Is a Pre-Tax 401K the Same as a Post-Tax Roth?

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Rush
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Is a Pre-Tax 401K the Same as a Post-Tax Roth?

Postby Rush » Wed Jun 06, 2007 10:03 pm

If you have a fund available in your 401K and the same fund is available through your Roth IRA broker, all other things being equal, which route would you take? Just another scenario I've pondered. . .then I did the math. . .if, when you retire, you'll be in a higher tax bracket that you are now, then buy the Roth fund. If you'll be in a lower bracket, then the 401K is the correct vehicle. If you'll be in the same bracket, it doesn't matter. I just thought it was kinda weird as at least one high-profile "financial guy" always recommends a Roth over a non-matching 401k without ever considering the post-retirement income (and projected tax bracket). . .

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Re: Is a Pre-Tax 401K the Same as a Post-Tax Roth?

Postby pf101 » Wed Jun 06, 2007 11:09 pm

Rush wrote:If you have a fund available in your 401K and the same fund is available through your Roth IRA broker, all other things being equal, which route would you take? Just another scenario I've pondered. . .then I did the math. . .if, when you retire, you'll be in a higher tax bracket that you are now, then buy the Roth fund. If you'll be in a lower bracket, then the 401K is the correct vehicle. If you'll be in the same bracket, it doesn't matter. I just thought it was kinda weird as at least one high-profile "financial guy" always recommends a Roth over a non-matching 401k without ever considering the post-retirement income (and projected tax bracket). . .


Conventional wisdom is that most people should invest in this order:

1 - 401k to match
2 - pay off all high rate/consumer debt
3 - max out Roth
4 - max out 401k
5 - contribute to taxable accounts

It can be hard to figure out what your post-retirement income and tax consequences are going to be. By following the above formula you get to take advantage of the free money of the match and the tax deferred growth of the 401k while also getting the tax free growth of the Roth and giving yourself tax diversity. I think it's important to have accounts with different tax treatments so you have more control over the taxes that you will have to pay in retirement.

With so much being unknown and up for change in the coming years you're just kind of hedging your bets by doing a little of everything.

ETA: as I start getting more conservative in my investments, I would be inclined to keep lower-producing/growth investments and fixed income in my 401k and the higher growth investment in my Roth because of the difference in tax treatment so I guess it would depend on what the fund is before I could say would I put it in my 401k or my Roth.

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Postby plonkee » Thu Jun 07, 2007 12:01 am

Well, I think that people recommend the Roth as the next step because it has more restrictive limits - particularly for income, so if you don't take it now you might not get the chance - and also for tax diversification, unless you're very close to retirement its hard to predict whether it'll work out better to pay tax now or later.
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Postby nickel » Thu Jun 07, 2007 5:01 am

Interesting question. It all comes down to the assumptions, I guess. In our case, we've diversified the tax risk a bit by doing both tax deferred and Roth savings (although we're no longer eligible for Roth contributions).

The bottom line is that tax brackets are incredibly hard to predict. Even if you were currently in (say) that second to bottom tax bracket and you knew you would still be in that same (relative) bracket at retirement, the actual tax rate might be considerably higher or lower.

The one that that I sometimes think about is how screwed Roth investors would be if we moved to a consumption tax (along the lines of a federal sales tax). In that case, you'd be much better off taking a traditional IRA deduction (if eligible) as there where would be no income tax on distributions (since there's be no income tax period). Rather, the money would get taxed when you spend it, and I can't see a workable way of excluding dollars from a Roth from a tax of this sort. So in that case, traditional IRA investments would *never* be subject to taxes, whereas Roth investments would effectively get double-taxed.

Having lived in a state with a sales tax instead of an income tax, I can say with confidence that that sort of tax scheme would be bad on many levels. But the effect that it would have on people with Roth IRAs would probably be one of the most unexpected.

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Postby Dylan » Thu Jun 07, 2007 5:07 am

Look at fees in a 401(k) plan and in the investments in the plan. Some, not all, 401(k) plans hold "special" classes of shares, so even though it looks like the same mutual fund you could buy in your IRA/Roth IRA, the expense structure is different (usually higher). Check the prospectus! This is most often the case when your 401(k) provider is an insurance company. Another cost that may be built in to some 401(k) plans is a portion of the administrative fees in an investment "wrap" fee passed on to the participants proportionately. When these additional fees are deducted over long periods of time, they really take a bight out of your future value. Even if everything appears equal, it may not be.

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Postby pleb » Sat Jun 09, 2007 6:28 am

Say you're in the 33% tax bracket and can either put $2000 post-tax in the Roth or $3000 pre-tax in traditional. In this case, you're right, it's pretty much a wash, depending entirely on whether your tax bracket will be higher or lower later.

However, if you can afford to max your retirement savings, you are way ahead with a Roth at the current limits. At my company I have the choice between a normal 401k with a $15,500 limit, or a roth 401k with a $15,500 limit. In this case, the math is not even close. The roth lets far more of my money grow with a tax advantage. Investing $15.5k in my roth would be like being allowed to put $23k into my traditional 401k.

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Postby JerichoHill » Sat Jun 09, 2007 11:45 am

Pleb,

That assumes you have enough disposable cash left over to be able to afford to max out the roth. Not to meant the Roth has a contribution limit of 5K, I believe, a year. So that doesn't exactly work out.

I have always assumed its
401K First
then max IRA (whatever you have)
then individual savings accounts
then ETFS and stocks
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Postby pf101 » Sat Jun 09, 2007 12:24 pm

JerichoHill wrote:Pleb,

That assumes you have enough disposable cash left over to be able to afford to max out the roth. Not to meant the Roth has a contribution limit of 5K, I believe, a year. So that doesn't exactly work out.

I have always assumed its
401K First
then max IRA (whatever you have)
then individual savings accounts
then ETFS and stocks


It's $4k/year and most people say you should only contribute to get the full company match first, then do the Roth (if you can - if you can't might as well just stick with the 401k if you have good investment options), then if you can afford more max out the 401k and start investing in taxable investments.

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Postby pleb » Sat Jun 09, 2007 7:03 pm

JerichoHill wrote:That assumes you have enough disposable cash left over to be able to afford to max out the roth. Not to meant the Roth has a contribution limit of 5K, I believe, a year. So that doesn't exactly work out.


For young people in 2007, the Roth IRA max is $4k and the Roth 401k max is $15.5k. You can have both. Not all companies offer Roth 401ks.

I was making the point that if you can afford to max your retirement accounts, there is a very big difference between Roth and Traditional. Specifically, in this case choosing the Roth will lead to 1) significantly fewer taxes and 2) significantly more money. If you are not maxing both retirement accounts ($19.5k), this point doesn't apply to you. It does, however, "work out".

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Postby tinyhands » Mon Jun 11, 2007 1:08 pm

In any case, it's a decision that I don't believe many people can make without sitting down and making a good-faith estimate at their yearly budget. The decision-making process relies on valid data and, in some cases, the data makes these decisions for you.
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