive income that these taxes become unavoidable, it just means that we are sitting pretty after all.

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retirebyforty October 23, 2013 at 6:27 am

Roth is great for tax planning. Good luck with retirement.

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Eric October 23, 2013 at 5:51 am

Higher brackets resulting from regular taxable distributions also means higher rates on capital gains from your regular taxable transactions as well. So there’s a third reason in favor of the Roth. If you thread the needle just right, you could live pretty comfortably while paying hardly any tax at all. Social security, plus Roth distributions, plus qualified dividends and capital gains, plus very little else on your tax return, equals practically nothing in tax.

Good luck all!
Eric

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Eric October 23, 2013 at 6:59 am

And by the way, I do understand the articles that argue against the Roths, but it seems to me most of them are stricly a “tax bracket now vs tax bracket later” sort of analysis. Very few factor in the impacts of taxable distributions on social security taxability, Obamacare taxes, or cap gain and dividend rates. I think that is where they fall down. You think you are heading for lower brackets in the future, and then…oops! Not so much, if you look at true marginal rates.

My opinion only of course! Your mileage may vary!

Loving your blog. I’m a newbie here and going through the archives in chronological order, so don’t be surprised if you see a comment here or there on more old posts, or ones that have been updated long since.

Keep up the good work.

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retirebyforty October 23, 2013 at 8:12 am

You’re right about all the extra taxes. I’m sure the tax will go up at some point too.
I like to have a mix of traditional and Roth. That way we have more flexibility when we withdraw.
Thanks for reading! Some old posts are sub-par so you can skip those. :)

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