Choosing Between the Roth or Traditional 403b / 401k : Our Decision Process

My wife now has the new option of contributing to Roth 403b plan with her new position, and we had to make a decision on whether or not to go with it. Here is our thinking process, which should also apply to Roth 401ks.

I found a few good articles online, including Is the Roth 401(k) Right for You? by Emily Brandon at US News, and Choosing Between Traditional and Roth 401(k)s from Yahoo Finance. Here is a nice table outlining the major differences:

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As my last video post outlined, the main difference between a Roth 401k and a Traditional 401k is when you pay the taxes. With the Traditional, you get to defer your income taxes now, but you must pay taxes up on withdrawal. With the Roth, you pay tax now, but you don’t own any taxes upon withdrawal.

So the first question is – when do you want to pay the taxes? Obviously this takes a bit of guessing as who know what tax rates will be in the future. You can also try and look at the 2007 tax brackets for a little guidance. Historically, I believe our tax rates are actually on the low side. If your income is relatively low now compared to what you think you’ll make when withdrawing, you should lean towards the Roth. If you expect an especially high income this year, it may be better to go Traditional. Be sure to take into any big tax deductions that you might have now but not in retirement (think mortgages and child credits). If you think it will be the same, I think you’ll see below that the Roth tends to win any tie-breakers.

(There are also those that think Roth accounts will be double-taxed in the future, so you might as well get the tax break now.)

Before, when our incomes were lower, it was an easy choice to go with the Roth. Now, we may get bumped into the 33% bracket. I doubt we’ll be making this much in retirement, I just don’t plan on saving up long enough to generate that much income. But I have a suspicion that tax rates will also be higher later. And I haven’t even considered possible AMT consequences.

The Roth has “bigger” contribution limits. Sure, the official employee contribution limit for both of them is $15,500 for 2007, but you can see that $100 in post-tax contributions requires a bigger out-of-pocket sacrifice than $100 of pre-tax money. This means that maxing out a Roth effectively allows you to defer taxes on more money. Since we aren’t eligible for a Roth IRA anymore, perhaps we should take advantage of this additional opportunity.

Matching works the same either way. Employer matches can only go in your Traditional 401(k) pool of funds, so we don’t have to worry about this here.

Roth 401(k)s get rolled over into Roth IRAs, which don’t have Required Minimum Distributions (RMDs) and other attractive estate features. I like the idea being able to delay withdrawing any money until I want to, which I can’t do with a Traditional 401(k). I’m not really concerned with inheritance stuff right now.

Final Decision? I still need to look into AMT effects, but for now I think we will be going with the Roth. Here is our plan: I want to max out my Traditional 401k this year in order to lower our taxable income and keep us in the 28% marginal bracket. Then, I think we can take full advantage of the Roth 403(b) on my wife’s side. This also gives us some diversification between accounts – If we have a high-tax year in retirement, we can withdraw Roth funds. If we have a low-tax year, we can withdraw and pay tax on Traditional funds. Did I miss anything?

Comments

  1. The Roth has ?bigger? contribution limits. Sure, the official employee contribution limit for both of them is $15,500 for 2007, but you can see that $100 in post-tax contributions requires a bigger out-of-pocket sacrifice than $100 of pre-tax money. This means that maxing out a Roth effectively allows you to defer taxes on more money. Since we aren?t eligible for a Roth IRA anymore, perhaps we should take advantage of this additional opportunity.

    I don’t understand that.

    You don’t defer any taxes with a Roth IRA. You defer taxes with a 401k.

  2. income limits says:

    I want to max out my Traditional 401k this year in order to lower our taxable income and keep us in the 28% marginal bracket.

    If you’re in the 33% tax bracket, then you make at least $195,851 in 2007 for a married couple filing jointly. The Roth IRA has income limits for joint filers of up to $156,000 (to qualify for a full contribution) or $156,000-$166,000 (to be eligible for a partial contribution).

    This means that, if you’re in the 33% tax bracket, you don’t even have the option of contributing to a Roth because you make too much. So, your only option would be your 401k anyway… unless I misunderstood something somewhere.

  3. I have gone through the same thought process and decided to go with a regular 401k. My wife and I also max ROTH IRAs, but we are probably within 1 or 2 years of exceeding the income limits.

    My concern about a Roth 401k is that we could find the tax structure drastically different than it is today. I am less concerned with prevailing tax rates and more concerned that the government could shift the tax structure towards a VAT or other sales tax type of system. This would seem to be a growing temptation for the government as the value of ROTH IRA/401k accounts increase and these accounts are effectively off-limits for tax purposes right now. If there was a fundamental shift towards a sales tax like system, people could easily find themselves with less purchasing power than they anticipated. Maybe I am being paranoid, but my thought is to diversify account types (regular 401k and Roth IRA) while we can to minimize the risk of this type of tax shift.

  4. Steve Austin says:

    Andrew, if the guv’mint *shifts from income to sales* tax, purchasing power goes down on the back-end (prices are higher), but purchasing power goes up on the front-end (incomes are higher).

  5. We have hit the income limitations for the Roth IRA, so we are trying to go around the back end and contribute to a traditional IRA then convert to Roth in 2010 when the income limitation disappears (for the conversion). This is all based on the assumption that the law isn’t changed before then.

    Does anyone know what the 401(k) contribution will be for 2008? It is supposed to adjust annually based on inflation after 2007.

  6. Steve Austin, you are right about the shift on the front-end. But, if I focused all of my retirement savings in ROTH-like accounts, then today I would pay income taxes and 30 years from now I would pay VAT on the same money that was suppossed to be tax free. However, if I saved in a regular 401k, today I would pay no income taxes and 30 years from now I would pay VAT. Granted, this isn’t exactly probable and if a VAT or other sales tax was created it would probably be in addition to rather than a replacement for income taxes, but it seems like the total amount of money in ROTH like accounts will be enormous by the time I am likely to start withdrawing funds from my retirement accounts and that will prove to be just too tempting to not subject it to some type of tax.

  7. Actually, when I sat down with my company’s retirement consultant earlier this year, his pitch on the Roth 401(k) was, “How would you like to control how much you pay in taxes?” Having the two separate accounts is a good idea for just that reason; you can push yourself into a lower tax bracket now by contributing to 401(k) and balance your Roth and 401(k) withdrawals at retirement to dictate your taxable income bracket. It’s a pretty elegant system, really.

  8. Diversifying for future tax environments is smart, because you don’t know what the future holds. I have generally held 100% Roth savings, but that balances with a pension that would be taxed.

    Last year my income has fell near a tax boundary (although slightly different than the usual “brackets”) between a marginal rate of 15% and a marginal rate of 27.75%. I made pre-tax contributions down to the boundary, and Roth contributions from there. That’s a pattern I intend to follow forward.

  9. I contribute to a Roth 401k at work, and I think it’s definitly the best way to go. 1) I plan to have a high income from a variety of sources even and especially into retirement, so my tax bracket will do nothing but rise. 2) As you point out, tax rates accross the board could rise during my lifetime, so even if I WAS in the highest tax bracket now, that could increase by the time I retire. 3) I would rather pay taxes now when I know I can afford them. That is one less expense I’ll have to worry about in my old age. 4) The longer your investment horizen, the better deal the Roth 401k is. All your gains and dividends are TAX FREE. You aren’t taxed on them up front OR when you withdraw them. I would rather pay taxes on a few grand a year now than pay taxes on (potentially) hundreds of thousands of dollars a year later as I make withdrawals. 5) You’re already getting some tax diversification from investments you (may have) made into Traditional 401ks or IRAs because company matches are made into Traditional Plans even if your contributions are Roth.

  10. Look at it this way: If you contribute the max (or any equal amount) to a Traditional plan and to a Roth, you’ll end up with the same amount at the end–let’s call it $1,000,000. The difference is that your $1,000,000 Roth is all yours; you owe taxes on every dollar you take out of the Traditiona. So that Traditional 401k/403b is really only worth around $750,000 (assuming 25% tax bracket). That’s a huge difference to a retiree planning his/her future. Do you think a retiree would think that the tax break she got every year was worth it? Or do you think she would wish she’d put her contributions in a Roth and was able to draw her money tax free (giving her $250,000 more cushion to play with)?

  11. Let me see if I have this right. You are going to be in the 33% tax bracket and don’t expect to be in retirement, yet you are favoring a Roth over a traditional IRA? The only way I could possibly agree with you in your situation is if you are also planning on maxing out your solo-401K to get you out of the 33% bracket and avoiding AMT. Otherwise you are prepaying 33% taxes to avoid paying a lower rate in retirement.

  12. I don’t understand what’s so hard to decide. Either you pay taxes now or you pay taxes later. You’re in the 33% bracket now….if you think by the time you’re 59.5 you’ll be in a higher bracket, max out the Roth 1st while you’re in the lower bracket. Also, if you are a business owner, use business expenses to help lower your tax bracket (S-Corps and LLCs come in handy).

  13. he’s not talking about roth ira’s folks, he’s talking about roth 401(k)’s, there’s a pretty big difference. whenever you leave jobs it has to go into an ira, that is the only mention of ira in here.

  14. Huge point to think about….

    Most 403(b), roth or traditional, plans (due to the lack of competition) have increased fees. Granted there are a few companies with controlled fees (schwab, T-Rowe, and a few others).

    If you are looking at a 403(b) with a 1% – 3% higher fees, then I think you know where you should go…

    Additionaly, no one has mentioned the huge point that was passed in brief about the RMD (required min dist)…Rolling over into a Roth allows this particular account to pass IN ITS ENTIRITY to those children that do not exist yet, if you are lucky enough not to have to invade it. This flexibility is HUGE in estate planning (estate planning atty here). It allows for various trusts whereby you could provide multiple generations large amounts of cash….or donate the money to charity and save on the 47% estate tax currently in place…etc etc

  15. Steve W.

    “I don?t understand that.

    You don?t defer any taxes with a Roth IRA. You defer taxes with a 401k.”

    You’re right. The point is that you are putting away more pre tax dollars in a Roth than a Traditional vehicle. With a roth, at 25% tax it takes $5333 to make a 4000 contribution. With a traditional it takes 4000. So when you take the money out it is the future value of $5333 (after tax) vs. the future value of $4000 after tax. So if you can afford to make the maximum contribution then you should be doing a roth (all things equal). However with a traditional, you could just invest the other $1333 and pay taxes on it as you go. The only real difference being that you will pay taxes every time you realize capital gains on the money, effectively lowering your yearly return on investment.

  16. I know you’re thinking about this already, but the ROTH leaves you with a higher adjusted gross income than a traditional 401(k) and that could result in the loss of other tax benefits that have phase out limits, such as child-care tax credit. In addition, a higher adjusted gross income could make you hit AMT.

    It’s hard to estimate AMT; I’ve used the turbotax and H&R block websites both have free calculators. I’ve been plugging in different numbers to get a sense of how AMT is triggered.

  17. My apologies Jonathan. Rereading the post, I see that you have your tax priorities (lowering your bracket) in order. Still, it’s a bit of a wash. Whatever happened to that solo-401k you used to talk about? With its higher contribution limits, you ‘d have the option of maxing it out and having your wife only contribute enough for the employer match, if you have better control over the investment choices in the solo, specifically expenses.

  18. Traditional. Because the match in a roth is put in a traditional IRA but based on an after tax contribution, it like the match is taxed twice. For example:

    At a 25% bracket….

    Trad with 50% match
    $2K pre tax
    $1K company match

    Assume no growth (the growth cancels out anyways since it is multiplied)

    $2.25K in After tax money.

    Roth with 50% match
    $1.5K post tax ($2K – $25% taxes)
    $0.75K company match (50%)

    Assume no growth

    $1.5K + $0.75K * 75% (since the match is in a traditional 401k) = 2.0625K.

    Basically, the Match gets “taxed” twice with the roth.

  19. Mike said: “Whatever happened to that solo-401k you used to talk about? With its higher contribution limits, you ?d have the option of maxing it out and having your wife only contribute enough for the employer match, if you have better control over the investment choices in the solo, specifically expenses.”

    We want to max out both ;) It’s also hard to max the Solo out completely unless you have a lot of biz revenue.

  20. If you?re in the 33% tax bracket, then you make at least $195,851 in 2007 for a married couple filing jointly. The Roth IRA has income limits for joint filers of up to $156,000 (to qualify for a full contribution) or $156,000-$166,000 (to be eligible for a partial contribution).

    This means that, if you?re in the 33% tax bracket, you don?t even have the option of contributing to a Roth because you make too much. So, your only option would be your 401k anyway? unless I misunderstood something somewhere.”

    Roth 401k, not Roth IRA.

    I will contributed to regular 401k. Wife will contribute to Roth 403b.

    Actually, when I sat down with my company?s retirement consultant earlier this year, his pitch on the Roth 401(k) was, ?How would you like to control how much you pay in taxes?? Having the two separate accounts is a good idea for just that reason; you can push yourself into a lower tax bracket now by contributing to 401(k) and balance your Roth and 401(k) withdrawals at retirement to dictate your taxable income bracket. It?s a pretty elegant system, really.

    Diversifying for future tax environments is smart, because you don?t know what the future holds. I have generally held 100% Roth savings, but that balances with a pension that would be taxed.

    Last year my income has fell near a tax boundary (although slightly different than the usual ?brackets?) between a marginal rate of 15% and a marginal rate of 27.75%. I made pre-tax contributions down to the boundary, and Roth contributions from there. That?s a pattern I intend to follow forward.

    That’s reassuring that others are thinking this way as well.

    Basically, the Match gets ?taxed? twice with the roth

    Hmm… it’s interesting if the match is based on the absolute value of your contribution vs. the pre-tax equivalent.

  21. I just re-opened a Roth based on your previous article. Thanks for the advice!

  22. Mark Freeman says:

    I think most people have the mindset of a either or choice. I think that the most practical way to do this is with both Roth and non Roth accounts.

    The complete Roth choice is the most conservative choice IMHO because you are fixing your tax choice now. You know what you will pay (since you pay now). Of course, things could change, but you don’t have to guess what rates will be or your tax bracket in the future.

    Three other reasons I like the Roth more:

    1) No RMD to worry about. I think this may really bites some folks. Sort of like not keeping up with your AOR payments!

    2) As Evan mentioned, being able to pass the Roth entirely (with stretch provisions) tax free to your kids is HUGE.

    3) No tax torpedo (sell below)

    One reason I like the traditional more:

    1) I really like the idea of paying taxes as late as possible. Sort of how I like to pay off my credit card bills on the last possible day.

    One HUGE reason I hate the traditional:

    1) The tax torpedo as I have heard it called. This is where your traditional taxed retirement plan puts you over the SS limits and reduces your SS income. This is especially painful once the RMD’s start. On the other hand, is SS even going to be around when you retire? At 50, I think there is a good chance something will be there for me. And if enough peeps get caught up in the torpedo, maybe it will be around even longer. Who know for sure?

    Here is my plan. I’m in the 15% bracket and expect to be there for the foreseeable future.

    1) Convert as I go along up to the top of the 15% bracket.

    2) Retire around 60 and use my traditional as much as possible until I start taking SS. I plan on deferring the start to as late as possible depending how far the traditional money takes me. Once I start SS, I’ll use my Roth money so I can avoid the tax torpedo and then try to convert the rest (if any) of the traditional so I don’t have to mess with any RMD’s.

    Maybe this is too simple of a plan, but I think I’ll sleep fine at night.

  23. Jonathan,

    With you future goal of being able to work less/not at all while raising your family do you still expect your income tax rate to be higher in the future? I would think you might be entering your peak earning years if you are still working towards this goal.

  24. 2mil, that’s a great question and a perfect intro into my next post. Essentially, I think 28% is a pretty low rate when looking at history.

  25. Mike Franz says:

    I think a lot of you are missing the fact that employer contributions go in as traditional 401k. This means that if you are either roth prone or want to have eggs in both baskets the easiest thing to do is contribute to your roth 401k yourself and let your employer do their match on the other end.
    Also what is all of this concern with getting to a lower tax bracket? They are marginal tax brackets, so it is not like if you just barely hit a breakpoint it has much of an effect at all. If you are $1000 bucks over the 28% breakpoint your are dumped into the 33% bracket. This means that you now have to pay a whole $50 dollars extra in tax. Yes it matters but it is not something I would restructure my retirement accounts over.

  26. I currently have a 403b plan but have the option of a 403b Roth – stupid question – is it possible (or advisable) to take advantage of both?

    I’ve been contributing 2% pre-tax to max out my employer’s match (3%), and my employer contributes an additional 6% which is vested at 3 years. I recently started contributing another 4%, but I’m wondering now if it would be better to (1) move that 4% to a post-tax contribution, or (2) take that money and invest in a Roth IRA outside of my retirement plan. I’m in my early 30′s, so I assume that my tax bracket at retirement will be higher than it is right now.

    Another factor is that I may be starting a 3 year graduate program within the next year. My employer will pay for some but not all of the program, so I will have both out of pocket expenses and tax implications to consider – I understand that the portion the employer funds is considered an “income” benefit?

  27. I am in a fortunate (& thrifty) position where I can save the maximum $15,500. I am wondering if I can continue to contribute to the other one up to $15,500? In other words, is the maximum $15,500 combined or $15,500 each? Thank you!

  28. I’m pretty sure the salary deferral limit is the total across all such defined contribution plans. Sorry!

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