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Solo 401(k) employee contribution: Roth vs Traditional

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  • Solo 401(k) employee contribution: Roth vs Traditional

    WCIers, I am asking for your input on choosing to place my 2023 employee contribution for my solo 401(k) into my Roth or Traditional account.

    Background:
    -Three years out of fellowship
    -In my transitional year between fellowship and practice, I placed my employee contribution into the Roth 401(k).
    -I max out the 401(k) each year so I am still placing a significant amount of money into the traditional 401(k) via the employer contribution.
    -Marginal tax rate for 2020 and 2021 was 32%. I expect that to remain unchanged for 2022 and 2023.

    I have used a couple online calculators.
    - https://www.solo401k.com/roth-vs-tra...on-calculator/
    - https://www.citizensbank.com/financi...alculator.aspx

    These were my assumptions playing with the calculator.
    -Current age is 35.
    -Retirement age 55 or 65.
    -Maxing out whatever the employee contribution will be each year.
    -"Invest" the annual tax savings generated by the traditional account each year; as opposed to spending this money.
    -Expected rate of return 7%
    -Current marginal tax rate 32%.
    -Retirement tax rate: 15% or 22%.

    It is very clear that if I spend the annual tax savings instead of investing those dollars, that the Roth 401(k) is the better choice.

    The main difference seems to be regarding what my retirement tax rate will be. The higher the retirement tax rate, then Roth is probably the better choice.

    Currently, my traditional 401(k) bucket is 8.25x the size of the Roth 401(k) bucket, or 1.67x all of our Roth assets.

    Our taxable accounts are slightly more than our traditional 401(k) account.

    .....

    TLDR: Is it reasonable to put my future solo 401(k) employee contributions in the Roth 401(k) to increase my Roth bucket as opposed to waiting to perform Roth conversions later in life?

    Thanks!

  • #2
    Is this solo 401(k) your only 401(k)?

    Comment


    • #3
      Originally posted by bovie View Post
      Is this solo 401(k) your only 401(k)?
      Yes

      Comment


      • #4
        Your marginal rate suggests that sticking with traditional 401(k) contributions is probably wise.

        Max out your Roth IRA annually (if you aren’t already) and when the time comes, develop a plan for Roth conversions of traditional 401(k) assets.

        You don’t mention your actual income, savings rate, marital status, other retirement accounts, etc., but I’d bet that you should be making contributions to a taxable account as well.

        This will be especially helpful for your tax planing in retirement, in conjunction with your pre-tax and Roth assets.

        Comment


        • #5
          Originally posted by bovie View Post
          Your marginal rate suggests that sticking with traditional 401(k) contributions is probably wise.

          Max out your Roth IRA annually (if you aren’t already) and when the time comes, develop a plan for Roth conversions of traditional 401(k) assets.

          You don’t mention your actual income, savings rate, marital status, other retirement accounts, etc., but I’d bet that you should be making contributions to a taxable account as well.

          This will be especially helpful for your tax planing in retirement, in conjunction with your pre-tax and Roth assets.
          Thanks for the reply.

          Income: $500,000
          Married filing jointly
          I have an S Corp as my income is solely from being an independent contractor.
          No state income tax.

          Save at least 25% gross income yearly since starting practice.
          -Max out back door Roth IRAs for myself and my spouse
          -Max out HSA
          -Max out solo 401(k) employee and employer contributions
          -Approximately $45,000 or more into taxable

          Most of what I have read/listened to suggests that those with greater than 30% marginal tax rate should. My thought was since I am putting in a larger amount into traditional 401(k) and taxable now, it might make sense to pay the taxes (example using 2022 numbers: 0.32 * $20,500 = $6,560) now so that I can try to keep the three buckets (Roth, tax deferred, taxable) somewhat more proportional.

          I think I read an article a few years back where Physician On Fire contributed to his Roth 401(k) instead of traditional. Dave Ramsey is another who states he converts everything to Roth now as he plans to leave all his Roth money to his heirs.

          Comment


          • #6
            Appreciate the additional details. Helps sharpen the picture, and it seems like you’re in a good spot.

            Yeah I get where you are coming from with wanting to even out your buckets, so to speak. But the longer you work, the less proportional they will become—just how it is (for now), and that’s okay.

            But it really just comes down to math in terms of how you contribute, and a couple of variables which are currently unknown (but can be estimated).

            I think you are unlikely to have a higher marginal tax rate in retirement than you do now. It really does just come down to math.

            And the tax deduction you get now for your contributions is also valuable. Make sure to put it into the taxable account.

            You can always convert to Roth in low income years, or in early retirement. And you also have your HSA, which is even better.

            Doesn’t really make sense to make Roth contributions over tax-deferred right now. It won’t kill you if you do, but it’s unlikely to be your optimal route.

            Keep feeding your taxable account. The flexibility this will provide you is enormous.

            Comment


            • #7
              It’s not all about the math. Being a CFP and CPA, I realize this sounds ignorant and I am ok with that. But I believe it is important to project your future financial situation and consider how you will feel (yes, “feel” - it matters here) about having a huge tax-free pot of Roth IRA investments versus a huge pot of pre-tax TIRA. My money says you won’t be patting yourself on the back for saving taxes all those years because you’ll be focusing on your current financial picture. May be wrong, of course, just something to consider.
              Our passion is protecting clients and others from predatory and ignorant advisors. Fox & Co CPAs, Fox & Co Wealth Mgmt. 270-247-6087

              Comment


              • #8
                Originally posted by jfoxcpacfp View Post
                It’s not all about the math. Being a CFP and CPA, I realize this sounds ignorant and I am ok with that. But I believe it is important to project your future financial situation and consider how you will feel (yes, “feel” - it matters here) about having a huge tax-free pot of Roth IRA investments versus a huge pot of pre-tax TIRA. My money says you won’t be patting yourself on the back for saving taxes all those years because you’ll be focusing on your current financial picture. May be wrong, of course, just something to consider.
                I too am in the Roth is OK camp even if it's not quite the correct "mathematical" decision. Prior to 2012, the bulk of my savings were in taxable and pre-tax with >50% in taxable and a very small portion in Roth (only available since 2010). As a part-time 1099 MD since 2012, my marginal tax rate bracket has decreased from 33% -> 28% -> 24% over the years. All of my retirement contributions since then have been to Roth accounts. In 2018, I learned about using the MBDR from this forum and began significant Roth converting as I turned 59.5 . This has completely changed the make-up of my financial assets to taxable ~= Roth > pre-tax. While my net worth is probably smaller now than if I had just continued making the maximum possible yearly pre-tax contributions, I feel much more comfortable having some control over how much and from which account I want to withdraw. I am confident that when I'm 72, SS + RMD won't exceed our typical yearly spending with any necessary balance coming from the taxable account. The Roth accounts are now either insurance for bad life events or passed along to our beneficiaries as I feel comfortable that taxable and pre-tax accounts will be more than enough to sustain our retirement needs.

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