Roth 401(k) for People Who Contribute the Max

Back in March I wrote The Case Against Roth 401(k) in which I said I think for most people the majority, if not 100%, of the contribution should go to a Traditional 401(k). I gave these reasons:

1. Fill in lower tax brackets in retirement
2. Avoid high state income tax
3. Leave the option open for Roth conversion in the future
4. Avoid triggering phase-outs and AMT

I still believe these are valid reasons in favor of contributing to a Traditional 401k instead of a Roth 401k. A few comments to that post said Roth is better because a Roth 401k lets you effectively shelter more from taxes than a Traditional 401k. That is true. My response was that the higher effective maximum comes into play only if someone actually contributes the maximum allowed, currently at $15,500 per person per year. According to a study by Vanguard, only 10% of people contribute the maximum. It's not surprising because in order to contribute the maximum, you need either a high income, a high savings rate, or both. Consider a married couple. The combined 401k and IRA maximum contributions are $41,000 per year. At 25% savings rate, this couple needs $160,000 of income. At 15% savings rate, this couple has to earn $270,000.

What if you are one of the 10%? People who read finance blogs probably earn more and save more. What is the value of the higher effective contribution limit in a Roth 401k?

It turns out that for the marginal dollar, a Roth 401k is worth about 5-10 percentage points in marginal tax rate. That is if you contribute the marginal dollar to a Roth 401k and your marginal tax rate drops 5-10 percentage points between now and retirement, you are still better off than contributing that same marginal dollar to a Traditional 401k and put the tax savings in a taxable account. Say you are down to the last $100 which you can either contribute to a Roth 401k or a Traditional 401k. If you contribute to a Traditional 401k, you also get a tax deduction. But because you already hit the max, you cannot put the tax savings into the Traditional 401k. Your only choice is a taxable account. The Roth is compared to Traditional + Taxable because the assumption is that you maxed out the contribution limit. If you are not maxing out, you can always gross up the contribution to the Traditional account.

How much exactly is a higher effective contribution limit in a Roth 401k worth depends on a number of assumptions. I made this spreadsheet on Zoho. You can plug in your own assumptions and see the result for yourself. Plug in some different assumptions and see how the results change. That's what a spreadsheet is for. Zoho is nice because it's all online. You don't need Excel or any other spreadsheet program. You don't have to register for Zoho either if you just want to use the spreadsheet.

For example, here's one set of assumptions I used.

For tax rates, I'm assuming the Bush tax cuts will expire after 2011. Dividends will be taxed as ordinary income and long term capital gains will be taxed at 20%. I also put in a factor for the cost advantage in a taxable account because 401k plans often have higher cost funds and higher admin costs. And here are the results.

Roth 401k and "Traditional 401k + Taxable" break even if the marginal tax rate at retirement is about 28%, versus the current marginal tax rate of 35%. That means the higher effective contribution limit is worth about 7 percentage points.

Here's the link to the spreadsheet again if you want to play with your own assumptions.

Traditional Or Roth 401k

Finally, please note we are still talking about the marginal dollar here. The reasons for favoring the Traditional 401k are still valid for the majority of one's retirement dollars. If you max out all your tax favored contributions, you still have to decide how much should go to traditional. Those dollars in traditional will fill in the lower brackets after you retire. They will also be converted to Roth along the way if you have a window of opportunity.

Free Digital TV Over the Air

Don't laugh. I finally got TV in my home. I have a TV, the physical device. I use it for watching DVDs. I just haven't had TV programming in the last few years. I canceled my cable subscription because I found myself not watching at all for weeks on end. Occasionally I wanted to watch something like the Oscars or the Olympics. I also missed the PBS programs although I don't understand why they keep having Robert Kiyosaki and Suze Orman on their personal finance shows. Because I live far from the broadcast towers, the signal quality from an indoor antenna isn't very good. So I didn't bother.

A couple of months ago I read on the Bogleheads forum that you can get a coupon from the government for a digital TV converter box if your TV doesn't have a digital tuner, because broadcast TV will move to all digital in February 2009. You can ask for up to two coupons, each worth $40. It took them two months to send me the coupons. I went to Circuit City and bought myself a converter ($60 plus tax, minus $40 coupon) and an indoor antenna. I hooked them up and voila, I got TV! I receive about 20 channels, not counting the ones which broadcast in languages I don't understand. For the channels I receive, the signal is crystal clear. There is no static or distortion. I guess that's the benefit of digital broadcasting. But out of the major network stations, I only get Fox, not ABC, NBC or CBS. I'm not sure whether it's because they are not broadcasting in digital yet or their signals are still too weak for me. I'll go to Radio Shack tomorrow and try some different antenna.

Free digital TV over the air gives me one more reason for not dealing with a cable company.

Book Review: Gotcha Capitalism

I'm reviewing the book Gotcha Capitalism today. I first heard about the book on public radio. The author Bob Sullivan was interviewed on Fresh Air by Terry Gross (36 minutes) and on Marketplace by Tess Vigeland (7 minutes). This book is about the annoying fees and the disingenuous pricing and marketing schemes we face every day from many places.  You know those fees. They are everywhere.  I also wrote about a few of them in the past: ATM surcharges, bank overdraft or NSF fees, credit card late fees, 12-month-same-as-cash deferred interests, finance charge in insurance payment plans, 401(k) plan admin fees, and numerous fees in VUL policies. There are also many more I haven't touched on: airline excess baggage fees, cell phone early termination fees, hotel parking fees, many mysterious line items on rental car contracts and telephone bills, etc. etc.

Some of these fees are more of a nuisance while some (like 401(k) plan admin fees and VUL fees) are more serious. The author puts it very elegantly:

"Sneaky fees peck away at us like a swarm of mosquitoes that ruin an otherwise beautiful summer evening. And like mosquitoes, an individual bite might seem trivial, barely more than a nuisance, but repeated bites can actually change the way you live. They chase you inside, make you build a screened porch, and in extreme cases make you sick." (p. 4)

The book primarily serves two purposes: (1) expose the various fees; and (2) provide tips and strategies for fighting back on these fees. It's not a surprise that most of the fees the book talks about are from services, not physical products, because when you buy physical products, if you don't like the final amount, you can return them (most of the time, except when you buy a car). A lot of the services involved are also sold by a monopoly or an oligopoly, for example land line telephone and cable TV. Why are there so many fees and what should we do about them? The author says there are a lot of fees because businesses engage in "shrouding" which attempts to make the true cost of their service look lower than it actually is. They put in these fee traps to catch the "myopes." Myopes are customers who are drawn to the headline sticker price -- "free checking" or "$39.99 a month" -- but who can't understand the total cost before they sign up or who are not able to navigate through the minefields of fees and after-charges. People are usually overconfident. They think they won't bounce a check or they will always be able to refill the gas tank before they return the rental car. But for all consumers as a whole, some people eventually fall prey to those gotchas.

The art and science of complaining are a big emphasis of this book. In the author's own words,

"This book is designed to make you an expert complainer. Not a whiney complainer, not a bitchy person, and not a penny-wise and pound-foolish consumer. A well-informed, successful, efficient complainer." (p. 31)

The book provides estimated rate of success on reversing different fees so you can pick your battles. It also provides sample call scripts, letters and information on regulatory agencies for different industries.

This small paperback (selling for $10.46 on Amazon) is packed with good information. It is very worthwhile reading. If you can't get hold of the book yet, you can at least listen to the interviews I linked at the beginning of this post.

If I have to criticize it, I have to say the author didn't emphasize enough a very important weapon consumers have. That is voting by your wallet. Don't buy the service if you think the pricing is unfair or too complex. Favor businesses that have more transparent and straight forward pricing.  For example I don't subscribe to cable TV. I have no appetite for signing up for a promo rate for 6 months and calling the retention department every 6 months for a lower rate. I simply refuse to play their game. Netflix is much more straight forward. I also don't subscribe to any cell phone contract. I use a prepaid service. The per-minute cost is higher but I pay for what I use. There's never any surprise. I fly Southwest Airlines, which doesn't charge a change fee, even if their fare isn't always the lowest. Most of the time, there are alternatives to tricky prices. If banks are evil, use a credit union. Burn me once, shame on you. Burn me twice, shame on me. If you stay away from businesses with unfair or complex pricing schemes, you are less likely to be charged those fees in the first place and you won't have to worry about how to stage your complaint and get your fees refunded.

Also, because it was written by a journalist, the examples in the book are sometimes on the sensational side. Take credit card fees for example. The book told a story about a Mr. Wesley Wannemacher, who charged $3,200 for his wedding on a credit card and never used the card again. Because he went over the card's $3,000 credit limit, he was charged an over-the-limit fee. And because he didn't make enough payment to bring the balance below the credit limit, he was charged an over-the-limit fee again in the next month, and the next month. All told, he was charged the over-the-limit fee 47 times. Because he was also consistently late in making the payments, he was also charged a late fee more than 30 times. I mean, come on, if it stings, stop doing that. Pay it down, ask for a credit limit increase, or transfer the balance to another card with a higher credit limit. If nobody is willing to offer you a higher limit, that tells you something, doesn't it?

Related links:

• The Red Tape Chronicles - An online column on MSNBC.com written by the same author. It's very popular. Some posts get as many as 800 comments.
• Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets by Xavier Gabaix and David Laibson - A research paper by MIT and Harvard professors which forms the theoretical foundation for the book.