Contributing Max Amount to Roth 403(b) Allows

[Mr. Frugal]

So I was reading about the pros and cons of contributing to a Roth 403(b) vs. a traditional 403(b). Based on Dr. Dahle's and others advice I have been contributing the maximum amount per year to my employer sponsored traditional 403(b) plan. In the process of reading more about these retirement vehicles, I came across a number of articles stating that if you are contributing the maximum amount each year, you may be better off choosing the Roth as opposed to the traditional plan. Here is one such article:

https://thefinancebuff.com/roth-401k-for-people-who-contribute-max.html

The problem is, I still don't really get it. I don't understand why you might be better off contributing to a Roth if you are contributing to the maximum amount each year. Can someone please break it down for me and my feeble mind?   Should I rethink my strategy of contributing solely to my traditional 403(b) plan? Should I start diversifying and being contributing to both accounts? Thanks for your thoughts!

[ticker]

A Roth contribution of $18,000 already has had taxes taken out of it, so the $18,000 is all yours.  If that compounds for 20 years at 7%, you'll have $69,654 at year 20 and pay no tax on it.

A traditional 403b contribution of $18,000 includes both the part you'll get to keep AND the taxes that you have deferred by putting it into a traditional 403b.  These taxes will be taken out later, when you withdraw the money. So, if you're going to be in the 15% bracket at retirement, you'll have the same $69,654 in your account at year 20, but just $59,206 after 15% taxes are taken out.  To think of it a different way, assuming a 15% marginal tax rate again, it's as if your $18,000 traditional contribution each year can be divided into the $15,300 you'll get to keep and the $2,700 that is earmarked for taxes later.  Both of those amounts with compound over time.  With the Roth, all $18,000 are already yours.

Therefore, you end up with more in the Roth account... but only because you have effectively put more in to begin with, by pre-paying the taxes.  So, if you want to get as much money as possible into retirement accounts, the Roth account is "worth" more.

[FIREshrink]

It’s worth more, but at a serious cost. If you are in a significantly higher tax bracket now than you will be in retirement (and most but not all docs are) then a traditional is superior. Save the difference in taxable and don’t look back.

[Farfetched]

I argue even at a very high marginal tax bracket, if you have enough time to let it compound, would the Roth option be better than saving the tax up front in a traditional 401k?

 

I have 401k and 457 retirement accounts. I am only couple years out from training and do not anticipate touching that money till I deplete all other funds, so maybe another 40 years unless I crap out early. On one account I put in 18000 pretax and the other 18000 as roth, foregoing half of the potential tax saving. 33% bracket.

 

Is that a dumb thing to do?

[Mr. Frugal]

And here in lies my dilemma - the differing schools of thought as presented by "Ticker" and "Fireshrink". I have been ascribing to Fireshrink's line of reasoning but thought maybe I had gotten it wrong - and hence the reason for my post.

Thank you "Ticker" for explaining the opposing reasoning more clearly. I understand the concept fully now. But who is right?! ;-)

Thanks again to everyone's thoughts on this subject!

[Farfetched]

Let's assume a current marginal tax bracket of 33% and retirement tax bracket of... 15%? optimistically 30 years later, and 7% annual return.

 

1) Traditional 401k: put in 18000, save 6000 which let's put into a taxable account also for the next 30 years.

-18000 x (1.07^30) = 137021, all of which needs to be taxed at 15% - $116468

-6000 x (1.07^30) = 45674, 39674 of which needs to be taxed at 15% - $39723

Total of $156191 post tax money in 30 years

 

2) roth 401k:

-18000 x (1.07^30) = $137021 post tax money in 30 years

 

Obviously a lot of assumptions but looks like I am losing almost 20k with each year's contribution after 30 years. Doh

[jfoxcpacfp]

Here's the problem: very few people who contribute to the pre-tax account will actually take that tax savings and invest it. Unless you do that religiously, you will be better off with the Roth because you are forcing yourself to prepay the tax and you don't have the "choice" to grow your lifestyle by that much. Theoretically, pre-tax is better in the years you are at peak earnings. Practically, it doesn't usually work out that way.

I also happen not to believe that the super savers on this forum will be taxed at a marginal bracket of 15% at retirement. But there's no way to know that, jmo.

I write the above for the learning lurkers, not the financial fanatics who do most of the conversing on the forum.

Farfetched wrote:

Is that a dumb thing to do?

Click to expand...

I believe that is a good compromise.

[FIREshrink]

Farfetched wrote:

Let’s assume a current marginal tax bracket of 33% and retirement tax bracket of… 15%? optimistically 30 years later, and 7% annual return.

 

1) Traditional 401k: put in 18000, save 6000 which let’s put into a taxable account also for the next 30 years.

-18000 x (1.07^30) = 137021, all of which needs to be taxed at 15% – $116468

-6000 x (1.07^30) = 45674, 39674 of which needs to be taxed at 15% – $39723

Total of $156191 post tax money in 30 years

 

2) roth 401k:

-18000 x (1.07^30) = $137021 post tax money in 30 years

 

Obviously a lot of assumptions but looks like I am losing almost 20k with each year’s contribution after 30 years. Doh

Click to expand...

major error. in the 15% tax bracket the LTCG rate is 0%. so you’re losing even more than you thought.

[jfoxcpacfp]

FIREshrink wrote:

major error. in the 15% tax bracket the LTCG rate is 0%. so you’re losing even more than you thought.

Click to expand...

IRA distributions are taxed at your top marginal tax rate, not LTCG. Were you talking about some other income?

[Farfetched]

Dammit!

ok so i did more elementary school algebra, and found out based on the above crude assumptions, it doesn't matter if I change the annual return rate OR even the number of years compounding. The ONLY way that roth beats out traditional contribution (plus investing the tax saving into taxable) is if the taxed rate (not accounting in LTCG right now) is more than 20%

[Farfetched]

jfoxcpacfp wrote:

FIREshrink wrote:

major error. in the 15% tax bracket the LTCG rate is 0%. so you’re losing even more than you thought.

Click to expand…

IRA distributions are taxed at your top marginal tax rate, not LTCG. Were you talking about some other income?

Click to expand...

Think hes referring to the extra money earned from taxable account using the 6k

[FIREshrink]

jfoxcpacfp wrote:

FIREshrink wrote:

major error. in the 15% tax bracket the LTCG rate is 0%. so you’re losing even more than you thought. 

Click to expand…

IRA distributions are taxed at your top marginal tax rate, not LTCG. Were you talking about some other income?

Click to expand...

he will not owe any tax on the taxable portion of his investment. his $45,674 will remain $45,674.

[jfoxcpacfp]

FIREshrink wrote:

he will not owe any tax on the taxable portion of his investment. his $45,674 will remain $45,674.

Click to expand...

Got it. If he's at the top of the 15% tax bracket, he'll be taxed on the amount that pushes him above 15%.

[ticker]

Mr. Frugal wrote:

And here in lies my dilemma – the differing schools of thought as presented by “Ticker” and “Fireshrink”. I have been ascribing to Fireshrink’s line of reasoning but thought maybe I had gotten it wrong – and hence the reason for my post.

Thank you “Ticker” for explaining the opposing reasoning more clearly. I understand the concept fully now. But who is right?!

Thanks again to everyone’s thoughts on this subject!

Click to expand...

To be clear, I do not necessarily espouse the view I was trying to explain.  I contributed to Roth when I was at 15% and switched to traditional the year I moved to the 28% bracket.  So, I agree with Fireshrink that traditional contributions are preferable when you are in a higher bracket.

[Mr. Frugal]

jfoxcpacfp wrote:

Theoretically, pre-tax is better in the years you are at peak earnings.

Click to expand...

Thanks for your perspective and thoughts jfoxcpacfp! I think you are the first person I have ever heard make the above statement around these parts! It seems to go against what Jim recommends in his post on this subject too where he states:

 

"I only have one rule of thumb, and that’s that residents (and military docs) should make Roth contributions and attendings should generally make traditional, tax-advantaged, but there are plenty of exceptions even to that rule."

https://www.whitecoatinvestor.com/should-you-make-roth-or-traditional-401k-contributions/