I was reading all about how to decide between a Roth 401k and a traditional 401k, and I gathered that it all boils down to whether I think my tax rate will be higher when I retire than right now.
So let’s fast forward 40 years and I’m retired. I’ve chosen a Roth 401k and, for simplicity, my 401k distributions will be my only source of income. Since that money’s been taxed already, would my after-retirement income tax bracket be 0%?
And alternatively, wouldn’t a traditional 401k discourage me from saving as much as I would with a Roth, since the more I save, the higher my after-retirement distributions. This could bump me up to a higher tax rate and make me regret not going with the Roth.
I thought I understood how this works, but the 401k-distributions-as-income part’s introducing this weird pseudo-recursive thing and I’m getting a bit confused. I’m sure I’m not taking Roth’s taxes into account or something. How do you determine your after-retirement income bracket?
Well, you’ll also have Social Security. But for most of us, we’ll earn less when retired. Thus, it’s better to get a 28% “deduction” now than a much lower or 0 deduction when you retire.
It’s doubtful that you’ll have so much socked away in a traditional 401K that your bracket will be high. If you were religous about it, say you have $1 million. Now before, you earned 100K a year, and you lived nicely off 4000/mo after taxes and retirement. You will likely then need only $3000/mo to live as well. Your funds will last you more than 30 years. Actually, it’s better. Roll the 401 over into a annutity. No taxes due at time of roll over, and then get $5000/mo for life.
There was just a thread that turned into a big debate about this. You really want to talk to a pro who can look at your specific numbers.
There’s more to look at than your tax bracket now vs. later. What you probably want is a mix of tax-free and taxable retirement income - a Roth AND a traditional (or some other equivalent). The reason is that you can game the tax brackets during retirement - if you play the numbers right, you might pay 0% tax on everything, even the traditional IRA. Here’s an example of what I mean with two scenarios that provide 60k to live on each year:
Income: 20,000 social security, 20,000 Roth, 20,000 401k (taxable).
In this scenario, you could pay 0 tax. The taxable income is low enough that no Social Security is taxed, and married couple’s standard deduction and exemptions would be enough to eliminate tax on the 20,000 traditional 401k.
Income: 20,000 social security, 40,000 401k (taxable)
In this scenario, everything is from taxable income. Because taxable income is over the SS limits, something like 8,000 of the social security becomes taxable too. $48,000 less $20,000 for deductions and exemptions means you’re still paying something around $5,000 in tax.
And… having a combination of tax-free and taxable means you can always game the system. No matter what they do in the future with taxes, you’ll be able to pull some money from each source to control how much tax you pay.
Thanks DrDeth, the line about people earning less after retirement makes a lot of sense to me. How do people earn more when they stop working? Apparently there are enough of them out there to effect the creation of Roth 401k and IRAs.
I plan on ‘earning’ more after retirement then before. My wife and I both put away the max under both our 401k and Roth plans, so our take home pay is significantly reduced from our gross pay. When I retire I actually will have more take home pay then I do now! With my wife’s pension, SS and what I draw off our retirement funds I easily will have an income about 25% higher then it is now. My goal is to make as much of it non taxable as I can.
In addition to Hakuna Matata’s scenario, if you can start saving in a Roth early in your career (when not earning much) you will likely be in a lower tax bracket than when you retire.
Really rich people love Roth IRAs. But honestly, if you have plenty in your traditional, then a small Roth can be a good idea.
The problem (and good news) about a Roth is that the cost of early withdrawal is much less than with a Traditional. But for most dudes, that makes it too damn easy to raid your retirement. If your Roth is your only retirement, that spells disaster later on in your life.
If you get really rich by having a high income then you may not even have the option of choosing a Roth. There are income limits. In which case, it’s the traditional IRA or nothing (outside of other non-government deferred tax plans).
Traditional IRAs also have income limits (at least, if you want them to be tax-deductible). Above a certain income you can only open non-deductible IRAs. However, as of this year you can convert these IRAs to Roths with no income limits.
Few people earn more the next day when they stop working, but lots of people earn more when retired than they do in the first decade or so of their employ.
I’m in my 20s, and I’ve been aggressively contributing to a Roth IRA because, while I don’t expect to earn more when I retire than I did the year before I retire, I do expect to earn more when I retire than I did last year.
Fortunately, the new tax laws (effective for 2009 on) provide a loophole you could drive a bus through by permitting people at any income level to do Roth conversions even if they can’t do Roth contributions. So you make the traditional Roth contribution and then convert it to a Roth.
Even if you’re at an income level above where you can do traditional contributions, you can still contribute to a 401k, switch jobs and then convert the 401k to a Roth.
If I had 40 years until retirement I’d convert all my IRA accounts to Roth IRAs. New ones would also be Roth. There is no better deal. At 61 it’s not worth it for me to do so.