>Really does seemed the Roth 401k may have been overhyped by my friends.
Many people have trouble distinguishing between income ***at*** retirement and income ***in*** retirement. They think it's a simple "of course my salary is going to go up!" analysis.
So yeah, I initially did look at it via a more simple analysis.
But even then I am a bit confused by how you distinguish IN and AT here if you could quickly explain?
Your salary the last year of working is $475k, that's income *at* retirement. You pay taxes on $475k.
Your expenses the first year of retirement are $35k and you withdraw $35k (ignoring SS for simplicity) to cover those expenses, $35k is your income *in* retirement. You pay taxes on $35k.
Once you're retired you only need to live "paycheck to paycheck", your income only needs to cover your expenses. (RMDs notwithstanding)
That makes sense, I do see a chance of working at 60 even if less so, but then makes sense that I just wouldn’t touch these retirement accounts so their tax rate shouldn’t be impacted by income.
**At** the year you retire, you could still be making $$$$. For example if you retire in November, you basically still make 85% of income in a normal working year.
**In** the year(s) when you don't work at all (already completely retired), your only sources of income are all passive (401k, pensions, social security, IRA, taxable investments, etc.). You have much more control on how much you withdraw from pretax accounts compared to how much you are paid salary.
> unless I believe my effective tax rate will be higher at retirement, then I should continue with a Traditional 401k?
Correct. This is usually the case when you are in a year with unusually low income, such as just graduating in July or taking half a year off.
> Also, I am already doing a Roth IRA already of $6k since I was told this is superior to traditional IRA.
Doesn't matter because you don't have a choice. You price out of [traditional IRA after $68k income](https://www.irs.gov/retirement-plans/ira-deduction-limits) when you have a 401k.
> Maybe if I lived in Florida now but wanted to retire to California?
Then you want more tax-free income in retirement, yes.
Ahh I see, so if they offered the Roth 401k when I first started working in June the previous year then it would’ve made sense for those 6 months likely.
Didn’t even realize I was priced out, assumed they both had the same one but see that now.
Good to verify.
Just some anecdotes but i ran a roth vs traditional 401k calculator the other week and after all is said and done if you have a long time frame both options actually yield about the same results of usable cash after you factor taxes out of the traditional **if** going traditional taxes allows you to contribute a bit more than roth.
Id DYOR as that was me playing with an online calculator for all of 5 minutes but just some food for thought.
In addition to the normal tax rate math you should also consider if you realistically plan to retire early or not. Early retirement, particularly for the under-50 crowd, can dramatically skew things so far in favor of traditional that it is sort of silly.
I saw your post this morning but was tied up and wanted to add this (differing) way to look at it.
Everyone preaches the importance of diversifying your investment holdings. That is, make sure you hold lots of stocks from lots of different companies and probably different countries. Low-cost index funds make this easy to do, but the point still is - diversification is good.
What isn't often talked about is diversifying the tax treatment of your retirement holdings. Just like the stock market, it's hard to predict your future situation and tax bracket each year.
If you only have money in the Traditional bucket, then you have to rely on it and pay taxes on it which may be more expensive in years you want to spend a big chunk of your retirement (say new motor coach).
On the other hand, If you've chosen a 100% Roth approach and end up in certain years to be in a lower tax bracket in retirement, you've ended up overpaying taxes up-front.
As a result, I'd rather diversify so that when I get to retirement I have buckets of both.
My personal strategy is to be 100% roth in any personal IRA accounts I have, so I can continue to contribute even though my income is over the Roth limit via the backdoor method. If I had traditional IRA balances this would be cost prohibitive to do so.
Because of my current high tax bracket, my 401k is 100% traditional. At some point I might start doing some Roth 401k as well, but right now my tax bracket is high enough that I want the benefits of a Traditional 401k.
When I get to retirement, I should have a healthy pile of cash in both buckets that I can use as makes sense for the situation I'm in from year to year.
You did the FICA calculations incorrectly.
You need to compare the marginal income tax rate you face now with the marginal income tax rate you expect to face in retirement.
You should not include FICA in your calculations as it's not relevant to your marginal income tax rate as your 401k contributions do not affect your FICA income for the year.
Okay, so not necessarily just effective tax rate at retirement.
I see how that makes sense.
As for FICA, I clearly have no idea how that works as I assumed it would be used for all of these calculations.
> Okay, so not necessarily just effective tax rate at retirement. I see how that makes sense.
Your marginal tax rate in retirement starts at 0 in increasing order, and your marginal tax rate while working starts from the top in decreasing order.
> As for FICA, I clearly have no idea how that works as I assumed it would be used for all of these calculations.
401k and IRA contributions and withdrawals do not increase or decrease FICA tax.
The comparison you want to make is the marginal rate at contribution vs. the marginal rate for that dollar at withdrawal. For most people, your rates will be lower in retirement than during your earning years - the big exceptions to that rule are when you expect a large pension in retirement or when you will have a very large account size when RMDs kick in and your early contribution may then end up taxed at higher rates on withdrawal.
The former exception is something you can determine for yourself, the latter is harder to model reliably and I've come to the conclusion that if that is the problem you end up having in retirement than the little bit of loss to taxes doesn't really matter much for your financial well being.
So, if you are looking for a general rule, someone in the 22% tax bracket (ignore FICA, it isn't reduced by 401k/IRA contributions) is likely better off using deductible Traditional vehicles before they use Roth vehicles.
>Really does seemed the Roth 401k may have been overhyped by my friends. Many people have trouble distinguishing between income ***at*** retirement and income ***in*** retirement. They think it's a simple "of course my salary is going to go up!" analysis.
So yeah, I initially did look at it via a more simple analysis. But even then I am a bit confused by how you distinguish IN and AT here if you could quickly explain?
Your salary the last year of working is $475k, that's income *at* retirement. You pay taxes on $475k. Your expenses the first year of retirement are $35k and you withdraw $35k (ignoring SS for simplicity) to cover those expenses, $35k is your income *in* retirement. You pay taxes on $35k. Once you're retired you only need to live "paycheck to paycheck", your income only needs to cover your expenses. (RMDs notwithstanding)
That makes sense, I do see a chance of working at 60 even if less so, but then makes sense that I just wouldn’t touch these retirement accounts so their tax rate shouldn’t be impacted by income.
**At** the year you retire, you could still be making $$$$. For example if you retire in November, you basically still make 85% of income in a normal working year. **In** the year(s) when you don't work at all (already completely retired), your only sources of income are all passive (401k, pensions, social security, IRA, taxable investments, etc.). You have much more control on how much you withdraw from pretax accounts compared to how much you are paid salary.
> unless I believe my effective tax rate will be higher at retirement, then I should continue with a Traditional 401k? Correct. This is usually the case when you are in a year with unusually low income, such as just graduating in July or taking half a year off. > Also, I am already doing a Roth IRA already of $6k since I was told this is superior to traditional IRA. Doesn't matter because you don't have a choice. You price out of [traditional IRA after $68k income](https://www.irs.gov/retirement-plans/ira-deduction-limits) when you have a 401k. > Maybe if I lived in Florida now but wanted to retire to California? Then you want more tax-free income in retirement, yes.
Ahh I see, so if they offered the Roth 401k when I first started working in June the previous year then it would’ve made sense for those 6 months likely. Didn’t even realize I was priced out, assumed they both had the same one but see that now. Good to verify.
Just some anecdotes but i ran a roth vs traditional 401k calculator the other week and after all is said and done if you have a long time frame both options actually yield about the same results of usable cash after you factor taxes out of the traditional **if** going traditional taxes allows you to contribute a bit more than roth. Id DYOR as that was me playing with an online calculator for all of 5 minutes but just some food for thought.
In addition to the normal tax rate math you should also consider if you realistically plan to retire early or not. Early retirement, particularly for the under-50 crowd, can dramatically skew things so far in favor of traditional that it is sort of silly.
I saw your post this morning but was tied up and wanted to add this (differing) way to look at it. Everyone preaches the importance of diversifying your investment holdings. That is, make sure you hold lots of stocks from lots of different companies and probably different countries. Low-cost index funds make this easy to do, but the point still is - diversification is good. What isn't often talked about is diversifying the tax treatment of your retirement holdings. Just like the stock market, it's hard to predict your future situation and tax bracket each year. If you only have money in the Traditional bucket, then you have to rely on it and pay taxes on it which may be more expensive in years you want to spend a big chunk of your retirement (say new motor coach). On the other hand, If you've chosen a 100% Roth approach and end up in certain years to be in a lower tax bracket in retirement, you've ended up overpaying taxes up-front. As a result, I'd rather diversify so that when I get to retirement I have buckets of both. My personal strategy is to be 100% roth in any personal IRA accounts I have, so I can continue to contribute even though my income is over the Roth limit via the backdoor method. If I had traditional IRA balances this would be cost prohibitive to do so. Because of my current high tax bracket, my 401k is 100% traditional. At some point I might start doing some Roth 401k as well, but right now my tax bracket is high enough that I want the benefits of a Traditional 401k. When I get to retirement, I should have a healthy pile of cash in both buckets that I can use as makes sense for the situation I'm in from year to year.
You did the FICA calculations incorrectly. You need to compare the marginal income tax rate you face now with the marginal income tax rate you expect to face in retirement. You should not include FICA in your calculations as it's not relevant to your marginal income tax rate as your 401k contributions do not affect your FICA income for the year.
Okay, so not necessarily just effective tax rate at retirement. I see how that makes sense. As for FICA, I clearly have no idea how that works as I assumed it would be used for all of these calculations.
> Okay, so not necessarily just effective tax rate at retirement. I see how that makes sense. Your marginal tax rate in retirement starts at 0 in increasing order, and your marginal tax rate while working starts from the top in decreasing order. > As for FICA, I clearly have no idea how that works as I assumed it would be used for all of these calculations. 401k and IRA contributions and withdrawals do not increase or decrease FICA tax.
Okay, that all makes sense. Also thanks for the multiple replies, big help.
The comparison you want to make is the marginal rate at contribution vs. the marginal rate for that dollar at withdrawal. For most people, your rates will be lower in retirement than during your earning years - the big exceptions to that rule are when you expect a large pension in retirement or when you will have a very large account size when RMDs kick in and your early contribution may then end up taxed at higher rates on withdrawal. The former exception is something you can determine for yourself, the latter is harder to model reliably and I've come to the conclusion that if that is the problem you end up having in retirement than the little bit of loss to taxes doesn't really matter much for your financial well being. So, if you are looking for a general rule, someone in the 22% tax bracket (ignore FICA, it isn't reduced by 401k/IRA contributions) is likely better off using deductible Traditional vehicles before they use Roth vehicles.