Roth vs. 401K

[Fairchild]

Hi there -- I have been lurking and reading all of your posts for some time now, and I am finally ready to jump in. I have a question…

My husband makes over $100K (we are in our mid 30s) and all of our retirement is in pre-tax accounts (mainly his 401K). I have been mulling over the idea to start saving some in a Roth since the contributions are after tax and the withrawals will not be taxed.

I know that when we withdraw his 401K money it will be taxed at our then current income rate. Roth money we contribute now is taxed at our now current rate. Won’t our rate NOW be higher than our rate THEN??

If we are wanting to increase our retirement savings, what would be the benefit of starting a Roth and paying taxes in our current tax bracket instead of upping his percentage with the 401K and waiting until he retires to pay tax on the money when he is making very little? (BTW-- he currently puts in 6% in his 401K and his company puts in 12%)

Thanks in advance for your comments!

[jIM_Ohio]

Gross pay will lead you to inconsistent conclusions. My wife and I gross 110k+ per year (which is in middle of 25% tax bracket). Our taxable income in 2007 was 62k (in 15% tax bracket).

IMO your goal should be to get into 15% tax bracket, then use the Roth. Pay taxes at 15%, not 25%, if at all possible (gives you a 10% raise).

To do this you need tax deductions, our two biggest tax deductions in 2007 were our mortgage interest/property taxes (40k+) and 401k contributions.

In my case I used 401k contributions to get me from 25% tax bracket into 15% tax bracket. Then I took 10k of that money earned and contributed to a Roth IRA.

With a Roth 401k, it is tougher. You need to look at whole tax situation to make a good decision.

Look at tax return, there are 3 numbers you want to review:
1) Gross Income- this is what you bring in
2) Adjusted Gross Income- this is income after 401k and health care deductions, after SS deductions and similar, and does NOT include deductions from the 1040 form (exemptions, mortgage interest, property taxes, small business etc...)
3) taxable income (this is the income which calculates how much tax you owe the government based on the deductions not included in AGI -like mortgage interest, property taxes...).

3) is where the Roth will kick in.
For married filing jointly taxable income below $66,100 is taxed at 15%, Taxable income between $66101 and ~135k is taxed at 25%.

If you are in 25% bracket now, use the 401k and tax the deduction now, worry about taxes later.

If you can calculate how much 401k you need to use to lower taxable income to $66099, send that in pre-tax, then use the Roth provision for the balance of 401k contributions.

I generally try to pay taxes when taxes are lowest. If I can pay in 15% bracket now, that is better than paying in 25% bracket later. If I am in 25% bracket now, I will defer taxes paid until another year where I am in 15% bracket.

75% of the US population is in 15% tax bracket (max taxable income of $66100).

[InDebtInDC]

Max out both 401(k) and Roth deductions. Problem solved.

[sweeps]

I tend to think the way you do, OP. I'm concentrating more on maxing out my 401k than putting money in my Roth IRA. I enjoy the tax break now while I know it's there, and the calculations I make show that my income will be the same or less in retirement. (If it's higher then I guess that's a good problem to have -- I'll deal with it then.)

Having said that, contributing to your Roth in addition to your 401k greatly increases your flexibility in the future. In a pinch, you can withdraw the contributions from your Roth tax and penalty free. And you can combine pre-tax and post-tax withdrawals in retirement to keep your retirement income high while your tax rate is low.

One other quibble I have is about the treatment of Roth IRA withdrawals 30 years from now. Can we really trust Congress not to mess with the tax-free treatment of Roths? I'm not so sure.

[noppenbd]

One other quibble I have is about the treatment of Roth IRA withdrawals 30 years from now. Can we really trust Congress not to mess with the tax-free treatment of Roths? I'm not so sure.

At least as much as we can trust that income tax rates will stay the same. Current federal tax rates are low by historical comparisons. Most likely all tax rates will be higher in the future due to unfunded SS and Medicare liabilities, plus surging national debt. From 1992 to 2008, the "middle" tax bracket dropped from 28% to 27% to 25%. The "middle-high" tax bracket dropped from 31% to 30% to 28%. High-income tax brackets were added in 1993 and those subsequently dropped from 39.6% to 35%.

In fact, no one really knows how taxes will change in the future. IMO those who have maximum flexibility will be in the best position. For me that means about 60% of my retirement savings is in pre-tax accounts, and 40% is in Roth IRAs.