OT: 401K vs Roth 401K

[saab2000]

This past weekend was spent flying with the type of guy who makes me sick - someone who really has his act together..... :D Smart, motivated, hot girlfriend, open, friendly, honest, etc.

He told me that since our company has made available a Roth 401K and a traditional 401K that it is much smarter to have all future contributions go into the Roth 401K. All else equal (and I believe it is) this seems to make sense.

So today I went to the website at T.Rowe-Price and made the switch. I am contributing all I can at the moment (yes, matching is maxed out) but I would like to contribute even more if I could. Anyway, he said that switching to the Roth will have the effect of lowering my take-home paycheck somewhat. I can deal with that I think, but I will have to watch it.

Anyway, for those financial gurus out there, does anyone think that switching all future contributions to a Roth 401K is a bad move vs keeping these contributions going to the regular 401K?

My buddy's reasoning is that by the time we retire we are likely to be in a significantly higher tax bracket and then will take a much, much bigger hit then than we do now. The Roth 401K withdrawals will be tax free.

Thoughts?

[WadePatton]

Dave Ramsey always recommends the Roth. The way I unnerstand it that building your investment with pre-tax moneys and paying the taxes later is generally a better bet.

DaveRamsey.com

[coylifut]

Dave Ramsey always recommends the Roth. The way I unnerstand it that building your investment with pre-tax moneys and paying the taxes later is generally a better bet.

DaveRamsey.com

the beauty of the roth is you don't pay the taxes later.

[J.Greene]

Dave Ramsey always recommends the Roth. The way I unnerstand it that building your investment with pre-tax moneys and paying the taxes later is generally a better bet.

DaveRamsey.com

Sounds like you have your topics confused.

IRA=pretax
Roth= post tax
Hyman Roth=Money Maker

JG

[dave thompson]

Dave Ramsey always recommends the Roth. The way I unnerstand it that building your investment with pre-tax moneys and paying the taxes later is generally a better bet.

DaveRamsey.com
Roth IRAs are paid with post-tax money, the taxes have already been paid. When taking money from a Roth, the withdrawals are tax free.

[stevep]

saab.
i think you should invest more in bike parts,
for 6-7k you could get something nice.

for the other question.
you need to figure it out yrself.

[coylifut]

Roth IRAs are paid with post-tax money, the taxes have already been paid. When taking money from a Roth, the withdrawals are tax free.

let's keep the subjects separate. we are talking about a Roth 401(k) which has the came contribution limits as a regular 401(k) which $15,500 for 2008 unless you are a geezer and in that case it's $20,500. The other key difference is there's no income limit. Everyone who has one available can contribute even if you make greater than $101,000 - $116,000 (singles) and $159,000-169,000 (couples)

Roth 401(k)s are very rare. The last I checked, a mere 10% of companies offer 'em even though they've been available since 01.

[dave thompson]

let's keep the subjects separate. we are talking about a Roth 401(k) which has the came contribution limits as a regular 401(k) which $15,500 for 2008 unless you are a geezer and in that case it's $20,500. The other key difference is there's no income limit. Everyone who has one available can contribute even if you make greater than $101,000 - $116,000 (singles) and $159,000-169,000 (couples)

Roth 401(k)s are very rare. The last I checked, a mere 10% of companies offer 'em even though they've been available since 01.
Cool! In either case, IMO a Roth is the best way to stash your money for the long term.

[rphetteplace]

let's keep the subjects separate. we are talking about a Roth 401(k) which has the came contribution limits as a regular 401(k) which $15,500 for 2008 unless you are a geezer and in that case it's $20,500. The other key difference is there's no income limit. Everyone who has one available can contribute even if you make greater than $101,000 - $116,000 (singles) and $159,000-169,000 (couples)

Roth 401(k)s are very rare. The last I checked, a mere 10% of companies offer 'em even though they've been available since 01.

I thought 2008 limit for single person for ROTH IRA was $5K imho

[drssyoon]

Isn't there a limit on how high your income can be for Roth IRA? Regular IRA doesn't have that limit. If you make more than the limit, you are penalized.

Or am I confused about Roth IRA not being equal to Roth 401K?

[davids]

Dave Ramsey always recommends the Roth. The way I unnerstand it that building your investment with pre-tax moneys and paying the taxes later is generally a better bet.

DaveRamsey.comYou got it backwards. Pay taxes first, then never again on all the compound interest you earn.

[coylifut]

I thought 2008 limit for single person for ROTH IRA was $5K imho

we are talking about a ROTH 401K not a ROTH IRA. Two separate subjects. The reason why folks aren't up to speed on these is because they are rarely available as part of an employer's plan.

ROTH IRAs are a consideration for folks who don't exceed the income limits.

[saab2000]

saab.
i think you should invest more in bike parts,
for 6-7k you could get something nice.

for the other question.
you need to figure it out yrself.

Unfortunately, bikes and bike parts are a bad investment. That's why I buy a lot of used stuff. Very good used stuff. :banana:

[saab2000]

Well, for all the whining I do about my company, I am thankful that this Roth 401(k) has become an option. More choice seems like a good thing.

And yes, a Roth IRA and a Roth 401(k) are two separate things.

[LegendRider]

Does your company match the regular 401(k) only (that's the most common method)? If that's the case, contribute enough to the traditional 401(k) to get your full company match and then additional contributions should go to the Roth 401(k). Max total contributions for 2008 is $15,500 (unless you're old enough to qualify for the catch-up).

Of course, there is no correct answer because we don't know future tax rates. Roth makes sense if you think your rates will be higher in the future (which seems like a good bet).

[saab2000]

Yes, my company matches equally for both. This year moving from 4% at an 8% contribution to 5% at a 9% contribution. Free money. Also, my job is one which traditionally does grow significantly in earning potential over time.

We'll see what actually happens. I sorta see very dark clouds on the horizon for the airline business... Nationwide economic downturn and seriously high fuel costs being the two biggest issues.

[dekindy]

If you invest equal amounts in an traditional 401k account and a Roth 401k account, invest in the same investment (earn the same rate of return), withdraw at the same rate, and pay the same income tax at withdrawal time as you did when you contributed, then they are mathematically equal, it does not matter which account you invest in.

What does contribute the same amount mean? It means that if your income tax rate is 25%, then if you invest $1,000 in a 401k, you only have $750 to invest in a Roth 401k because you had to pay $250 in taxes on the amount contributed to a Roth. The error that all calculators make is they showing $1,000 going into both accounts. They neglect the $250 income tax paid on the Roth contribution.

Let's take a simple example.

$1,000 contributed to a traditional 401k in year 1
$1,100 balance in year 2 because it earned 10%
Withdraw entire $1,100 balance in year 3 less income taxes $275 ($1,100 x 25%) nets $825

$750 contributed to a Roth 401k in year 1
$825 balance in year 2 because it earned 10%
Withdraw $825 income tax free in year 3

So when is a Roth effective?

Somebody already gave one reason, that is if you think your marginal income tax rate is going to be higher in the future.

Another reason would be if you have so many non-401k assets that you really don't need them for retirement, and want to continue the deferral and avoid the minimum distribution rules so your beneficiaries inherit your Roth 401k and continue the deferral over their lifetime (at that point they are subject to minimum distribution rules). The Roth 401k transfers much more wealth in this situation.

It is my opinion that the Roth IRA benefits the rich. They are more likely to pay higher marginal income tax rates in the future and they are more likely to have excess assets that they want to defer income tax to the next generation.

Don't feel bad if you do not understand this. Most CPA's and CFP's don't know this either.

[Dekonick]

If you invest equal amounts in an traditional 401k account and a Roth 401k account, invest in the same investment (earn the same rate of return), withdraw at the same rate, and pay the same income tax at withdrawal time as you did when you contributed, then they are mathematically equal, it does not matter which account you invest in.

What does contribute the same amount mean? It means that if your income tax rate is 25%, then if you invest $1,000 in a 401k, you only have $750 to invest in a Roth 401k because you had to pay $250 in taxes on the amount contributed to a Roth. The error that all calculators make is they showing $1,000 going into both accounts. They neglect the $250 income tax paid on the Roth contribution.

Let's take a simple example.

$1,000 contributed to a traditional 401k in year 1
$1,100 balance in year 2 because it earned 10%
Withdraw entire $1,100 balance in year 3 less income taxes $275 ($1,100 x 25%) nets $825

$750 contributed to a Roth 401k in year 1
$825 balance in year 2 because it earned 10%
Withdraw $825 income tax free in year 3

So when is a Roth effective?

Somebody already gave one reason, that is if you think your marginal income tax rate is going to be higher in the future.

Another reason would be if you have so many non-401k assets that you really don't need them for retirement, and want to continue the deferral and avoid the minimum distribution rules so your beneficiaries inherit your Roth 401k and continue the deferral over their lifetime (at that point they are subject to minimum distribution rules). The Roth 401k transfers much more wealth in this situation.

It is my opinion that the Roth IRA benefits the rich. They are more likely to pay higher marginal income tax rates in the future and they are more likely to have excess assets that they want to defer income tax to the next generation.

Don't feel bad if you do not understand this. Most CPA's and CFP's don't know this either.

Good information. Thanks!

[pdxmech13]

Sounds like you have your topics confused.

IRA=pretax
Roth= post tax
Hyman Roth=Money Maker

JG

POTN :beer:

[Chad Engle]

Last time I spoke with my investment guru we determined that the additional taxable income would put me in the next higher tax bracket. So I hesitated.

So now I max a roth and get the total match from the company on the 401K. Best of both worlds maybe?

[KeithS]

Coylift wrote...
$15,500 for 2008 unless you are a geezer and in that case it's $20,500
Watch who you're calling a geezer. You will get there faster than you think.

Yup, I put in $20k the same year I bought me a new Serotta. Not everything about being a geezer is bad.

[coylifut]

Watch who you're calling a geezer. You will get there faster than you think.

Yup, I put in $20k the same year I bought me a new Serotta. Not everything about being a geezer is bad.

I love Geezers
:beer: :beer: :beer:

[WadePatton]

the beauty of the roth is you don't pay the taxes later.

Sorry 'bout my confusion. The first part was right--Dave Ramsey ALWAYS recommends the Roth. And he's a smart guy.

[dekindy]

Sorry 'bout my confusion. The first part was right--Dave Ramsey ALWAYS recommends the Roth. And he's a smart guy.

I just went to his website and read one of his articles. He makes the same mistake everyone else does. His example shows a comparision of contributing the exact same amount to both accounts, the traditional 401k and the roth 401k amount. Since you have to pay taxes on the amount invested in a Roth 401k, you do not have as much to invest in a Roth 401k account and you have to take that into consideration.

You take the tax aspects into consideration on the contribution to make an apple to apple comparison.

I repeat, the advantage of the Roth is if you are:
1)confident your marginal income tax rate at withdrawal will be higher than your marginal tax rate at the time of the contribution, or
2)you objective is to get your 401k funds to the next generation as efficiently as possible.

See my previous post on this thread for the mathematical explanation.

I am not trying to discourage anyone from using a Roth. Just do it based upon fact, not flawed reasoning or assumption that something is always the best. When is that ever true? Okay, when we are talking about bicycles then Serotta is always the best! But it is seldom true anywhere else. A Roth 401k versus Traditional 401k decision has real potential advantages and disadvantages, just like any other decision.

As a CPA and CFP I tend to favor strategies that minimize taxes now and then strategize in the future when I get there. One thing is certain, if the assumptions you are using to make a decision deal with events that are very many years into the future, you better have a good crystal ball or trust to luck.

The soundest tax strategies are based on the rules now. At least you have the facts, most of the time.

[dwightskin]

1) It's OK to have some of both. When you retire, YOU choose where you'll get your money from. You'll still get the "standard deduction" and a bunch of other deductions, so you aren't paying taxes on that first $20k per year or so. So why not have that money be from a tax deferred account? But have Roth IRA or 401k, too. Then when you want to withdraw $60,000 for a new boat or Serotta, you can do that tax free!

2) Here’s a typical formula:

a) Contribute to 401k first, up to the company match. This money ONLY goes into investment vehicles chosen by your company and can only be moved if you quite (or get fired)
b) Then contribute to a IRA (roth or regular) up to the max allowed ($5000 for 2008). This money can be invested in nearly anything and can be moved very easily.\
c) Additional funds beyond that can go into 401k again up to the max allowed ($15,500).

Either the IRA or 401k could be Roth (pay taxes now) or Tax deferred (pay taxes later).

[Mikej]

Got any pictures of his g.f.? Retirement planning is so scary to me, I hate it, I figure somehow we are going to get reamed - the market craches, taxes end up being WAY more than I thought, Or I die w/ 2.5 million in a 401k and my kids have to pay 2.0 million in taxes, while I spent 400k on interest over my life span so I could save for retirement. My bud at works father partied his whole 86 years worth of life away and never looked back. Best plan ever - do what you like.

[Skrawny]

Not that Charles Schwab are the experts, but I have been trying to teach myself the basics, and I have some of my money with Schwab, so I have been availing myself of some of their online material. From what I read it is inline with what dekindy and others are saying...

From C Schwab:
"Roth 401(k)s: particularly appealing for younger workers.
If your employer offers the Roth 401(k) (not all do—it was just introduced in 2006), it works much like a Roth IRA: Contributions come from after-tax dollars (no up-front deduction), and qualified withdrawals are free from income tax. One big difference is there are no income limits to participate, and the contribution limit of $15,500 per person (plus an additional $5,000 catch-up contribution if you're 50 or older) is much higher than the Roth IRA limit.

Additionally, you can roll over the balance from a Roth 401(k) into a regular Roth IRA. According to the rules, any employer match would automatically go into a separate traditional 401(k) account, regardless of where your contributions are directed. The choice of a Roth 401(k) could make sense if you think your tax bracket will be the same or higher in retirement. That might not be a bad guess if you expect to generate lots of portfolio income and anticipate hefty retirement distributions. Also, there's the risk that currently low marginal federal tax brackets might be raised to deal with looming federal budget and entitlement program deficits.

As with a Roth IRA, the Roth 401(k) could be especially attractive if you're young and have yet to reach your peak earning years. Whatever your situation, if your employer offers both types of 401(k)s, you can stay flexible by splitting contributions between the traditional and Roth options. That way, your retirement income will be further diversified between taxable and nontaxable buckets."

[willy in pacifi]

As a CPA and CFP I tend to favor strategies that minimize taxes now and then strategize in the future when I get there. One thing is certain, if the assumptions you are using to make a decision deal with events that are very many years into the future, you better have a good crystal ball or trust to luck.

The soundest tax strategies are based on the rules now. At least you have the facts, most of the time.

I agree with dekindy on minimizing your taxes whenever you can. And his math works as far as there being no difference at the end of the day if your tax rate does not change between when you contribute and when you distribute.

My one thought was this. When you are earning your income you do not have as much flexibility in how much you make if you are on salary. you make $100k you pay on taxes on that $100k less deductions/exemptions. Of this $100k you put $15k into the 401k so did not need this money to live on.

When you retire and break into your 401k you may be better able to manage your withdrawls and this may allow you to manage your tax rate better.

I fund my 401K to the max each year and take the tax savings and use it to fund mine and my wifes Roth IRA.

willy in pacifica (CPA, Masters in Tax)

[TimB]

Dekindly says:

"I repeat, the advantage of the Roth is if you are:
1)confident your marginal income tax rate at withdrawal will be higher than your marginal tax rate at the time of the contribution, or"

So - let's assume that I make $100K/year while employed and contributing 15% to my 401(k) - whatever flavor. After I retire and begin to withdraw, I'm relatively certain my income is likely be considerably less than $85k - enough to lower my marginal tax rate. This is the scenario that makes a traditional 401(k) better for me than the Roth, correct?

[willy in pacifi]

Dekindly says:

"I repeat, the advantage of the Roth is if you are:
1)confident your marginal income tax rate at withdrawal will be higher than your marginal tax rate at the time of the contribution, or"

So - let's assume that I make $100K/year while employed and contributing 15% to my 401(k) - whatever flavor. After I retire and begin to withdraw, I'm relatively certain my income is likely be considerably less than $85k - enough to lower my marginal tax rate. This is the scenario that makes a traditional 401(k) better for me than the Roth, correct?

Tim,

You are correct but you never know what the future may hold as far as tax rates, and tax beneifts are concerned.

There may be laws between now and when you retire that apply a lower tax rates to 401k withdrawls due to Social Security issues. You just don't know so I feel I am better off deferring the taxes until later. Maybe I don't want to retire so will not need the money until I am forced to take it out or maybe I die before I retire.

One of the benefits of putting money into a regular Roth IRA over a 401K (not sure about a Roth 401k) is that you can get at it a bit easier. You can use some of it to buy a first home and you can take withdrawls tax free if you lose your job as long as you do not touch the untaxed earnings and only get at your contributions. I would not recomend it but it can be a bit of a safty net in emergencies without 50% going to taxes and penalties. But once the money comes out of a deferred account it cannot be replaced due to annual limits.

willy in pacifica

[dekindy]

Dekindly says:

"I repeat, the advantage of the Roth is if you are:
1)confident your marginal income tax rate at withdrawal will be higher than your marginal tax rate at the time of the contribution, or"

So - let's assume that I make $100K/year while employed and contributing 15% to my 401(k) - whatever flavor. After I retire and begin to withdraw, I'm relatively certain my income is likely be considerably less than $85k - enough to lower my marginal tax rate. This is the scenario that makes a traditional 401(k) better for me than the Roth, correct?

In this simple scenario the answer is yes if your taxable income falls below these thresholds. Married marginal rates change at $65,100 taxable income and $78,850 for singles based upon 2008 tax rates. $65,100 is 76% of $85K so there is a distinct possibility this would be true.

In practice, you need to do a detailed retirement income tax projection. I don't know anything else about your tax scenario. It will depend on if you are itemizing now and will not itemizing after you retire, extra personal exemption amounts based upon age, whether AMT applies to you, etc. This is difficult to do very few years in advance.

The bottom line is just understand the rules and don't buy into this Roth thing as the best solution using inaccurate comparisons to a traditional IRA.

I am a firm believer in investment diversification and I feel that tax diversification is good also. Investing in a Roth account and cash value life insurance are the two major avenues to generate tax-free retirement income. Municipal bonds may be a possibility if you are in the highest federal bracket and in a high marginal state income tax.

If investing in a Roth instead of a traditional IRA now would increase your current marginal income tax rate, you might want to reconsider. I don't think I have seen that caution anywhere!

[dekindy]

Another possible advantage of a Roth that may apply in limited cases now but more in the future, is taxation of Social Security benefits, which going into detail is way beyond this discussion. But currently Roth withdrawals are not included in calculating the modified AGI thresholds for Social Security benefits taxation. But the people this applies to are highly likely to pay a lower marginal rate in retirement so you get into some detailed analysis to determine if applies. But it could possibly be an asterisked advantage that you could list under the Roth.

[dekindy]

I agree with dekindy on minimizing your taxes whenever you can. And his math works as far as there being no difference at the end of the day if your tax rate does not change between when you contribute and when you distribute.

My one thought was this. When you are earning your income you do not have as much flexibility in how much you make if you are on salary. you make $100k you pay on taxes on that $100k less deductions/exemptions. Of this $100k you put $15k into the 401k so did not need this money to live on.

When you retire and break into your 401k you may be better able to manage your withdrawls and this may allow you to manage your tax rate better.

I fund my 401K to the max each year and take the tax savings and use it to fund mine and my wifes Roth IRA.

willy in pacifica (CPA, Masters in Tax)

I like the phrase "betweem when you contribute and when you distribute". Do you mind if I use this?

[dekindy]

Actually I ran into CPA's 20 years ago that would personally not defer any taxes in a retirement account because they felt that future income tax rates would be much higher. And this was a long time before the Roth concept became law. It is not my philosophy. But these folks were just as educated as me. So you can find plenty of Roth supporters.

Call me cynical but I am a little suspicious about any law enacted for your good that has you paying more taxes now!

[willy in pacifi]

I like the phrase "betweem when you contribute and when you distribute". Do you mind if I use this?

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