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Should I Invest In 401k Or Roth IRA?

by retirebyforty on September 19, 2011 · 80 comments

in early retirement, investing

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Many young investors have this exact question – Should I Invest In a 401k Or Roth IRA? I’m talking about a specific situation where someone already invested in the 401k enough to get company matching. After that, should you invest further in 401(k) or Roth IRA?

Most people who consider investing assume that they should invest in Roth IRA because the investment will never be taxed again. However, the tax advantage of the 401k plan is still substantial even with no company matching.

Let’s use an excel sheet to calculate which one is better for an average investor.

Here are some assumptions.

  • The investor is in the 25% tax bracket. He can invest $5,000 in Roth IRA or $6,666 pre tax in 401k.
  • 8% annual gain
  • Investor retires at 60 and lives until 80. (A bit depressing.)
  • Withdrawal rate is (total money left / years left to live.)
  • After retirement, his income is derived solely from this portfolio, thus he has lower tax rate.  This is a big assumption, but mostly valid. Most retirees make less money after they retire and pay less tax annually.

Here is the graph of the 401(k) vs Roth IRA.

Should I invest in 401k or Roth IRA

As we expected the 401(k) portfolio grew much more than the Roth IRA because you start out with more money invested. The 401(k) portfolio grew to $815,558 at age 60 and the Roth IRA $611,668.

We need to zoom into the withdrawal period to see the differences between the two. This graph shows the income after tax.

401k vs Roth IRA withdrawal

The 401(k) plan has a bit of advantage here due to the lower tax rate after retirement.

At age 61, the 401k investor withdraws $40,778 from the 401(k) and receives $34,457 after tax. Assuming today’s tax rate, the investor pays about 15.5% tax on this income.

Withdrawal formula (total value of portfolio/years left to live) = ($815,558/20) = $40,778.

The Roth IRA investor withdraws $30,583 and keeps the whole amount.

We can see that if you invest in 401(k), you’ll have more retirement income even after tax. $4,000 might not seem like a large amount, but it is over 10% difference in income. In fact, the retiree will enjoy a total of $63,000 extra by investing in the 401(k) instead of the Roth IRA.

Of course, we made some assumptions above and the biggest one is that the tax rate will be lower after the investor retires. If the tax rate goes up in the future, then it maybe better to invest in the Roth IRA. I don’t think this will be true for me so I will continue to put the 401(k) first.

What do you think? Is it better to pay tax now and invest in Roth IRA or wait to pay tax after you retire? Personally, I think it’s better to max out the 401(k) first and then invest in Roth IRA. It’s best to max out both 401(k) and Roth IRA so you can take advantage of both programs. What do you do currently?

There is a great new website to help you manage your investments – Personal Capital. You can keep track of your income, expenses, and investments, all in one place. Personal Capital is geared for investors and have many great tools. See my review of Personal Capital and how they helped me reduce my investment fees.

You can read more about traditional 401(k) vs Roth 401(k) as well.

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{ 71 comments… read them below or add one }

cashflowmantra September 19, 2011 at 2:50 am

I have been maxing out the 401(k) although did start contributing to the Roth 401(k). I currently don’t have any individual accounts.

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retirebyforty September 19, 2011 at 3:40 pm

I contributed to Roth 401k last year, but I changed back to traditional 401k this year. I like the diversification, but I don’t like paying tax…

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Jon -- Free Money Wisdom September 21, 2011 at 7:34 pm

I am maxing out my Roth IRA first…and still contributing to my 401k. For me, the ROTH is the way to go.

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Little House September 19, 2011 at 6:51 am

Great number crunching going on here. My plan next year is to max out my 403(b) (without any matching since my pension is matched instead.) If I can eek out enough for an IRA, then great. If not, I’ll just have to hope my pension fund doesn’t disappear before I retire!

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retirebyforty September 19, 2011 at 3:41 pm

Great plan! Good luck with the pension, who knows what will happen in 30 years…

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Kevin @ Thousandaire.com September 19, 2011 at 7:42 am

The immediate liquidity of the Roth IRA makes it easily the first choice for my retirement (after the 6% matching my company gives me)

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retirebyforty September 19, 2011 at 3:42 pm

I forgot about the liquidity aspect. I’m not planning to withdraw anytime soon so it doesn’t matter all that much to me at the moment, but situation can change.

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Chris G September 19, 2011 at 8:28 am

I like Kevin’s comment, the ability to pull out the principal before 55 gives me a warm fuzzy. Also, I think that higher tax rates in the future would be a safer assumptions. But I say why not do both if you can :) Live frugal now, live like a king later.

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Roshawn @ Watson Inc September 19, 2011 at 10:08 am

I was going to point out the assumption that your income will be lower during retirement, but you already made that point. I like your last suggestion for most people: do both :)

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Ashley @ Money Talks September 19, 2011 at 10:50 am

My husband’s company doesn’t offer a match, so we just use the Roth. I like that better. I don’t agree with the assumption that your taxable income will be lower in retirement. Who knows? Right now I have a lot of deductions, kids, a mortgage, business expenses. Plus, who knows what the tax rates will be in 40 years. They might be higher, they might be lower. I might have more income, I might have less income. I mean, there are a lot of variables between now and then. I feel like I have more control over the investment choices in the Roth and I know that my obligations are already paid tax wise. But again, who knows, the government might change their mind about that too.

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retirebyforty September 19, 2011 at 3:46 pm

It’s going to take a huge change in the tax code to have my after retirement taxable income be more than my current income. Once I stop working, a big chunk of my income will disappear. I can’t see anyway that I will have more income in my retirement. It might be different if you are self employed though.

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Denise @ The Single Saver September 19, 2011 at 11:27 am

I live my life low-risk, so I do both (diversify!). I get a company match for my 401K so it would be foolish not to take advantage of that (fee money). I also assume the government will find ways to get more tax money from us as the years go on, so I contribute to my IRA now to protect myself from potentially higher taxes in the future.

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Aaron Hung September 19, 2011 at 4:26 pm

Right now I’m just working on my 401k, I have a Roth account but not much in it because I have to take care of all my debts first. Once I’m ready, I’m gonna go full speed on the Roth because I rather pay tax now than later

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The College Investor September 19, 2011 at 5:31 pm

I am still sticking with my 401k. The thought of Roth IRA has not entered my mind yet, maybe in the next 6 months.

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retirebyforty September 20, 2011 at 3:28 pm

Really? You should look into Roth IRA. As you can see from the comments, there are many fans.

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101 Centavos September 19, 2011 at 5:44 pm

Nice calcs, RB40.
Does it matter if the funds in the Roth pay a dividend?

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retirebyforty September 20, 2011 at 3:29 pm

I don’t think it matters if the investments in Roth pay a dividend. I have a few shares of AGNC in my Roth IRA portfolio. It’s nice to not pay tax on that dividend.

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Well Heeled Blog September 19, 2011 at 6:27 pm

For most folks, I think the formula would be to (1) contribute 401K up until company match, (2) max out Roth IRA, (3) go back and contribute to 401K. For 2011, I’ve maxed out my 401K – first year I’ve been able to do this! – and will max out my Roth IRA by the end of this year. I think I’ve got another $2,000 to go. I don’t get a company match. My fiance gets 10% from his employer, and he will max out his Roth IRA and then put another 5% of salary to his 401K.

I love the Roth IRA because I get to chose where and what to put into it. I love the 401K because it’s automatically deducted from my paycheck, the limit is higher than the Roth, and it lowers my taxable income. How can I choose?! ;)

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retirebyforty September 20, 2011 at 3:31 pm

That’s a good plan. I’d rather max out my 401k first because my tax bracket is 28%. If I was in the lower tax bracket, then I probably would invest in Roth first. I maxed out both when I was able to.

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Kellen September 22, 2011 at 7:10 pm

Another option, if you’re in the 25% tax bracket, is to contribute enough to your 401(K) to get you down to income taxed at only 15%, and THEN switch to putting money in your Roth.

So for single filers in 2011, the cut off between the 25% and 15% bracket is $34,500. Standard deduction is $5,800 – so if you make $43,000, your standard deduction will take you to $37,200 in taxable income. You will pay the 25% rate on your taxable income over $34,500 – so on $2,700. In this case, it might make sense to put $2,700 into the tax deferred 401(k) and avoid paying 25% on it, and then put any other savings into a Roth, since that’s only taxed at 15%.

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retirebyforty September 23, 2011 at 10:16 am

This is a great point! I try to minimize paying the higher tax bracket as much as possible with deduction and 401k contribution.

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krantcents September 19, 2011 at 7:19 pm

I believe you will be in a lower tax bracket in retirement. Therefore invest in the 401K. To hedge my bet, I also invest in a Roth. The only advantage is no withdrawal requirement and you can leave it to your heirs.

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retirebyforty September 20, 2011 at 3:32 pm

I agree with Krantcents. I can’t see any way that I would be in a higher tax bracket when I retire. There would have to be a huge huge change in the tax code for me to pay more tax in retirement and I don’t see it happening. I invest in Roth when I can as well.

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Kellie February 7, 2012 at 6:07 am

In your second-to-last paragraph, you write…
“I really doubt that your tax rate after retirement will be lower than while you are working though.”

Sounds from your comment above like you meant to write the opposite, no?

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SB @ One Cent At A Time September 19, 2011 at 7:31 pm

I am maxing my 401(k) for now and will continue to do so, I have other investments in MFs and stocks which can cater to my liquidity needs. You cna say I am betting on tax rate keeping low when I retire.

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retirebyforty September 20, 2011 at 3:33 pm

No investment in Roth IRA at all?

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Christa September 20, 2011 at 2:43 pm

We have an IRA for all of our previous jobs, just to keep our investments straight. But we max out the current 401(k) and will continue to do so as far as I can see ahead in my crystal ball :-)

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retirebyforty September 20, 2011 at 3:34 pm

What about Roth IRA?

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Ben September 20, 2011 at 3:26 pm

The reason the Roth is better really is in the flexibility associated,including the ability to withdrawal your basis, buying your first house, and there are no required minimum distributions meaning you could pass more wealth on to your children and grandchildren.

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retirebyforty September 20, 2011 at 3:35 pm

Roth is better for the flexibility, but I have liquidity else where. I like the no required minimum distributions since it add a lot of flexibility to my withdrawal strategy.

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Shaun @ Smart Family Finance September 20, 2011 at 7:38 pm

Just the 401k for me.

Like you, I beleive my tax rate will be lower at retirement. The pre-tax benefit of the 401k allows me to contribute more principal, which in the end, will leave me a much larger nest egg.

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retirebyforty September 21, 2011 at 9:34 am

That’s what I thought earlier, but the larger nest egg is a bit of an illusion. When we withdraw, the tax does hurt quite a bit. The difference is quite a bit less than I thought it would be.

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Tom August 20, 2012 at 1:17 pm

The difference will increase as you contribute more per year. Your analysis was talking about 5 to 6k per year but most people here are talking about approach yearly limits.

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Everyday Tips September 20, 2011 at 7:42 pm

My husband and I both max out our 401ks. Can’t see us being in a higher tax bracket when we retire, although who knows.

What a great post though.

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retirebyforty September 21, 2011 at 9:36 am

Do you also contribute to Roth IRA? It could be helpful.

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Squirrelers September 20, 2011 at 9:32 pm

Both are great retirement vehicles in their own right.

One note about taxes – who really knows what they’ll be in the future? Perhaps we’ll be taxed like crazy and the entire tax structure could be different far down the line. Maybe that could result in a higher tax rate in retirement vs now? You just never know. Thinking out of the box here…

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retirebyforty September 21, 2011 at 9:36 am

It’s difficult to see where the country will be in 20 years. Hopefully we won’t be where Greece is today. Their tax rate is shooting through the roof…

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Buck Inspire September 20, 2011 at 10:37 pm

Nice analysis! I’m trying to max out my 401k, no matching though. I have a Roth going and try to max it if I have spare change.

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retirebyforty September 21, 2011 at 9:38 am

No matching? Sorry to hear that. Hope you can take advantage of the Roth IRA!

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20'sFinances September 21, 2011 at 6:10 am

This is great work here! Since I am in my early 20′s, I am using both. I am investing up until the match (and a little more) in the 403(b) and then trying to max out the ROTH IRA. I will probably make more money in retirement than I am now, so I think the ROTH IRA is the best way for me to go right now. I also like that I can take out the contributions for any reason.

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funancials September 21, 2011 at 9:22 am

The more analysis I see from you, the more I wish I included you in my Smart article. I contribute up to my employee match maximum (4%) and max out my Roth each year. I chose the Roth over additional 401k contributions as a house down payment fund rather than retirement.

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Financial Success for Young Adults September 21, 2011 at 10:38 am

Thanks for laying this all out. The 401k definitely seems like the way to go. I prefer a Roth for the potential gain because I might be able to make more trading on my own in my Roth than I can with mutual funds in a 401k. But with the employer match and a lower tax rate at retirement, the 401k seems like the way to go.

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retirebyforty September 21, 2011 at 9:53 pm

I like Roth more for the freedom too, but I’m actually negative due to being too aggressive there. You really show contribute to the 401k up to matching. It’s guarantee 100% gain. That will be quite difficult to pull off in the Roth IRA account.

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Miss T @ Prairie Eco-Thrifter September 21, 2011 at 11:33 am

I don’t have either of these in Canada but I do have similar options to choose from. I say max them both out.

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retirebyforty September 21, 2011 at 9:53 pm

Good call!

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Hunter @ Financially Consumed September 21, 2011 at 5:57 pm

I don’t have a choice, being unemployed. I max out my spousal Roth IRA. I think the answer to you question depends upon how you plan on withdrawing the funds in retirement. 401k tax considerations need to be weighed against RMD’s. I favor the Roth because of its flexibility, but having both gives you flexibility too.

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retirebyforty September 21, 2011 at 9:55 pm

You can open a 401k and contribute any income from your blog right? I haven’t looked into this much, but it sounds like a great way to go. I’ll have to do more research and write a post on that.

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Leigh September 23, 2011 at 3:07 pm

I am in the 28% tax bracket and I have to max out my 401(k) to be eligible for a Roth. I like having the flexibility since my 401(k) is missing a couple of funds that I need to accomplish my target asset allocation. Plus, by using both of them, that’s more non-taxable room.

I think my favorite part about the Roth IRA is the ease of early withdrawal. It has also made it easier to learn how investing works, without having to figure out the taxation issues.

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Money Reasons September 23, 2011 at 6:15 pm

Ideally my current theoretical plan is this:
Plan Ideal
1.) 401k (if there is a match), if no match then Roth IRA
2.) Roth IRA
3.) Personal brokerage account.

But, in reality what I practice is this:
Plan Actual
1.) 401k (if there is a match)
2.) Personal brokerage account.
3.) Roth IRA

I’m hoping once I get enough money in my brokerage account (especially dividends), I’ll switch to Plan Ideal :)

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Andrew @ Money Crashers September 25, 2011 at 12:48 pm

As you said, this is an age-old question. Ultimately, I would say that if you’re in a situation where you have a solid amount of funds to set aside for retirement, it makes sense to use a combination of the 2. The Roth is great because your earnings grow tax-free while also allowing you to withdraw your contributions at any time. On the flip side, if your company offers a 401k, not taking advantage of that to the max that they will match is like giving up free money. And of course you get the short-term tax benefit as well. Ideally, if you can accomplish both, that’s not a bad strategy. Great stuff on a really thoughtful post!

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Matt Wegner @ Financial Excellence September 25, 2011 at 8:29 pm

I prefer to take the 401(k) up to the company match where applicable, then max out the Roth. In my case I assume I’ll be in a higher tax bracket at retirement. That may not be the case but I just like the idea of not having to worry about taxes at that point.

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gaurav October 16, 2011 at 7:35 pm

One more thing you did not mention is State Income taxes. I am in California and I would be paying 9% CA state income tax on the $16500 I wouldn’t have contributed to 401k.

With state income tax, my marginal tax bracket is 35%. My plan is to move to state with no state income taxes i.e. Florida and Texas after retirement. This in itself would provide a 10% gain in post-retirement payout on top of the reduction in federal tax bracket.

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retirebyforty October 17, 2011 at 9:01 am

An additional 9% in tax is quite painful. I think Nevada and Washington also has no state income tax. I’ll have to think about moving too, but the family likes it here….

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Darcie November 12, 2011 at 11:28 am

I’m a newcomer to the site, but a little confused by the debate of either/or, isn’t the max on a Roth IRA 5k/year? It seems like it would be silly to do the roth only and save so little for retirement, but I think I must be missing something…

And for the record, my husband I max out both.

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retirebyforty November 12, 2011 at 4:53 pm

Hello Darcie,
Our goal is also to max out both Roth IRA and 401k contribution. Many readers are not in the position to do that and they are not sure which one to prioritize, Roth IRA or 401k.
Most people plan to contribute to the 401k to get all the employer matching and then contribute to Roth IRA. After that, they will maximize 401k contribution.
Thank you for visiting!
-Joe

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Darcie November 13, 2011 at 1:32 pm

That makes sense, thanks! I like your site.

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Chris Barber March 1, 2012 at 8:50 am

I would rather pay the taxes now instead of when I retire only because I know at that time I’ll be on a fixed income, so I find it beneficial to pay now instead of getting caught later. However, I probably won’t have as much income when retired, so would the tax rate be less or is it the standard %15 capital gains tax?

I checked out that 401k rollover comparison tool on FiPath and it was pretty sweet.

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retirebyforty March 1, 2012 at 9:16 am

Any 401k withdrawal will be taxed as ordinary income, NOT capital gains. If you think you will have less income after you retired, then it’s more beneficial to pay tax later.
Thanks for stopping by!

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nattu March 3, 2012 at 9:47 pm

hi rb40, I never did IRA’s until now. I could get an extra refund of 1900 $ by stashing 10k in 2 traditional Ira’s right now (me &spouse) or not take the 1900 $ and lean towards roth ira’s. I feel taking the extra 19% gain right now and cumulating that money would more than cover for the tax penalty (10%?) and future income tax in the traditional IRA’. ? What am I missing here? Married filing jointly and single income we pay lower taxes anyway.

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retirebyforty March 3, 2012 at 10:46 pm

If you withdraw after you’re 59 and a half, then you shouldn’t have to pay any early withdrawal penalty (10%.)
It all depends on your tax rate after you retire. We don’t really know what that rate will be so if you are paying a low tax rate now, it’s better to stash the money in the Roth IRA.
If you are paying high rate (25% or more), then I would put it in the traditional IRA to put off paying the high rate.
Roth IRA also give you a more flexible withdrawal rate. You can minimize tax by withdrawing from both the traditional and Roth IRA.
I’m not a tax professional so this is just my opinion.

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Nina March 3, 2012 at 11:06 pm

I think it might be helpful if you calculate what your tax bracket might be in retirement based on this year’s tax bracket (assuming the tax laws don’t change too much). For example, if your 401(k) is your only source of income in retirement and assuming a 4% withdrawal rate you would need to have about $2,176,500 in your traditional 401(k) before even moving out of the 15% tax bracket!!!

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Bill March 17, 2012 at 6:41 pm

I’m 52, however I am a health fanatic and hope to live well past my 80s, even though I do have to take prescription meds, but have not stopped my insane workouts and my commitment to keeping a flat stomach. Anyhow I converted a big chunk of my tax deferred plans to Roth IRAs. Since the end of 2010 those accounts are up by 26% and I just calculated the taxes I am paying on the conversion (split between two tax years). At this point, I am ahead after those taxes still. So it was a good decision.

I realize in the future I open up my potential places to retire simply by diversifying my tax strategy. I can retire in my native California and it won’t touch my retirement nest egg from my Roth IRAs. Some boomers I met in California are looking to retire in the Rocky Mountain states. Perhaps because their traditional IRAs gains will be taxed as ordinary income.

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SavvyFinancialLatina March 19, 2012 at 11:33 am

Since we are DINKs, we are going to be contributing to our 401Ks until we can get to a 15% tax rate. My plan is to increase our contribution every year until we start maxing it out, hopefully in our mid 20s. Right now we are in our early 20s. AS far as contributing to our ROTH IRAs, I’m not sure when we will start. The first thing for us will be establishing personal goals for our extra income. Like when do we want to buy a house, etc. I have thought about contributing to our ROTH IRA, and then withdrawing money for our first home purchase when the time comes. This might actually be what I end up doing. Joe did you borrow from your ROTH IRA for your first home purchase?

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Matt C July 2, 2012 at 1:31 pm

Hey folks,

Name is Matt and I am 25 years old and just took on a 6 figure position as a pharmacist and am completely new to the investing scene. My employer matches 4% on a 5% contribution. They are partnered with T.Rowe Price and while setting up my 401k I am asked to allocate funds to things like low cap value, high value, dodge and cox, and others. I only slightly understand exactly what all of this means, but I was wondering how I should allocate my funds as well as my employer match funds. I am also considering Roth IRA on top of it all. Is that a smart idea with 7 years worth of college debt? I do not have many tax write offs as I have just graduated college and I feel maxing my investments would decrease my burden. Let me know what you think from a more professional stance!

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retirebyforty July 2, 2012 at 8:19 pm

That’s a loaded question, but you should probably figure out what is your risk tolerance first.
If you have high interest student loans, then you probably should prioritize that as well.
As for the fund in your 401k. I would keep it simple and stick with index funds for now.
Maybe 50% large cap, 20% small cap, 20% international, and 10% bond. You’ll learn more and then you can adjust it later. In the beginning, it’s much more important to start investing right away. Good luck.

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JoeTaxpayer September 29, 2012 at 9:46 pm

One large monkey wrench overlooked here – the effect of that income on your social security taxation. Just wrote about this, and it may very well put the $30k/yr withdrawal into a much higher bracket, try 46.25%.

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Jeff October 1, 2012 at 6:38 am

Can you please provide a link to the Excel file you created for this?

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Jeanene V. October 15, 2012 at 7:32 am

I have actually taken my money out of both of my 401k and my IRA and have invested both in real estate. I know it sounds crazy, and did to me at first also, but i am making a minimum of 8% every year! Neither my 401 or my IRA came close to touching the returns I am making. Retirement here I come, in about 30 years or so :) Good luck to everyone investing!

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Lee R. December 28, 2012 at 12:35 pm

I’ve been contributing to a 401(k) for over a decade but there are no matching funds from my employer. But, my question is what to do with my money since I’m within 3 years of retirement. I was considering rolling over my 401(k) to a Roth IRA but I’ve read at foxnews.com that said that I have to keep my money in the Roth IRA for 5 years before I can withdraw money from it. Also, I’m not sure if I should keep my money in the 401(k) because it’s quite possible that the Obama administration will cause taxes to increase. Since I’ll be eligible for retirement within 3 years, that wouldn’t be good for me. Also, there’s the possibility that the DJIA could drop to around 6000 again. If it’s true that my money would not be available to me, at retirement, if I put it into the Roth IRA, and since taxes are likely to go up, it seems that I should take my money out now and put it into a low interest savings account. It sure is tough to know where to put my money. I’ve even considered puting my 401(k) money into physical gold, also.

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retirebyforty December 28, 2012 at 3:17 pm

You can check the flow chart at the end of this post for more info.
http://retireby40.org/2011/04/retirebyfortys-investment-fundamental-6-roth-ira/
Basically you can withdraw the contribution anytime, but you might have to pay penalties on the gain if you don’t meet the conditions.
Your 401(k) should have a money market or bond options. Check with the plan. If you think the stock market will crash, then you can move your investment into a safer fund.
You probably shouldn’t roll over the whole amount into a Roth IRA at once. You’ll have to pay a ton of tax if you do that in one year.
Experts recommend moving more investments to bonds and cash when you’re near retirement. Good luck!

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Dan February 4, 2013 at 12:15 pm

This is very interesting to me as a CPA. I, for one, believe that it is very unlikely that you will be better off contributing to a Roth vs. pre tax 401k’s for most employed people. The reason is you take your 401k deduction at your highest rate of taxable income, say 25% for most professional single people, and withdraw the amounts at your retirement tax rates, which start at 0% and can climb to 15% or higher. However, you will need extremely large amounts of money to be taxed above 15%, particularly if you are married and your tax brackets are TWICE those of a single person.

I have both a 401k and a Roth IRA. My wife and I have saved and invested large sums of money and I actually believe now that I may be better off putting additional investments into a Roth because I may max out my 15% tax bracket at retirement. However, my work does not offer a Roth 401k that I would like, so I simply put money into a pre tax 401k. I’d rather have this account be over funded than under funded. Over funded is an easy problem to solve, under funded is much more challenging.

Most people should not only contribute to a pre tax 401k up to a company match, they should max this out before considering a Roth at all. At age 65, both singles and married couples also get an additional standard deduction, $1200 for one person and $2400 for a married couple, so that’s even more income, (indexed for inflation) that will be taxed at 0% when you retire instead of 25%.

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