Confusion about Roth 401K: Better for me to do pre-tax or Roth post-tax contributions?

Question

My company offers a 401K and a Roth 401K. Given the income level of my family (married filing jointly status), IRAs aren't really an option. We're past the Roth IRA limits and get no deduction for a regular IRA.

Currently I contribute to my regular 401K and have barely investigated the Roth 401K option until reading several questions here.

I think I understand the answers given on those questions, but I believe my situation may be different. Right our 401Ks are the only we we lower our taxable income (no mortgage, no children) besides charitable contributions. We are in a fairly high tax bracket. In the future, we actually expect our tax bracket to go down, as one of us may stop working. In retirement I don't see how we can be in a higher tax bracket than we are now (maybe than we will be if one of us stops working, we buy a house, we have a couple of kids, etc).

On top of that, since we are both fairly young all the money that would be going to taxes now has several years to earn compound interest in the 401K instead of being taxed now. Yes, all those savings will be taxed when they come out of the 401K in later years, but will that completely offset the value of having the interest compound now?

So should I switch over to investing in the Roth 401K and take the tax hit now, or is there anything to my current line of thinking?

Answer 1

Re:

"In retirement I don't see how we can be in a higher tax bracket than we are now (maybe than we will be if one of us stops working, we buy a house, we have a couple of kids, etc)."

That's assuming tax rates remain the same. What if tax rates go up? Consider the U.S. deficit and the debt, and unfunded entitlement programs.

Even though you may be in a lower bracket in retirement (bracket, as in ordered income ranges), there's still a possibility that at that later point in time, tax rates in general could be higher than today. So, even though you may find yourself in a lower bracket in retirement, who is to say the tax rate for that bracket won't exceed what you pay today in the higher bracket?

Don't think switch. Rather, I'd consider diversifying retirement savings across both pre-tax and Roth – i.e. make contributions to each type of account – so you're not gambling 100% on which bracket you'll be in, what tax rates will be like in the future, etc.

Then, you'll at least have some money in a Roth account that, in retirement, you can do with as you please without having a tax consequence ... assuming the U.S. government doesn't get so desperate as to change the tax-free nature of Roth account withdrawals! :-)

Answer 2

I have a different perspective. I believe the move to Roth may be beneficial to a select few, but not most, people. I coined the phrase RothMania as I believe that's what's happening. A relatively uninformed move based on fear and not enough analysis. Let's look at a retiree today. A Couple has a $11,400 standard deduction, and 2 exemptions worth $3650 each. This is $18,700 they can withdraw tax free. It would take pretax savings of $467K to support this withdrawal at 4%/yr. The 10% bracket is the next $16,700 of taxable income or another $417K in assets to produce this annual withdrawal. Last, for today, the 15% bracket is the next $51,250 which would require $1.28M to produce. The punchline? Today's retiree (couple) can have over $2.1M in pretax money (this includes pension value if any, of course), and still be in the 15% bracket.

If you can't deposit to a Roth, you are in the 28% bracket now or higher. Are you on track to have over $2M in today's dollars at retirement?

One point that few mention is there are not just the two endpoints. Today's tax rate vs retirement tax rate. Every year offers a situation where your income may drop. A job loss. A spouse staying home with a new child. A disability. A year back at school. These are the years that you might convert to Roth, just enough to fill your bracket back to your average prior rate. e.g. convert to a taxable income of exactly $137,300, and pay a marginal rate of 25%.

I'll be the first to congratulate those who tell me they have a defined benefit pension that will replace their income to such a level, that with their investments, they are retiring at a higher income level than while working. Roth is the answer for them.

Roth is great for the 80 yr old woman I help. 10 years ago, I observed her marginal rate to be 15%, and we convert just enough to put her at the top of that bracket, this year $34,000 in taxable income. This helps slow down the effect of her RMDs (required minimum distributions) continuing to rise and potentially put her in the 25% bracket.

So, to be clear, I'm not anti-Roth, I'm just in favor of a thorough analysis and avoiding the "Roth for everyone" mentality.

Edit - I was asked by a financial writer Kay Bell to write on this very topic, and appear on her site in a guest post Roth IRAs and your retirement income. It goes into greater detail than I could offer here. Tell Kay Joe sent you.

Answer 3

Given the income level of my family (married filing jointly status), IRAs aren't really an option. We're past the Roth IRA limits and get no deduction for a regular IRA.

There's something called the "backdoor Roth IRA". You can contribute to a Traditional IRA and then immediately convert it to a Roth IRA. Assuming that you don't have any existing money in Traditional IRAs, this is exactly identical to a Roth IRA contribution.

Answer 4

For most people, the longer you have until retirement, the more beneficial a Roth IRA becomes. As you get closer to retirement, your income should be higher than what you earn now, pushing you to pay a higher tax rate than what you are currently at, even if tax rates don't change.

You said you were fairly young. Let's assume you've got 35 years until retirement.

Assume you make $50K right now, and earn a 4% raise each year. When you retire, a common goal is to live off of 80% of your pre-retirement income. 80% of your pre-retirement income will be $157K/year based on 4% raises and 35 years until retirement. I can't predict future tax rates, but it is likely to be a higher tax rate than what you are paying now.

Say you invest $300.00 per month for 35 years at 9% interest (S&P 500 lifetime average is 10.5%).

In 35 years, you'll have contributed $126,000. The account will be worth about $890,000. That means that you'll have $764,000 of gain.

If you invested in a 401k, you'll pay taxes on every withdrawal from your $890,000 account, at your retirement rate.

If you invested in a Roth, you'll pay taxes on your contributions of $126,000 and not pay taxes on the gains. This grants you some immunity from tax law changes or even large withdrawals to buy a house, boat, etc. during retirement. All of the taxes paid will be at your rate when investing.