401K vs Roth Ira vs Traditional Ira

[alyssa10]

These are all so confusing to me. Can you help me decide what's best?

I have an old 401K with appx $7500 from a previous employer
DH has about $2500 in a roth ira (rolled over some retirement funds from an old employer into the roth)

What should I do with the 401K? Rollover into an ira or leave it where it is? Also what's better, roth ira or traditional ira?

DH &I make about $48000 per year and have 2 babies (1.5 year old twins). We try to contribute $5k/year to the ira.

Thanks!

[bUU]

One of the most depressing parts of personal finance, for me, is how much of what I think should be deterministic is in reality a matter of opinion, highly dependent on factors that cannot be predicted, and even beyond that, reliant on what the reader (you) means by "best", since even that varies from person to person. Perhaps the only thing anyone can say with assurance is that every possible direction you can go is something that someone will consider the best option for someone else, somewhere. Perhaps the first thing that you need to come to grips with is that there are no easy answers.

Let's pick apart one of the issues you raised: Roth versus traditional. In the abstract, Roth is going to be better if you expect to pay higher taxes in retirement than you will before then. That is a prediction made by those who are rather pessimistic about the future of Western economies, thereby the decision to go Roth instead of traditional is essentially the decision to speculate that tax rates will skyrocket rather than simply increase marginally over time. There are also some special cases that people who favor Roth love to trot out to support their preference.

The challenge in defending Roth always comes down to rationalizing away the power of compound interest on the portion of your income that you would otherwise invest in a traditional retirement account, which instead, since you chose Roth, you paid in income taxes instead (at your current tax rate, which for many people will be higher than what they'll pay in retirement, simply because they're in the earning phase of their career).

One of the most insidious aspects of the Roth issue is that it is much easier to defend when you're at the start of your career, when you're making bupkis. However, of course, that's the point in your life when you have the least discretionary income to sock away for retirement. By the time you're making enough money to seriously invest in your retirement, you're paying a higher income tax rater, nullifying the benefit of Roth.

You seemed to be asking specifically whether to roll your old employer 401(k) into a Roth IRA: Note that if you do that you'll pay income tax on that money in the current year, and it could very well bump you up into a higher tax bracket. We don't have enough of your financial data to advise you, but I think it would be very unlikely that that'll be a good idea for you.

Two last notes about Roth: While it is most likely not going to happen, it is possible that the core benefit of Roth could perhaps not withstand the years to come (Congress could enact changes that tax the gains, or allow states to do so), especially if you happen to end up at the high-end of the scale. Also, keep in mind that there are options for you to avoid substantial amounts of the tax on retirement distributions, simply based on where you choose to retire to. If you are calculating the benefit of Roth based on your current (or a worst-case) state of residence, you could be vastly overstating its possible benefit.

Now on to one of your other questions. Generally, its better to roll old employer 401(k)s into IRAs. That's because 401(k)s generally offer lesser choices than you can access from within an IRA. The power of the 401(k) is the ability to defer current income, and any matching funds you get. Once a 401(k) no longer offers you either of those benefits, it is almost surely no longer the best place for your money. There might be some great 401(k)s out there (my spouse has one, from a former employer) but it's very rare, and the chance that your old employer 401(k) falls into that category is pretty small.

[MonkeyMama]

Alyssa - roll the 401ks into IRAs so that you have full control over them.

I am guessing you don't pay much of anything in income taxes, so the ROTH would be better in your case. To be re-evaluated if income rises and deductions decrease, over time. Essentially, for now, you would be putting in money you didn't pay tax on, into a retirement fund that will grow tax-free. If you choose the ROTHs. Win-win.

It will be a taxable event when you move the 401k to a ROTH IRA, but I am guessing your taxes will be quite minimal. Your "$48k income and two kids" situation clearly puts you in a zero-tax situation (for Federal - not sure about your state taxes). So, probably never a better time to convert to ROTH. We actually did the same. (Converted all our 401ks and IRAs into ROTHs when we had your smaller income/large deductions - when we first had kids). The conversion will push your taxable income up, but with deductions and credits, it could be a tax-free conversion. Or you may owe a little tax on the conversion.

[bUU]

I am guessing you don't pay much of anything in income taxes

That's interesting.

I agree: If you don't pay "much of anything" in income taxes, then Roth is the way to go. Either that, or invest in a retainer for a good lawyer.

[MonkeyMama]

That's interesting.

I agree: If you don't pay "much of anything" in income taxes, then Roth is the way to go. Either that, or invest in a retainer for a good lawyer.

???

$48k income, MFJ, 4 exemptions, 2 child tax credits, would equal zero Federal taxes. No lawyer necessary - just file a 1040.

[bUU]

Different people do indeed have different perceptions of how much money is worth.