Roth IRA question

[skives]

When earnings from a Roth IRA are taken out do I pay taxes on them if they are qualified? The way I understand it they are not taxed which is weird to me because 401k earnings are taxed. Am I off track here?

[BuckyBadger]

Roth earnings aren't taxed when you take them out because a Roth is funded with after tax money. 401k earnings are taxed because a 401k is funded with pre tax money. You're only taxed once.

[skives]

Roth earnings aren't taxed when you take them out because a Roth is funded with after tax money. 401k earnings are taxed because a 401k is funded with pre tax money. You're only taxed once.

Yeah but earnings are earnings I don't get it. So everyone should have a Roth IRA?

[Goldy]

Yup, everyone should have one.

I agree with you that it's a bit odd since other investments you make on your own with post tax dollars have taxed earnings. I'm curious to see how long the Roth stays around.

[Petunia 100]

Yeah but earnings are earnings I don't get it. So everyone should have a Roth IRA?

That's the advantage of the Roth. Do you mean you don't get why it is offered? The government offers us tax breaks if we behave they way they have decided we should. They have decided people need to be saving for their own retirements.

IMO, yes, everyone should have some money in a Roth.

[skives]

So I have a 401k that I put 15% in but only need to do 5% to get full company match. Should I lower to 5% and do the rest of my retirement savings in a Roth IRA?

[disneysteve]

So I have a 401k that I put 15% in but only need to do 5% to get full company match. Should I lower to 5% and do the rest of my retirement savings in a Roth IRA?

Yes. The usual advice is to fund the 401k enough to get the full match, then fund a Roth to the max ($5,500/year if you are under 50). Then, if you have additional money to save for retirement, return to the 401k.

An alternative is if your company offers a Roth 401k. If that's the case, choose that option and you can consider keeping it all in one place. Roth IRAs still offer some advantages though as far as access to the money and investment options so that's a little tougher call.

[phantom]

If you look at what happens between the two accounts with some real numbers, I think that the way the taxes work makes sense. You've got two sets of equations to look at:

Amount going into your ROTH account = Amount you have available to put in * (1-tax rate)
Amount after earnings = Amount going in * Growth of investments
Amount you can pull out = Amount after earnings

Amount going into your Traditional account = Amount you have available to put in
Amount after earnings = Amount going in * Growth of investments
Amount you can pull out = Amount after earnings * (1-tax rate)

Let's assume you have $100 to put in, your tax rate is 25%, and your investments are going to double. In the first scenario, you put in $75 after taxes, it grows to $150, and you can pull out $150. In the second, you put in $100 before taxes, it grows to $200, and you can pull out $150 after paying your taxes.

Of course, your taxes now and your taxes when you're ready to pull your money out are likely to be two different things, and you'll likely get different growth since the accounts will give you different investment choices. So, you are unlikely to get the same number either way in the real world. But, I think that when you assume that the numbers are the same, the way the taxes work makes sense.

[autoxer]

So I have a 401k that I put 15% in but only need to do 5% to get full company match. Should I lower to 5% and do the rest of my retirement savings in a Roth IRA?

This really depends on what tax bracket you are in now and which one you expect to be in later on. If you expect to be in a higher tax bracket in the future, you are better off paying the tax now and funding the Roth. Conversely if you expect to be in a lower tax bracket in the future, then you are better off deferring the tax and funding either the 401k or traditional IRA.

It's not easy to predict how taxes will change, so it is good to use both types accounts to provide some flexibility with your tax planning. Personally I think if you are in the 15% tax bracket or lower, then you should prioritize the ROTH account, but if you are in the 25% tax bracket or higher, then you should max out the 401k and then fund the ROTH.

[disneysteve]

This really depends on what tax bracket you are in now and which one you expect to be in later on.

I've seen articles in Money magazine and elsewhere illustrating that the Roth wins in almost every case regardless of tax bracket. The exception is if you are getting a late start with your savings and don't have the benefit of decades of tax-free growth.

[skives]

Should I just kept my 401k funded they I have it and have my wife have the Roth ira? That way we have both.

[disneysteve]

Should I just kept my 401k funded they I have it and have my wife have the Roth ira? That way we have both.

I think everyone eligible to fund a Roth should do so. I also think everyone who has access to a 401k with a company match should take full advantage of that first.

[autoxer]

I've seen articles in Money magazine and elsewhere illustrating that the Roth wins in almost every case regardless of tax bracket. The exception is if you are getting a late start with your savings and don't have the benefit of decades of tax-free growth.

You can't drop a post like that without a link to the article to back up your claims.

I certainly see the value of a ROTH, but don't believe they always win. Although your current tax bracket is determined by your wages, your tax bracket in retirement will be determined by how much you plan to spend, so you will have more control over it than you think you do. If I pay off my mortgage before retirement, then I could easily live the same lifestyle that I currently do, but in a lower tax bracket, because my expenses would be lower. It simply doesn't make sense to pay tax in the 25% tax bracket now, if you can defer it and pay 15% later. If you are maxing out the deferred options, then using the ROTH on top of that becomes a no brainer.

There is even a strategy where a taxable brokerage account is a better choice than a ROTH, if you plan to keep your income within the 0% long term capital gains tax bracket. If your taxable income remains below $72,500, then your long term capital gains tax rate is 0%. If the benefit of the ROTH (tax free withdrawals) is available in a regular account, then using it is only giving you restrictions like the early withdrawal penalties. This is a good strategy if you intend to retire early and keep your spending low, because you won't have to worry about early withdrawal penalties.

[BuckyBadger]

It's hard to say - dare I even say impossible to say? - which is better. The higher your tax bracket is now the more likely it is that traditional contributions will be beneficial.

I think that just means it's smart to hedge your bets. Try to get some in both kinds of tax advantaged accounts.

Most people (who have retirement accounts at work) have a traditional pre-tax account. In that case, it makes sense to follow Steve's order of operations: 401k to match, max out Roth IRA, then back to 401k. If you have a Roth 401k option it's something to consider, but at the 4 companies my husband and I have worked at, only 1 had ever offered that.

[TheMom]

If you look at what happens between the two accounts with some real numbers, I think that the way the taxes work makes sense. You've got two sets of equations to look at:

Amount going into your ROTH account = Amount you have available to put in * (1-tax rate)
Amount after earnings = Amount going in * Growth of investments
Amount you can pull out = Amount after earnings

Amount going into your Traditional account = Amount you have available to put in
Amount after earnings = Amount going in * Growth of investments
Amount you can pull out = Amount after earnings * (1-tax rate)

Let's assume you have $100 to put in, your tax rate is 25%, and your investments are going to double. In the first scenario, you put in $75 after taxes, it grows to $150, and you can pull out $150. In the second, you put in $100 before taxes, it grows to $200, and you can pull out $150 after paying your taxes.

Of course, your taxes now and your taxes when you're ready to pull your money out are likely to be two different things, and you'll likely get different growth since the accounts will give you different investment choices. So, you are unlikely to get the same number either way in the real world. But, I think that when you assume that the numbers are the same, the way the taxes work makes sense.

While your earnings going to a Roth are at your marginal tax rate, your income at retirement is not all at that rate. Some will be taxed at 0%, some at 10%, some at 15% and finally some at 25%, so it's not just comparing marginal tax rates.

Where you are in those brackets makes a difference too. We put more in our 401k because it then drops us to the 15% bracket and our Roth is now funded with 15% money. If we stopped at what the company matches, we'd be funding our Roth with 25% money.