401k tax strategy.

[JustinH]

Something I have been thinking of.

My wife and I both have pensions from previous jobs, and we have independent IRA accounts. The IRA accounts were funded from various previous employers 401k's. Upon leaving the employer, we would just roll them into the IRA.

I like the IRA it offers great flexibility and more fund choices. Our IRA's were only funded with Rollovers, and pre-tax money.

So the pension accounts stay separate and we can't and don't touch those. Those will guarantee X funds for life starting at age 60 something.

So my wife accepted a role as a contractor on a US Military installation. Contractor job has high salary, but poor benefits.

This is no problem, I can put her on my government health insurance and she is covered, but the contractor company offers 0 percent match to 401k.

Her salary raise is about 40 percent over her current salary.

Does it make more sense to contribute to the 401k account with no match, so the money stays pretax, or fund the IRA with post taxed money?

Our goal is to contribute money to retirement, and lower our Tax liability. We owe quite a bit every year, and it would be nice to able to "lessen" her income on our annual tax filing.

We are both in our 30's.

 

[JohnnyG]

At age 30 I'd strongly consider a ROTH IRA. Tax paid money goes in, but your withdrawals in retirement will be tax free.

 

[supton]

If no match then I'd jump into a Roth. More flexibility in the short term regardless of tax advantage--that money can be viewed as a form of emergency savings. Not quite as liquid as cash but not locked up like a 401k. That I think is worth something.

Then go and contribute to the 401k.

 

[jrvn]

you can fund your own IRA yourself if you don't get an employer match at the job, and then use it as a itemized deduction on your income tax at the end of the year, plus it frees you up to make your own investments into funds/bonds/stocks that may pay more than whats offered at the jobs limited portfolio. or buy into a ROTH IRA and get the distributions tax free if your 60 years old now it wont be long till you start taking the money out if you plan on retiring and not working at all

 

[wwillson]

The 401k is much more tax efficient on the first $19,500 (I believe that is the correct number). But, you'll have to compare your effective tax rate now and guess at your tax rate at retirement. Run both scenarios through an investment calculator to estimate if the 401k or Roth will yield more at retirement.

 

[Quattro Pete]

Keep in mind, there are income restrictions on Roth IRA. Above certain income level, you're not eligible for Roth IRA contributions at all.

Roth IRA Contribution and Income Limits: A Comprehensive Rules Guide

In 2023, you can contribute up to $6,000, or $7,000 if you’re age 50 or older, to all of your Roth and traditional IRA accounts.

www.investopedia.com

 

[JeffKeryk]

If you fund retirement with after tax income, you lose all the time value of the taxes you pay. There is no free ride.

 

[Astro14]

With a $40K increase, I would do both. Seriously.

The 401(k) without a match saves you the income tax on that income at today's rates. The Roth will save you taxes at your retirement rate. The calculators will run the numbers, but they're based on your assumptions of parameters like tax rates, growth, inflation, etc. so they may, or may not, be accurate.

The marginal dollar, the last dollar she makes, will be in your highest bracket. So that dollar in a 401(k) will save you the max tax rate that you're paying. Between Federal and State, that can be a lot.

Personally, the savings now, which gives you the money in the account now, and the future growth on that money, as Jeff said. In my case, I am maxing out my 401(k). My IRAs, from the 1990s, were pre-Roth, so I will pay taxes on them, too. I make too much for a Roth, so I don't bother with IRAs.

 

[ARCOgraphite]

At age 30 I'd strongly consider a ROTH IRA. Tax paid money goes in, but your withdrawals in retirement will be tax free.

If you have no other substanatial income I would say your 401 K withdrawals - even at RMD - rates will end up tax free
in retirement. The ROTH may be good for extra post tax money for retirement savings only.

Show me the real world scenarios and the calculations including full state and Federal tax impacts.

 

[Donald]

Get the 401K with no match. Better than nothing.

 

[wwillson]

Here is a pretty good pre vs post tax retirement calculator. Play with the numbers to see the difference. I believe it demonstrates that both methods can yield similar results and the most important factor is to start saving when you are young and contribute as much as you can, regardless of which method you choose.

Calculator: Roth 401(k) vs Traditional 401(k)

A Roth 401k allows you to contribute on an after-tax basis. Use this calculator to help decide whether you should invest in a Traditional or Roth 401K.

www.aarp.org

 

[JTK]

Does it make more sense to contribute to the 401k account with no match, so the money stays pretax, or fund the IRA with post taxed money?

Our goal is to contribute money to retirement, and lower our Tax liability. We owe quite a bit every year, and it would be nice to able to "lessen" her income on our annual tax filing.

We are both in our 30's.

At your age, I would do a mix of pre and post tax.

Knowing you from BITOG over the years, either way, you're on the right track.

 

[JustinH]

Thank you folks, a lot of bright investors on here.

I am going to have her contribute to the 401k, as well as add a secondary account (Roth IRA) to our current portfolio, and contribute $6k to that.

We are right under the limit for contributing to ROTH so we mine as well do that while we still can.

 

[Astro14]

I read 40% as $40K. Still, If you're able to take the salary increase and invest it all for the future, you'll be fine. It's the act of investing, rather than than the particular details of those investments that lead to your future success.

I like the 401(k) because right now, today, you're facing a big tax increase, and if you take that salary increase and contribute it, you'll save that tax bite. If you can do a deductible Roth, you accomplish the same.

If the company 401(k) has limited investment choices, then make your investment in cash and do an IRA rollover at the end of the year - you get the tax savings now, keep the tax free growth, and open up the investment options to those you prefer in your IRA.

 

[Wolf359]

Thank you folks, a lot of bright investors on here.

I am going to have her contribute to the 401k, as well as add a secondary account (Roth IRA) to our current portfolio, and contribute $6k to that.

We are right under the limit for contributing to ROTH so we mine as well do that while we still can.

I believe the order would be to max out the Roth IRA first so both of you would do 6k each. Then you can max out the 401k and if you have any spare cash left over after that, you can just do regular investments. 401k plans tend to charge higher fees so an individual Roth IRA should be cheaper. Also funds can be limited in a 401k.

 

[JHZR2]

I don’t think we know your total salary. Roth IRA straight up may not be doable, need to use the backdoor Roth trick that folks who earn “too much” use. (Edit, see you’re right under the limit, so may be worth using the regular 401k to keep you under the limit for the long run), just reduce your ability with it, and bias how much you put in each to keep everything correct).

Does the contractor offer a Roth 401k? That might be easiest and straightforward. Since you’re in your 30s you can expect long term growth and so the tax free part is beneficial.

But don’t underestimate the advantages of using the regular Type to reduce your taxable income now, if it’s of benefit. You have to run the math...

 

[Kuato]

At age 30 I'd strongly consider a ROTH IRA. Tax paid money goes in, but your withdrawals in retirement will be tax free.

Yup, my first thought when reading your first post, JustinH. Taxes historically only go up, and having a nice portion of retitement funds available to withdraw tax free allows for flexible planning.

With a 40% increase in salary, I would take the after tax pay while I could and put the maximum into a Roth IRA, which is 5500 this year.

Then, arrange the 401k depending on what mix of Roth:standard makes the most sense from your calculations, and use the remaining increase in pay to fund that.

 

[doitmyself]

Oh man, I've been studying the Roth vs. other avenues all winter and cannot figure it out. I'm 65, about 2 years to retire - some told me to start building up my Roth account for diversification.
- Some Roths will have early withdrawal penalties before 5 years and/or 59.5 years age.
- One has to guess if when they retire, will they be in a higher or lower tax bracket compared to present day. I.E., if my spouse dies post retirement, as a single filer, it seems that I will jump into the next higher tax bracket (12% vs. 22%)????? Comments Anyone???? So, better to pay taxes now vs. later???????

Excellent question with difficult to ascertain answer because situations vary tremendously.

 

[Wolf359]

Oh man, I've been studying the Roth vs. other avenues all winter and cannot figure it out. I'm 65, about 2 years to retire - some told me to start building up my Roth account for diversification.
- Some Roths will have early withdrawal penalties before 5 years and/or 59.5 years age.
- One has to guess if when they retire, will they be in a higher or lower tax bracket compared to present day. I.E., if my spouse dies post retirement, as a single filer, it seems that I will jump into the next higher tax bracket (12% vs. 22%)????? Comments Anyone???? So, better to pay taxes now vs. later???????

Excellent question with difficult to ascertain answer because situations vary tremendously.

Hard to give good answers with more data which you probably don't want to share.

Key points being how much do you already have saved up? If you're already 65, the early withdrawal penalty won't apply. When will you need the money? Don't forget that it's not only about the tax bracket, but the tax free withdrawal at a later date. The longer you have it, the more it's worth as it grows the longer you hold onto it. The fact that you no longer qualify for a Roth IRA after a certain income should tell you that you should do the Roth first if you qualify, it has the most benefits. If you're going to be in a higher tax bracket later, a Roth IRA definitely makes sense, you pay lower tax dollars now and get tax free dollars later that would normally be taxed at a higher rate. If you're in a higher tax bracket now and expect to be in a lower one later, then a traditional IRA sounds appealing over a Roth but long term growth could affect the savings. The unknown is the length of investment period and the rate of return and the tax rate. Some of those are unknowable and some known only to you so hard to give real advice here.

 

[RhondaHonda]

The issue is nobody knows what the future tax rates will be. I know someone that retired 9 years ago and he makes more in retirement than he ever would’ve guessed investing in various businesses. He has a very sizable RMD to take every year but just chalks it up as a good problem to have.

doitmyself-I’d probably do whatever reduces your tax liability the most in the present as you are so close to retirement. If there is in fact a 5 year ROTH withdrawal restriction I’d just load up the 401k at this point or even keep some in cash as emergency funds depending on your situation.