Need help with balancing 401(k) and Roth IRA

[Razl]

contributions. I used to put in 15% into my company's 401k on a pre-tax basis. The employer in turn match 100% on the first 6%.

Last year, I decided to reduce my contributions to 10% because I was not happy with our 401k fund selections. Then I opened a life cycle Roth IRA with Vanguard, putting 5% (post-tax) of my pay into it each month.

I thought this ways a good descision becuase I'm still getting the full employer match on the 401k and in the end kept my contribution level the same.

However, I was told by a friend that I am better off maxing out ($14,000) my 401k contributions first before thinking about contributing to an IRA, Roth or Traditional. However, I didn't have time to go into the "why" aspect.

Is he right?

 

[kang]

I think the answer is in your post. The 401(k) is pre-tax, while your Roth IRA is post-tax. You’ll get the most benefit by maximizing your pre-tax contributions.

 

[Razl]

It wasn't sure if it was simply a matter of pre-tax versus post-tax contributions.

I view Traditional and Roth IRAs as the same net benefit, meaning do you want to pay the taxes now (Roth) or later (Traditional).

Thinking about what you said, would there be any disadvantage to contribute to a 401k and Traditional IRA since both are pre-tax moneys going in?

 

[Al]

The advantage in the Roth, unless I'm out in left field is you pay no capital gains on it when you cash it in. Correct me if I'm wrong.

 

[DKT]

I think it also has to do with age and tax bracket.

The thinking on age is that if you can defer taxes on the income over a long period of time, inflation will reduce the tax bite. For example if you take $1,000 pretax, and are in the 25% tax bracket then the current taxes would be $250. If you push the tax out 10 years, and the bracket stays the same, the present value of the $250 in 10 years will be less due to inflation (ie $250 in 10 years won't be worth what $250 is today).

The thinking on the tax bracket is that once someone retires they will probably be in a lower tax bracket than they are during their working life, and thus will pay less taxes in the future.

I have always tried to defer taxes whenever I can (probably to a fault, as I will hang on to investments that have gains longer than I should for fear of the tax bite).

 

[msparks]

quote:

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Originally posted by Razl:

However, I was told by a friend that I am better off maxing out ($14,000) my 401k contributions first before thinking about contributing to an IRA, Roth or Traditional. However, I didn't have time to go into the "why" aspect.

Is he right?

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Unless you plan on retiring "poor" so that you are in a lower tax bracket than now, you should be putting money in a Roth IRA.

Can you imagine having a couple of million dollars tax free???? Ask your friend that.


I would put enough in your 401K to get 100% matching, then after that put whatever else you have in an IRA. If you are maxing that as well, then up your 401K but only after you max your ROTH.

 

[msparks]

quote:

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Originally posted by DKT:
The thinking on the tax bracket is that once someone retires they will probably be in a lower tax bracket than they are during their working life, and thus will pay less taxes in the future.

I have always tried to defer taxes whenever I can (probably to a fault, as I will hang on to investments that have gains longer than I should for fear of the tax bite).

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If that is true, (your staying in the same bracket or lower) then go pretaxed.

I'm an optimist. I'm hopeful to have several million by retirement. The more that is "tax free" the better!!

Of coarse in my perfect world they would stop all taxes. And only charge a National Sales tax. Then I would be screwed big time since I already paid the tax on it. But I would take that since a use tax is better for everyone!!!

 

[msparks]

quote:

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Originally posted by Razl:
Thinking about what you said, would there be any disadvantage to contribute to a 401k and Traditional IRA since both are pre-tax moneys going in?

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With a tradition IRA you can invest in more things. Heck you can Day Trade your IrA if you want. (ask Pablo

)

 

[Razl]

quote:

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Originally posted by Al:
The advantage in the Roth, unless I'm out in left field is you pay no capital gains on it when you cash it in. Correct me if I'm wrong.

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Eligible distributions, including capital gains, interest, and dividends, are tax-free.

Thanks for everyone's input so far. I'm still left scratching my head

To keep things simple, let's say I have a 401k and Traditional IRA. Should I max out my 401k and then contribute anything left over to the IRA? Or the opposite, putting in just enough in the 401k to get the match and maxing-out on the IRA

 

[DKT]

Thanks for everyone's input so far. I'm still left scratching my head To keep things simple, let's say I have a 401k and Traditional IRA. Should I max out my 401k and then contribute anything left over to the IRA? Or the opposite, putting in just enough in the 401k to get the match and maxing-out on the IRA

I don't think it matters. I believe you can move money out of your 401k into your traditional IRA with no penalty as long as it is done within 60 days of the withdrawl (I could be wrong on the timeline). I left my company a few years ago (I'm back with them now) and I chose to rollover my 401k into my IRA, with no penalty. I'm now contributing back into the 401k.

The only advantage that I can see is that some 401k's have limited investment options, where with an IRA you have many investment options.

 

[3000GT VR-4]

quote:

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Originally posted by Razl:
It wasn't sure if it was simply a matter of pre-tax versus post-tax contributions.

I view Traditional and Roth IRAs as the same net benefit, meaning do you want to pay the taxes now (Roth) or later (Traditional).

Thinking about what you said, would there be any disadvantage to contribute to a 401k and Traditional IRA since both are pre-tax moneys going in?

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I just got back from a pre-retirement seminar put on by a local public employer. The instructor stated that for us it is better to keep the $$ in our 457 plan (what we have instead of the 401) because we are eligible to take money out beginning at age 55 without penalty instead of 59 1/2 with the IRA. You might want to check your 401 plan document to see what the minimum age is for that.

Usually you will be way ahead of the game by putting the money in pre-tax. You will have a larger sum to grow over time. With compound interest you will have a much larger total at the end. And most people will be in a lower tax bracket when they retire, so they save on taxes when they withdraw the money in retirement.

I believe the usual progression recommended by financial planners is to max out the 401K, then the Traditional IRA if you qualify, then the Roth.

 

[3000GT VR-4]

quote:

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Originally posted by Al:
The advantage in the Roth, unless I'm out in left field is you pay no capital gains on it when you cash it in. Correct me if I'm wrong.

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If you keep the Roth for 5 years you pay NO TAX of any kind on the $$.

 

[Scooby]

I do both Roth and 457.

I like the idea of the Roth because the money is tax free. I am positive that I will be in a higher tax bracket when I retire.

When I retire I will have my county pension, state FF pension, plus whatever from my 457. I'll retire at 50. Don't plan on hitting Roth until 60+.

 

[DKT]

I put together a spreadsheet that tries to model a Traditional Vs a Roth. If I have it set up right, the Roth is clearly the way to go for the criteria I set - 25 years of contributing, $3,000 per year, and then an extended retirement (I used 30 years). The only way the Traditional has an advantage is if your tax bracket drops to 15% when you retire. The tax bite is just too big on the Traditional. I used both 10% annual growth and 8%, and took into account the tax savings on the Traditional, and also the additional tax on the interest earned on this tax savings.

Anyone know how to paste an Excel spreadsheet? I tried the copy and paste (Ctrl C, Ctrl V), but the columns don't line up and it will be impossible to read.

 

[3000GT VR-4]

quote:

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Originally posted by DKT:
I put together a spreadsheet that tries to model a Traditional Vs a Roth. If I have it set up right, the Roth is clearly the way to go for the criteria I set - 25 years of contributing, $3,000 per year, and then an extended retirement (I used 30 years). The only way the Traditional has an advantage is if your tax bracket drops to 15% when you retire. The tax bite is just too big on the Traditional. I used both 10% annual growth and 8%, and took into account the tax savings on the Traditional, and also the additional tax on the interest earned on this tax savings.

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How did you figure the tax savings on the traditional? Add an additional amount to that account each year?

Remember, with the Roth you have to have an additional amount of cash now to pay the taxes on the amount you are depositing. So it's not a realistic comparison if you put the same amount into both accounts.

 

[DKT]

What I did on the Traditional was to calculate the tax savings based upon the amount ($3,000) and the tax bracket. For example at 28% tax the savings would be $840. I then calcuated the extra interest gained on this $840 at the investment rate, and for 10% it would be $84, and then I figured the tax on the $84, so for the 1st year the Traditional would look like this:

Contribution - $3,000
Tax Savings - $840 (28% bracket).
Interest off of savings - $84 (10%)
Tax on Interest - $24 (28% bracket).
Growth of the $3,000 - $300 (10%)
For a total year 1 impact of $4,200.

I then replicated these calculation over 25 years, but instead of growing $6,000 in year 2, I grew $7,200 ($3,000 plus $4,200).

I guess I'm assuming that everyone can pay their taxes on their current income and savings, so there is no additional tax for the Roth, but there is a tax savings for the Traditional.

 

[Gary Allan]

The Roth, IMHO, is the best deal. You're all going on the assumption that you'll be in a given tax bracket at retirement.

I'm of the assumption that the reactive nature of our future tax system will chip away at all sheltered pension type investments. Your house will likely be paid for ..etc...etc...and you'll have nothing to save you from the tax man.

You don't know what the future tax structure is going to look like. I assure you it will "follow the money". With a mass of the population bringing out taxable $$$ as they retire ..that tax will find them.

Don't think that 28% is the upper limit in your future when you retire. You may be in a 40% bracket.

Anyone think that they will escape higher taxes 30 years from now?? A Roth is the only currently available trump card in the game.

 

[DKT]

Gary,
I totally agree. I was just presenting the only scenario where the Traditional was superior, but the chances of that scenario panning out are low. The only way is in retirement to load up on tax fee municipals for the income to get your tax bracket low enough, and I don't know if the Alternate Minimum Tax would kill that approach or not.

The simple spreadsheet was sure an eye opener.

 

[3000GT VR-4]

quote:

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Originally posted by DKT:
What I did on the Traditional was to calculate the tax savings based upon the amount ($3,000) and the tax bracket. For example at 28% tax the savings would be $840. I then calcuated the extra interest gained on this $840 at the investment rate, and for 10% it would be $84, and then I figured the tax on the $84, so for the 1st year the Traditional would look like this:

Contribution - $3,000
Tax Savings - $840 (28% bracket).
Interest off of savings - $84 (10%)
Tax on Interest - $24 (28% bracket).
Growth of the $3,000 - $300 (10%)
For a total year 1 impact of $4,200.

I then replicated these calculation over 25 years, but instead of growing $6,000 in year 2, I grew $7,200 ($3,000 plus $4,200).

I guess I'm assuming that everyone can pay their taxes on their current income and savings, so there is no additional tax for the Roth, but there is a tax savings for the Traditional.

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OK, I think I follow you on that. What did you do with the Roth? Just take $3000 and grow it 10% each year? $3,000 + 300 = $3,300 at the end of year one, etc?

Then, at the end of the scenario, apply the new tax bracket to the traditional total only? And the Roth still came out ahead?

I wonder what you would get if you took a fixed amount that the person had to invest, say $3,000 and put it into the Traditional before taxes (all $3,000), then paid the tax on it before putting it into the Roth ($3,000 - 28%)?

 

[3000GT VR-4]

quote:

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Originally posted by Gary Allan:
The Roth, IMHO, is the best deal. You're all going on the assumption that you'll be in a given tax bracket at retirement.

I'm of the assumption that the reactive nature of our future tax system will chip away at all sheltered pension type investments. Your house will likely be paid for ..etc...etc...and you'll have nothing to save you from the tax man.

You don't know what the future tax structure is going to look like. I assure you it will "follow the money". With a mass of the population bringing out taxable $$$ as they retire ..that tax will find them.

Don't think that 28% is the upper limit in your future when you retire. You may be in a 40% bracket.

Anyone think that they will escape higher taxes 30 years from now?? A Roth is the only currently available trump card in the game.

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True. Or, they could just make our tax-free Roth IRAs taxable.