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 Post subject: Roth 401k vs. Traditional 401k
PostPosted: Tue Feb 12, 2013 8:25 pm 

Joined: Mon Jun 20, 2011 9:16 am
Posts: 12
Hey everyone,
I have been mulling over whether to use a Roth 401k or traditional 401k. I am 23 and just beginning my career. I am currently in the 28% tax bracket. I have researched it a decent amount but I had a few questions before I decide on where to put my money.

1) I've read that traditional 401ks have tax breaks while Roth 401ks do not. Is there any truth to this? Are there any benefits in terms of tax breaks (besides the obvious pre-deposit/post-deposit main differences of each)?

2) I have no idea what my retirement tax bracket will be. I don't know the typical amount of money one can expect to use in retirement, so I don't know if I will be shooting myself in the foot to invest it all so heavily in a fund that bets on your tax bracket being higher. Does anyone have any words of wisdom? It seems like maybe it is best to invest in a Roth 401k for the first half of your career, and then switch over to a traditional 401k around the midway point if you can expect an idealistic constant increase in income over the course of one's career.

3) Finally, if I did do a Roth 401k, I would not quite be maxing it out per year. If I am not maxing it out, is there any reason why I should be putting money in a Roth IRA? It seems as if both have equal benefits (in fact, it seems like the Roth 401k might be better because of the better withdrawal rules). My Roth 401k offering has low fee index funds (0.02%-0.07%) that would rival a Vanguard IRA so that doesn't seem to be an issue.

Thanks so much for the help.


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 Post subject: Re: Roth 401k vs. Traditional 401k
PostPosted: Wed Feb 13, 2013 7:38 am 

Joined: Wed Nov 16, 2011 1:26 pm
Posts: 38
I have also been looking at the effect of traditional vs. roth 401K. I see the decision as nothing more than a hedge against future tax rates. Since I will not be retiring for around 30 years, I have no idea what the tax rate will be then and have decided to split my contributions between traditional and roth. I am not an investment profesional and have only been researching the options for a short while, so please verify my responses to your questions.

"1) I've read that traditional 401ks have tax breaks while Roth 401ks do not. Is there any truth to this? Are there any benefits in terms of tax breaks (besides the obvious pre-deposit/post-deposit main differences of each)?"

It is my understanding that the money in either traditional or roth from the time it is contributed to the time it is withdrawn is treated the same. This would be tax free growth within the account. The differece between the two is when taxes are paid. A traditional 401K taxes are paid at the time of withdrawl, and a roth 401K the taxes are paid before contribution. If there is a flat tax with no deductions the accounts would have the same net effect. With the current tax code a portion of each years income has a tax advantage: standard deduction, personal exemptions, lower tax brackets, ... It is beneficial to have enough traditional (tax defered) retirement to utilize these tax advantages.

"2) I have no idea what my retirement tax bracket will be. I don't know the typical amount of money one can expect to use in retirement, so I don't know if I will be shooting myself in the foot to invest it all so heavily in a fund that bets on your tax bracket being higher. Does anyone have any words of wisdom? It seems like maybe it is best to invest in a Roth 401k for the first half of your career, and then switch over to a traditional 401k around the midway point if you can expect an idealistic constant increase in income over the course of one's career."

I also have no idea what tax bracket I will be in in retirement, mainly because the tax code is constantly changing. I am also not sure what expenses I will have in retirement, although a study of historical costs can help. The strategy of using a roth account earlier in ones career has merit, especially if you taxable income is entering a higher tax bracket by a smaller amount. Rough Example: Your marginal rate is 28% in 2012 with a taxable income of $95,000 if you do not contribute to a traditional 401K. With the 28% applying only to taxable income over $85,650 (single filer) it would have a greater benefit to contribute at least ($95000-$85650=$9,350) to a traditional 401K. This would reduce your taxable income to the %25 bracket.

"3) Finally, if I did do a Roth 401k, I would not quite be maxing it out per year. If I am not maxing it out, is there any reason why I should be putting money in a Roth IRA? It seems as if both have equal benefits (in fact, it seems like the Roth 401k might be better because of the better withdrawal rules). My Roth 401k offering has low fee index funds (0.02%-0.07%) that would rival a Vanguard IRA so that doesn't seem to be an issue."

This question is tougher for me to answer, as I do not know if there is an advantage in investment oportunities in your situation. I also have not looked into distribution limitations of a Roth 401K vs a Roth IRA.

I hope my input is helpful and I look forward to other input on this subject.

Thanks,
Andrew


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 Post subject: Re: Roth 401k vs. Traditional 401k
PostPosted: Wed Feb 13, 2013 7:52 am 

Joined: Fri May 04, 2012 2:23 pm
Posts: 810
Personally, if I was the OP, I'd pass on the Roth 401k. At least, I wouldn't contribute 100% to it. It is highly unlikely that the OP will be in the 28% his entire life. In fact, if he got married, it would be unlikely that he would be in it (and most young people are prone to be wed).

With uncertainty ahead, having a healthy amount from "traditional" funds and "roth" funds would be advisable. So, perhaps a maxed out t401k with a maxed out Roth IRA contribution. If more is left over to be invested, the OP can contribute to the Roth 401k and reduce the t401k contribution. Or, he can start some taxable investments. I have no idea what the OP has in mind for goals, so it is hard to see what is "best" for him.

It should be noted, that if one is to assume tax rates the same at contribution and at distribution, Roth accounts have a slight advantage assuming you max them out. This is an artifact of investing in taxable accounts eroding away value over time.

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Bichon Frise

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 Post subject: Re: Roth 401k vs. Traditional 401k
PostPosted: Wed Feb 13, 2013 12:14 pm 

Joined: Mon Jun 20, 2011 9:16 am
Posts: 12
Thank you both for the responses. Looks like for the time being I'll be doing traditional 401k. My goal is generally to have the option to retire in my mid 50's if i desire. I am still figuring out my cash flow so I might up contributions and max it out in the coming months. Thanks for the information. If I max it out, anything afterwards will go into a Roth IRA.

Currently I am distributed as:
50% S&P 500 mirror
30% Total Stock market index mirror
20% International total stock market index

Thanks again for the help. I might look into changing it up based on future knowledge I might gain as I advance in my career. I also might switch my percentages for the S&P 500 mirror and the TSMI mirror.


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