Looking for the 401k tax pros out there. I have four primary 401k tax related questions:
1) Income Tax Bracket at Retirement:
When retiring and "cashing out" on a trad 401k: I understand that we are taxed at whatever income bracket we're in at the time of retirement. How is this determined?Does the income tax bracket take into account how much retirement funds we have (aka will be receiving each month during retirement?)Or, is it literally where a person is immediately prior to retirement? Of course, this can't be the case, because what would prevent someone from taking a low-wage job immediately before retirement? I assume the final tax bracket is calculated by taking a person's total net worth upon retirement and dividing that over their working lifetime...? Is this correct?
This then brings me directly to my 401k specific questions...
2) Taxes on principal contributions, and taxes on 401k earnings / interest (if any):
Are we taxed on only the principal contributions to a traditional 401k upon retirement? Or, are we ALSO taxed on the principal contributions PLUS any gains & compounding interest made over the years? If so, it seems the Roth 401k is the clear choice for almost everyone since the gains/interest is tax free at retirement. If I have this correct, why would anyone choose a traditional 401k over a roth 401k if they have the option, besides a slight monthly takehome pay increase with the trad?
3) Tax payment on a split Trad 401k / Roth 401k account:
If my employer just began offering a roth 401k option, in addition to a trad 401k, and we have the ability to split the contributions between trad (taxes delayed) and roth (taxes paid), how would future contributions / taxes work if my split is (for example) 10% trad and 5% roth? Or do both trad/roth go into the same contribution pool, but each contribution is simply taxed differently come tax time, based on the original trad pool amount, the new trad/roth contribution ratio, and when the ratio was changed? In other words: would I lose out on compounding interest by splitting up my 401k contributions between both trad and roth, or do they go into the same 401k pool regardless?
4) Rolling over a trad 401k into a roth 401k:
Say I have $100k in my trad 401k, and I'm contributing the full $19k per year, and I'm currently in the 24% tax bracket. Now, say, a new big job offer comes by and I anticipate that I'll be moving into the 32% tax bracket in a few months or a year.
Can I roll the $100k (trad 401k) into a roth 401k and pay the trad 401k tax at 24% first, before moving into the 32% bracket, preventing paying 32% taxes on the original $100k? See what I'm saying here? The goal would be to minimize my retirement tax payment to Uncle Sam - surprise!
Thinking about this further... The problem is, I suppose, that if I move into that 32% tax bracket 5/10/20 years down the road, paying the rollover tax of 24% on ~$400k+ could be an extreme amount of cash that I may or may not have laying around (e.g. used for a home down payment instead), and using cash from the 401k itself to pay the rollover taxes would erase years of compounded interest. Is this line of thinking correct?
Thank you very much for taking the time to read through my questions. Looking forward to hearing back and learning more!
Replying to "user's" answer below... Looks like comments are limited in size, so I'll have to reply with an answer.
Great answers, thank you. Follow-up comments... (T plan = trad 401k = T-401k ; R plan = Roth 401k = R-401k)
1) Ok, I believe I understand this correctly. Thinking this through... Depending on how much a person chooses to withdraw from their 401k (RMD + more), plus any other retirement accounts and other sources of income, the combined sum is what determines their bracket. So, if a person just has a 401k upon retirement and they choose to withdraw the RMD, that would put them in the lowest possible tax bracket (trad being better since need to pay taxes still). If they choose to make large withdrawals that come out to greater than what they were earning normally when working, that will likely bump them up into a higher bracket (Roth being better since taxes already paid). A person may have additional income sources upon retirement, so that will play into the final tax bracket.
2) Because the contribution limit for both T & R plans is the same at $19,000 per year (2019), and that earnings ARE taxed with the T plan but NOT taxed with the R plan, I'm not seeing how the math works out. I understand $1 dollar today will (probably...) be worth more than $1 dollar in 30 years due to inflation etc. and that the pre-tax T plan savings are beneficial there --- i.e. the "time value" of money like you mentioned, but I don't see how this trumps NOT being taxed on EARNINGS with the R plan. Yes, contributing $19,000 per year to the R plan means an additional +XX% income tax now on top of that $19k, so I see the time value of money in play here. Perhaps that could be saved and put towards something else (e.g. house down payment, etc.) But, the fact that the yearly principal contributions grow linearly at $19k/year and the earnings (hopefully / theoretically) compound and grow exponentially, and these exponential earnings are NOT taxed with the R plan (but they are with the T plan) makes me think that the R plan is a better choice for most working / middle-class folks and up who contribute regular healthy amounts. This is most certainly the case if a person "thinks" they will be in a higher retirement tax bracket, which I think is the "answer" here, ultimately. Thanks again for your analysis.
3) Rephrasing this question: imagine a 401k account with $100k. Would splitting a current T plan contribution level of $19k into a 50/50 T/R 401k split ($9,500 T & R each) have a reduced compounding effect on the original T-401k already at $100k? Or, would that $9,500 going into a $0 balance new R-401k be better served going into the original T-401k already chugging along? Answering my own question after writing this... it shouldn't matter, correct? Mathematically I believe it comes out the same and a new split shouldn't have any negative interest & earnings effects. The only thing to be concerned with is the pre/post tax differences of the T and R plans, which we discussed above.
4) Got it, thanks.