Roth 401(k)

[Arrian]

So as of this coming year, my company is offering a "Roth" 401(k) option. I understand the basic differences between a regular 401(k) and a Roth. For those who don't:

In a regular 401(k), you put in the money tax-free, but pay taxes in the future, when you withdraw the money.

With a Roth, you pay the taxes now, but the withdrawals are tax-free.

So the question seems to be will one's taxes be more now or later? This is complicated, because not only might the tax scale change, but one has to guestimate one's retirement income.

The current plan is that my wife will switch all of her contributions over to the Roth (you can split your money any which way you want between the regular and the Roth) and I will stick with the regular one. Since we both have a fair chunk of change in our regular 401(k)s already, it will be some time before the $ amount in her Roth 401(k) climbs up to equal it. I'm thinking we want a balance of the two. Having a pool of tax-free money will be nice, and furthermore I figure taxes are more likely to rise than fall.

Any thoughts from the more financially savvy Apolytoners?

-Arrian

[DanS]

I balance the two approaches by maxing out both the 401(k) and Roth IRA. Am I understanding correctly that a Roth 401(k) would simply be you having a 401(k) maximum contribution ($15,500 per annum or whatever) and the Roth attributes?

My way is not a very precise way of doing it (I'm sure that there is an optimal blend for someone my age), but I suspect that it doesn't need to be too precise.

[Arrian]

Gotcha. We're not maxxing ours out at this point, though that may change once we've got our new house sorted out (we plan to buy this coming spring).

The $15,500 maximum is for all 401(k) contributions combined. So you could, for instance, put $8000 into your Roth and $7500 into your regular 401(k), not $15,500 into each.

The way our company is doing it, the investment account will be all-in-one, but they will track the "contribution streams" so they know what money you've paid taxes on and what money you haven't.

The Roth 401k option is nice to have now that I've found out there is an income cap for Roth IRA contributions.

-Arrian

[DanS]

Yes, there's an income cap for a Roth IRA, which as I recall vaguely, starts phasing in around $100,000 or $110,000.

My employer doesn't have a Roth 401(k) option.

Obviously, if you're young, you should skew the share toward the Roth. If you're older, you should skew the share toward the traditional.

[Arrian]

That's about right, IIRC, but the problem is it's not double that for couples. Married filing jointly it kicks in at $150,000 and phases out your ability to contribute at $160,000.

-Arrian

[DanS]

I crossedited you, adding some concepts about the balance of the two approaches.

[Arrian]

Originally posted by DanS
Obviously, if you're young, you should skew the share toward the Roth. If you're older, you should skew the share toward the traditional.

My apologies if I'm a little dense about this, but why exactly is this? I know it's conventional wisdom about retirement planning, but can you give me the play-by-play reasoning?

Perhaps we should both switch entirely over to the Roth for a while. We both turned 30 this year (well, a couple more weeks for me), so we're relatively young. And we've already accumulated decent-sized traditional 401ks.

-Arrian

[Arrian]

Heh, I've been "DanSing" you too.

-Arrian

[KrazyHorse]

My apologies if I'm a little dense about this, but why exactly is this? I know it's conventional wisdom about retirement planning, but can you give me the play-by-play reasoning?

Because you're in a lower tax bracket when you're young than you should be when you're retired?

That's the only situation in which Roths make sense versus traditional.

[Arrian]

That appears to be the assumption. By is that assumption necessarily valid? I mean, why wouldn't you be in a higher bracket while you're in your prime earning years?

-Arrian

[Imran Siddiqui]

Depends on where you work. Though usually people make more as they get older, due to being more senior or having more experience and therefore having more promotions under their belt.

[Arrian]

Yes, true, but I'm talking about now vs. retirement. In retirement, your income will be dispersements from your retirements savings accounts (IRA, 401(k), pension, social security , etc.).

-Arrian

[Ogie Oglethorpe]

Roth Ira's tend to be a sound investment for those who are young and presumably at lower tax brackets. As one achieves seniortiy and/or increases in wages due to promotins/job switches etc. your tax rate likewise increases thus making it more costly to max out your contributions in terms of pretax dollars.

Quick and easy spreadsheet. Interest income is very simply expressed here but gives you the idea.

[pchang]

Don't trust the government

There is a marginal cost to paying tax now vs. paying tax later. You could use the tax savings to save now in a taxable account. The longer you can do this, the more likely it is that you will make more money in the long run. Also, making Roth vs. IRA calculations assumes that the tax structure in the future will be the same as it is now. This is almost certainly not going to be true if the future is anything farther than 10 years out. In general, never pay taxes now when you can pay later.

Edit - my situation is probably more straightforward than most regarding Roth vs. Traditional 401K/IRA

[Arrian]

As one achieves seniortiy and/or increases in wages due to promotins/job switches etc. your tax rate likewise increases thus making it more costly to max out your contributions in terms of pretax dollars.

That makes more sense! Thank you for that, and for the spreadsheet (I'll grab it once I'm home... downloading it here @ work would not be smart - less smart than posting at 'poly in general, even ).

-Arrian