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I am contributing to my employer's Roth 401(k). The consensus in this question is that when you're young you should make your retirement contributions after-tax so that they grow tax free, and that when you get closer to retirement and your tax bracket increases, you should switch to saving in a pre-tax way like a standard 401(k).

How do I know when I should make the switch? What are the factors, variables, etc. that I need to consider?

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    "The consensus in this question is that when you're young you should make your retirement contributions after-tax so that they grow tax free" I don't see anything that says that. – user102008 Mar 22 '13 at 6:21
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It's not so much a matter of your age as it is a matter of what your current tax rate is vs. what your tax rate will be when you take out the money. As long as your current tax rate is lower than what you anticipate it will be when you withdraw the money, it makes sense to pay the tax now.

Of course you can't know for certain what your tax rate will be when you take out your money, but the answer for most people is going to be "higher than it is now". Some reasons why:

  1. As you age you start to lose deductions (home mortgage gets paid off, kids grow up and move out). You likely won't gain any new deductions that would lower your tax rate as you age, you'll only lose them.

  2. Tax rates now are historically low, and budget deficits are high. That means that higher tax rates are almost certainly coming.

So unless your circumstances are very unusual, I would pretty much always recommend saving after-tax dollars.

Now that I've said that, I'll throw a small wrench into that plan - when you save with a Roth IRA, you are paying taxes today with the anticipation that you won't have to pay taxes later. But this may not necessarily be the case:

  1. The government could decide to tax Roth IRA gains in the future (would be a very unpopular move, but if they decided to do it, who's to stop them?)

  2. The government could change the tax system by lowering income tax rates and creating a VAT, or instituting something like the "Flat Tax". Your Roth money is exempt from income tax, but not from a VAT or national sales tax.

So, you also need to consider the possibility of those things happening and how that would affect you. Ten years ago nobody would have dreamed of the US having a VAT, but now it looks more and more possible.

  • I agree with most of this, but have one small correction. I could easily see the government taxing Roth IRA gains, but not contributions. The reason is that income tax has already been paid on the contributions. – KeithB Dec 30 '11 at 19:54
  • @KeithB - good point, updated my answer. – Eric Petroelje Dec 30 '11 at 20:07
  • Eric, I'm back to this answer, and curious if you have any data to support the "higher than it is now" assertion. My gut says that would apply to 10% of households or less, far from most. I don't see the typical $100k family so easily passing $2M saved. And surely the typical current 15%er isn't saving their way to 25. I'd like to understand how you conclude "most" when I'm at "few". – JoeTaxpayer May 1 '12 at 19:58
  • @JoeTaxpayer - This of course depends on a lot of things, but here's one link that mentions the reason I gave, and a few more I didn't consider: savingadvice.com/articles/2007/06/11/… – Eric Petroelje May 1 '12 at 20:09
  • Much appreciated. I think see your point, but think there's far more discussion needed to get a solid conclusion. There are too many variables along with the unknown of major change to the code. As I uncover more hard data, I'll add to my answer below. – JoeTaxpayer May 1 '12 at 20:23
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I respectfully disagree with Eric. If you invest from day one in a Roth, where, exactly will taxable income come from to put you in a higher bracket at retirement?

I agree, maybe for other reasons than you list, that early on, post-tax is the way to go, because I'll assume that one starts work in a lower bracket. There's probably a majority who start work in the 15% bracket, but over time work their way to 25%. As they grow to 25%, using the pretax 401(k) and IRA can keep them at 15% for some number of years. In any year of low income, for whatever reason, they can convert the pretax money to Roth to top off the 15% bracket.

To bring the point home, if you went post tax the whole way, imagine retiring with $2M in the Roth, but no pretax money. You now have a standard deduction, exemption, and the full 10% bracket each and every year gone to waste. Money you paid 25% tax when you could be paying zero on some of it. The deduction and exemption add to $9750 in 2012, and the 10% rate applies to the first $8700 of taxable income. If you do the math, this is $17,500, and if you plan a 4% withdrawal rate, you'd need 437,500 pretax money to give you the 17500 each year. Last, all three factors (standard deduction, exemption, and bracket limits) all rise a bit each year. An increase of $200 is another $5000 to save pretax.

Edit - 2013 brought the ability to convert within one's 401(k) from the traditional pretax side to the Roth side. This makes possible turning 100% of one's 401(k) money to Roth, and retiring without the benefite of the standard deduction, exemptions, etc.

  • I think this makes sense, but probably doesn't affect the reality of the situation much. First, you are assuming that you have no taxable income whatsoever in retirement. For most, this will probably not be true as even social security can be taxable. Second, the contribution limits on a Roth are small enough that very few people could actually fully fund their retirement with a Roth. So they would need an IRA or 401k to supplement that, leaving them with a source of taxable income in retirement to take advantage of the standard deduction, exemption and 10% bracket you mention. – Eric Petroelje Dec 30 '11 at 20:25
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    The Roth 401(k) makes it very possible a misguided investor can have every cent saved post tax. The current year's limit is $17,000, enough to cover the retirement need right up to the top 10%er. It takes about a million dollars to fill the 10% bracket in retirement at a 4% withdrawal rate. Social security is taxable as income plus half of SS exceeds $25000 today, so it's a consideration, I agree. – JoeTaxpayer Jan 28 '12 at 0:49

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