Comments on: The Case Against Roth 401(k)

By: Josue

Josue — Sun, 31 Jan 2010 01:06:19 +0000

Hello,

I just finished college and started working a couple weeks ago. I’m single for the momment and my salary is around 70k… I believe that because I just started working full time, Roth might be the way to go. What would you advise me?

By: Fred

Fred — Sat, 23 Jan 2010 06:57:55 +0000

Okay.

So I can maximize my 401k and my Roth IRA AND have some for taxable investments.

Should I do Roth 401k or Traditional?

Seems absolutely braindead obvious to do Roth 401k.

By: wx27

wx27 — Wed, 20 Jan 2010 17:41:17 +0000

Hi Chappy,
If you assume your effective tax rate on traditional 401k withdrawals is the same as the effective tax rate you pay now while contributing to the Roth 401k, then the two accounts are worth exactly the same IF you can store the taxes you aren’t paying right now with the trad 401k inside a tax-deferred acount.
Trad starts with $X, grows to X * (1+r), taxes are t * X * (1+r), you are left with X * (1+r) * (1-t) after taxes.
Roth starts with $X * (1-t), grows to X * (1-t) * (1+r), withdrawn with no further taxes.
Now since usually the deferred taxes on the trad 401k can’t all be stored in another tax-deferred account, you end up with some tax slippage on that money over time and the Roth comes out slightly ahead.
Note that all this is assuming effective tax rates are equal across time.

By: Chappy

Chappy — Wed, 20 Jan 2010 03:32:38 +0000

One more question: On second thought, the above analysis seems to ignore the gains in the account, unless I’m missing something. For the regular 401k, taxes on the income & gains are deferred. In the Roth 401k (after the 5 year period) there’s no tax on withdrawals, so if returns turned out to be fantastically huge (just go with me on this), wouldn’t the Roth come out ahead, since the tax would be zero and the traditional would be large (fantastically huge times any tax rate = large)? Appreciate any thoughts. Thanks!

By: Chappy

Chappy — Wed, 20 Jan 2010 01:10:23 +0000

Well done analysis which has helped me reconsider my planning. Two questions: 1) Doesn’t the time value of money alter the equation (i.e. isn’t a dollar in taxes saved today worth more than taxes saved later because the latter’s present value will be less (assuming typical inflation, returns, etc.)?
2) I heard there’s an option to convert traditional 401k money to Roth 401k in 2010, much like the IRA situation, but I can find nothing to confirm this rumor online. Is it true?
Thanks!!

By: bud

bud — Fri, 15 Jan 2010 16:25:08 +0000

very nice article. my company just introduced roth to us as well. As for myself, this is all new to me and maybe someone can advise suggestions to give me a general idea of what is best for me. I’m 25 years old and I plan to attend college in the next 4 months. I plan to stay with the company and hopefully move up as i finish my education, but like i mentioned, all this is new to me and maybe someone can point me in the right direction. Thanks in advance.

By: PatentGuy

PatentGuy — Thu, 14 Jan 2010 07:41:25 +0000

Tax rates will be as high as possible as time goes on. We love our entitlements and God-given benefits for free. There will be more old people that do not work but get lots of entitlements and benefits. In their minds, they earned every penny and then some. But, there will be less young people who actually have good paying jobs (high tax payers) to pay for the old people.

This would seem to make the case for converting to Roth now, and paying tax now at the GW Fed rate (2010), sla you are young enough and anticipate accumulating a big amount of “tax free” earnings by the time you are old and ready to tap into said earnings.

BUT, the government of the future can/will simply change the rules and tax you anyway on those earnings. There are many ways to tax you without calling it a direct tax, such as by taxing any other income or SS benefits you may have at an extreme rate. You will be demonized for getting these “tax free” earnings unfairly. if you accumulate wealth, by definition, it was unfair of you to do so. time to “give back to the community” which you have robbed blind by paying taxes to convert your IRA to Roth back in 2010.

It is year 2035. The U.S., top to bottom, is broke. They will need every penny they can get from you. They are not going to cut-off any entitlements just so you can get the benefit of some “loop hole deal for the rich” back in 2010.

Mark my words. (Go ahead, mark them. Use a highlighter pen or something like that).

By: Ren

Ren — Thu, 14 Jan 2010 06:34:50 +0000

Hmm.. I must have missed the AMT exemption phase-out. I could have sworn that when I did my taxes last year (TurboTax), adding a $100 of income after AMT was triggered only increased my taxes by $28 (as long as AMT still applied). I was certainly mindful of the standard exemption and deduction phase-outs, as I mentioned.

Perhaps the AMT exemption phase-out is obscured by the standard phase-outs that may be occurring at similar income levels.

In any event, I’m glad that I never made the jump to the Roth 401k.

By: TFB

TFB — Thu, 14 Jan 2010 04:25:43 +0000

Ren - Unless you are talking about really high income, the 28% rate is actually more likely 35%. See my previous post about AMT brackets. With regard to your final point about Roth conversion, I just did it after rolling over the pre-tax money in the traditional IRA to a 401k plan. See previous post Rollover IRA to Solo 401k.

By: Ren

Ren — Wed, 13 Jan 2010 20:31:31 +0000

I think there is another side to the AMT coin and how it impacts the comparison of Traditional and Roth 401k, though I may be mistaken.

If you are already being hit by AMT then it creates a window of income that has a marginal rate of 28% rather than the 33% (or higher) without AMT. In this situation, any extra income that can be shifted to that year is only taxed at 28% — up to the amount which pushes the regular tax due up to the AMT tax due.

Of course, the real trouble with this is that I’ve found it exceedingly difficult to estimate in advance the amount of AMT that will be due, particularly with income levels in the range that trigger the deduction and exemption phase-outs. Additionally, there are often better ways of shifting income from the following year rather than from retirement years.

One final point, unrelated to the rest of my comment and only vaguely related to your post: The newly available ability to convert from traditional to Roth IRAs without income restrictions is a definite boon for those of us without a large existing IRA balance to make non-deductible IRA contributions and then convert them to Roth IRAs. Since the contributions have already been taxed, the tax is only due on the gains.