Traditional 401k versus Roth 401k

[virmd]

I am about to start my first real job out of fellowship and my employer offers both a traditional 401k and a Roth 401k.  They are both self directed accounts with many funds available to choose from.  I am having trouble deciding which would be the best option for me.  I will be making $375,000 to start,  33 years old, single, and live in a state with no income tax.  I plan to work until at least until full retirement age.  My employer will also allow "profit sharing" of $35,000 which is nice at it would lower my W-2 income.  My overall target savings rate is 25% which I feel is easily achievable.  Does anybody have thoughts on whether the traditional 401k or the Roth 401k would be a better option?

[AlexxT]

The traditional 401k is better for you.

The primary difference between the two is the tax arbitrage benefit.   With the 401k you will not pay tax now, which would be at around a 33% marginal rate.  When you withdraw the money, it will probably be at a lower marginal rate.  Plus, other than social security, you will probably have only the 401k withdrawals as income, so you will be paying tax on that money not just at a lower marginal rate, but at an even lower effective rate.   If you also convert some of that money to a Roth during low income years after retirement but before social security ( ie retirement years from 60-70 ) you will pay even lower overall taxes.

If you did a Roth now, you would be doing the opposite:  Paying the highest tax rate now.

With both a Roth and a traditional 401k, your money is growing tax free.  It's just that with the traditional IRA, some of that money belongs to the IRS.  So one advantage of the Roth is that you get more money into the account.  However, with the traditional IRA you will have more money growing in a taxable account, which while not as good as a Roth, is pretty close if you use if for index funds.

One caveat:  Your income will be lower your first year in practice, since you'll only make a high income for a few months, assuming you start work in July or August.  So if that's the case, if you can, you should probably do a Roth for the first year, and then go to a traditional for all subsequent years.

[DMFA]

At that bracket, probably Trad since you'll probably want to pay taxes on your (likely lower) retirement income than at 33%, but keep in mind Roth has other attributes besides being taxed up front, like penalty-free withdrawal of principal and no required withdrawals at age 70.5.

[litovskyassetmanagement]

You can also do backdoor Roth IRA contributions in addition to your 401k contributions, so you can diversify your future tax liability.

[DarrVao777]

virmd wrote:

I am about to start my first real job out of fellowship and my employer offers both a traditional 401k and a Roth 401k.  They are both self directed accounts with many funds available to choose from.  I am having trouble deciding which would be the best option for me.  I will be making $375,000 to start,  33 years old, single, and live in a state with no income tax.  I plan to work until at least until full retirement age.  My employer will also allow “profit sharing” of $35,000 which is nice at it would lower my W-2 income.  My overall target savings rate is 25% which I feel is easily achievable.  Does anybody have thoughts on whether the traditional 401k or the Roth 401k would be a better option?

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I decided to take the opposite route despite starting off in a similar work situation. (Just as an aside, I think what I'm doing is mathematically wrong as other posters have pointed out above but I have a few reasons for doing so as listed below)

I'm also a high earning W2 living in a state with no income tax. Also plan on working for a while (for now). My employer does NOT allow profit sharing in the 401k plan so I get to squirrel away 18K and that's it.

I opted to put it towards a Roth 401k for the following reasons:

 

- Political/Economic Considerations = I tend to be a pessimist and feel that future tax rates will be much higher than current tax rates. I'm making the Roth contributions now at what I believe will be a lower rate.

- Estate Planning Considerations = I'm saving ~50% of my gross income annually. The vast majority of this is in a taxable account. My wife and I tend to be pretty frugal and while I wasn't planning on leaving an estate behind, it looks like I probably will. Roth contributions tend to be more helpful when planning on giving to heirs due to a lack of RMDs

- Ability to Contribute More = By making Roth contributions, I'm getting more money into my retirement account (on an after-tax basis) since it is one of the few accounts I have that receives preferential tax and asset protection.

- State Taxes = I currently live in a state with no income tax. I plan to return home to California for retirement. The Roth allows me to bypass California's highly progressive state taxes.

 

My wife (who has been working for much longer than I have) has been contributing to a traditional 401k since her first day of work so we should have some tax diversification amongst our retirement accounts.

[jfoxcpacfp]

AlexxT wrote:

 

With both a Roth and a traditional 401k, your money is growing tax free.  It’s just that with the traditional IRA, some of that money belongs to the IRS.  So one advantage of the Roth is that you get more money into the account.  However, with the traditional IRA you will have more money growing in a taxable account, which while not as good as a Roth, is pretty close if you use if for index funds.

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Point of disagreement: your money is not growing tax-free in a T-401k. It is growing tax-deferred and that is a big difference, given that the majority of your taxable withdrawals will be from growth in the account, not original contributions. Otoh, growth in a Roth is totally and absolutely tax-free (unless you monkey around with the 5-year rule). Personally, I lean toward the opinion expressed by @DarrVao777. I look at it as a form of delayed gratification. Given that doctors will (should) end up with large taxable account balances at retirement, I believe many of you will be in a higher tax bracket than you expect by age 70.5 (under the unrealistic assumption that the tax code in re: RMDs will not change) and will be paying a high rate on RMDs not to mention the realistic assumption that your spending will not require RMDs at that age and you will be, instead, focused on passing tax-free assets along to the next generation. Not to mention the belief that we are all living on borrowed time for the ability, particularly for HIPs, to stash money away in Roth IRAs (at imho).

However, I can't build a plan based upon what I think will happen, or the unknown, or a feeling, but what is today's reality, which is the current tax code. I counsel clients to take advantage of Roth IRAs at every opportunity, considering the sum total of the current tax code as it affects you today and in the future.

[AlexxT]

jfoxcpacfp wrote:

Point of disagreement: your money is not growing tax-free in a T-401k. It is growing tax-deferred and that is a big difference, given that the majority of your taxable withdrawals will be from growth in the account, not original contributions.

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I understand what you're saying, but functionally, much of that money is actually growing tax free.  I will clarify below.

Look at it this way:

Imagine $1000 in income taxed at a marginal rate of  25%.  Also assume a 25% marginal rate on withdrawal.  In this example, in order to maintain clarity, also assume a pension or other income such that the IRA funds will all be withdrawn at that same 25% marginal rate.

Now, if you earn $1000, and pay 25% in tax, you will be able to put $750 in the Roth. ( yes, I know you can put in the full $1000, and pay the taxes from other money, and that can make a difference, but again, I want to keep the variables constant for now)  Let's say it exactly doubles in 10 years.  At that point, you will have $1500 tax free.

Compare that to the tIRA.  You put in $1000 tax free.  Of that $1000, $750 is yours, and $250 belongs to the IRS.  In 10 years, it has doubled to $2000.   Now you withdraw the money.  You pay 25%, leaving you with $1500.  Exactly the same as with the Roth.  Why?  Because the tIRA is functionally two different accounts.  Yours, and the money you owe in taxes.

So the tIRA's primary advantage is in tax arbitrage: because instead of paying that full 25%, you will only pay 10  to 20% on withdrawal.  But both accounts function as if they have tax free growth on the original "tax free" principal.

Now, one advantage of the Roth is that you can stuff more money in there to grow tax free, if you can afford to pay the taxes.  However, this is usually a relatively small advantage, because the extra money growing tax free in the Roth is balanced by the identical amount growing in a taxable account. ( In other words, the money that you didn't pay in taxes is extra money that you can invest in a taxable account.  That will exactly equal the money that you will have to pay in taxes from the IRA when you withdraw the money, assuming the same tax rate)  If that account is in index funds, the drag will be about 0.5 % a year.  If it's sold, ( mine won't be) then capital gains will cost approximately  an additional 1.5% per year, but those costs will be overshadowed by  the tax arbitrage advantage, plus the advantage that the tIRA is most likely being withdrawn at a lower effective rate than the marginal rate at which it was deposited into the account.

There's a general misunderstanding of how these accounts work, and you end up with a tail wagging the dog effect, where people put money in Roths when they shouldn't.  For most people, who expect to be in an effective tax bracket in retirement that is lower than their marginal bracket while earning, the tIRA is better.  A Roth is a great option primarily when it's in addition to a tIRA/401k, such as in a backdoor Roth or an after-tax additional contribution to a t401k, where the Roth contribution is not displacing tax deferred money.  It's also great to convert in low income years.  But the tax-free growth actually happens in an IRA account as well, just only on most of the money, not all of it.

Does that clarify what I was saying?

[AlexxT]

DMFA wrote:

but keep in mind Roth has other attributes besides being taxed up front, like penalty-free withdrawal of principal and no required withdrawals at age 70.5.

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I agree, these are additional advantages of the Roth, which I neglected to take into consideration, but I also agree that these are smaller considerations that are dwarfed by the tax arbitrage advantages of the traditional IRA.

[AlexxT]

DarrVao777 wrote:

– Estate Planning Considerations = I’m saving ~50% of my gross income annually. The vast majority of this is in a taxable account. My wife and I tend to be pretty frugal and while I wasn’t planning on leaving an estate behind, it looks like I probably will. Roth contributions tend to be more helpful when planning on giving to heirs due to a lack of RMDs –

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Yes, but consider what their tax bracket will be relative you yours.  If they will be in a lower bracket, they are better off inheriting the tIRA.

DarrVao777 wrote:

– State Taxes = I currently live in a state with no income tax. I plan to return home to California for retirement. The Roth allows me to bypass California’s highly progressive state taxes.

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This is a great point.  I live in California.  It would cost me too much to leave, but state taxes are going to cost me a lot of money, especially because I will be getting a lump sum payment.

[jfoxcpacfp]

Does that clarify what I was saying?

AlexxT wrote:  Does that clarify what I was saying?

Well, it clarifies your misconception. Your argument is the same as saying you pay taxes when you buy a piece of real estate or when you fund a taxable account. Maybe you believe you pay taxes when you gift $14k per year to your children, just because you don't get a deduction? Spending and saving, imo, are not reduced to either "costing me taxes" and "a tax deduction".

I stand by my original point of disagreement - T-401k's grow tax-deferred, to be taxed at your highest marginal tax bracket when withdrawn. Roth IRAs grow tax-free, no matter how you slice the loaf.

As an aside, I've never known anyone to pay taxes out of their qualified retirement accounts, perhaps because I've never recommended that strategy, even during total conversions in 2010.

[jfoxcpacfp]

 

AlexxT wrote:  Does that clarify what I was saying?

Well, it clarifies your misconception. Your argument is the same as saying you pay taxes when you buy a piece of real estate or when you fund a taxable account. Maybe you believe you pay taxes when you gift $14k per year to your children, just because you don't get a deduction? Spending and saving, imo, are not reduced to either "costing me taxes" and "a tax deduction".

I stand by my original point of disagreement - T-401k's grow tax-deferred, to be taxed at your highest marginal tax bracket when withdrawn. Roth IRAs grow tax-free, no matter how you slice the loaf.

As an aside, I've never known anyone to pay taxes out of their qualified retirement accounts, perhaps because I've never recommended that strategy, even during total conversions in 2010.

[trackjunke]

I have also been debating this issue.  My wife and I both currently max out our retirement accounts at 53 k per year in traditional 401k (plus backdoor Roth) but have the option to contribute 17.5 instead into a Roth 401k option.  We did not pursue this initially as it was hard for me to imagine our tax rate will be higher in retirement and with the expect low returns of the markets over the next 10 years or so I was not sure how much of a difference it would even make versus investing the tax savings difference in the taxable account.  We are hoping for FI in 15 years (well before "normal" retirement age) so perhaps some Roth money would be advantageous or at least would hedge our bets on future tax changes.  Any thoughts on this?

[AlexxT]

jfoxcpacfp wrote:

. Your argument is the same as saying you pay taxes when you buy a piece of real estate or when you fund a taxable account. Maybe you believe you pay taxes when you gift $14k per year to your children, just because you don’t get a deduction? Spending and saving, imo, are not reduced to either “costing me taxes” and “a tax deduction”

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Yes, you pay taxes in those cases, because you don't have a choice.  However, in  choosing between a Roth and a tIRA, that is the precisely the choice you're making.  With one, you pay tax now.  With the other, you pay tax later.

 

jfoxcpacfp wrote:

As an aside, I’ve never known anyone to pay taxes out of their qualified retirement accounts, perhaps because I’ve never recommended that strategy, even during total conversions in 2010.

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That isn't what this is about. It's about how much money you have to invest.  If you pay taxes now, you have less money to invest.  That has to be included in the calculations.

I'll try one more time.  After that, you're on your own.

Lets look at someone who has exactly 4000 in after tax money  that they can devote to savings, and they are in the 25% bracket.   That person would be able to either put all 4000 into a Roth, or they could put that money into a tIRA.  By using the IRA they will get a refund of $1333, which they could then add to the IRA.  So such a person would have 5333 in an IRA, or $4000 in a Roth.  Again, when the Roth doubles, it would yield 8000.  When the IRA doubles, it will be worth $ 10666.  If that person is still is paying an effective rate of 25%, then they will owe $2,666 in taxes, and will be left with $8,000.  In other words, the same result, because that after tax portion of the money is effectively growing tax free.  No matter what you want to call it, if the tax rate is the same, the result is the same.

Now, it's most likely that even if they are in the same 25% marginal bracket, their effective rate on the withdrawal will be lower and it is further likely that they will be in a lower marginal bracket.

Hence, the only advantage in this case of the tIRA is the tax arbitrage, not the tax free growth, which is effectively there in the tIRA as well.

Also, while you talked about "paying taxes from a qualified account" that didn't happen here.  But surely you recognize that by putting money in a Roth, you have paid taxes.  That's the money that I'm talking about.

 

jfoxcpacfp wrote:

As an aside, I’ve never known anyone to pay taxes out of their qualified retirement accounts, perhaps because I’ve never recommended that strategy, even during total conversions in 2010.

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Then it's a good thing I'm not your client.   I will be doing precisely that.  Here's why:

I put money my 401k at 39%.   I am currently in some low income years, in the 25% bracket.   If I don't do conversions, I will be paying 33% or higher later due to RMDs.  So I will now be converting to a Roth, paying tax at 25 and 28%.   So, I put it in at 39%, and will pay 28% in order to get it into a Roth.   Is that a good idea?  Yes.  I will pay less tax:  28% now, vs 33 or 39% later.  And the after tax money will go into a Roth, where it will continue to grow tax free.  Will I be paying some of the tax from the qualified account? yes, but I still come out ahead.   Is it better to pay tax from a taxable account?  Yes, but not if I have to pay capital gains in order to come up with that  money.  Using outside money will be better, but in effect, that tax is just empty space that I can stuff other after tax money into, so it's free Roth space I can use.  But I still come out ahead even if that Roth space goes unused.