re: roth 401k vs regular 401k

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If they need $98,000 to live off of. What was the effective tax rate of their Roth contributions? That puts them in at least the 22% category.

Because you just showed the effective rate of their Trad to be 11.61%.

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Funny you should ask that, because I was just whipping that up.

Let's say our guy made $400,000 a year (spouse didn't work). That means he was firmly in the 32% tax marginal tax bracket. He just happened to make that same amount for the last 30 years of his career (worst case scenario for the Roth, higher income the whole time), and because he didn't read TD, he did't start contributing to his 401k until his last 30 years of work. He contributed $19,000 a year.

So 30 years of Traditional 401k contributions. Then a 30 year retirement. Lets see how that works out:



I modeled it out how it would actually happen, meaning I put $19,000 in the 401k, and then lowered his taxable income for each year of work by $19,000, and showed the resulting taxes and spendable income. As you can see, he paid $84,552 in taxes every year of work (effective tax rate of 21.14%), which sums to $2,536,563 over 30 years.

If his retirement expenses remained the same for 30 years, and he withdrew the same $68,350 every year, he would pay $342,420 in taxes over the course of his retirement ($11,414 x 30 years).

His total taxes paid over the 60 years of work and retirement would be $2,878,983

But what if our guy actually went and sat down with someone who knew what they were doing and could give him some advice 30 years ago when he started saving?



This time, he made Roth 401k contributions instead. I put $19,000 every year into the 401k, but those contributions didn't lower his taxable income. He paid taxes on all $400,000, resulting in $90,632 paid in taxes each year (effective rate of 22.66%), totaling $2,718,963 over his 30 year career.

While retired, he still needs $98,350 a year, but because he is able to withdraw from his Roth assets tax-free, he would only pay taxes on his social security of $30,000 a year. His total taxes each year would be $3,212 (effective tax rate of 3.27%.) He would pay $96,360 in taxes over his retirement ($3,212 x 30 years.)

His total taxes paid over 60 years of work and retirement would be $2,815,323.

Jesus tap dancing Christ! He would pay $63,660 LESS with the Roth? Even with his marginal tax rate going down 20%? What kind of black magic frickery is this?!

The difference in tax rates while working (21.14% for the Traditional, 22.66% for the Roth), is far less impactful than 30 years of the difference in in tax rates while retired (11.61% for the Traditional, 3.27% for the Roth).

Mind you, his spendable income (Gross Income - Deduction - Taxes paid) over his 30 years of work would have been reduced by $182,403 with the Roth. Netted out, over the course of 60 years the Traditional IRA would have given him $118,743 extra dollars. Less than $2,000 a year.

And this is in this very specific scenario, where he was in a high bracket his entire working career, and he cut his spending from $296,448 a year to $98,350. Not very likely. If instead, he needed 75% of his previous spending in retirement, that would be $222,336 a year, meaning he would need to withdraw $192,336 a year from his IRA, resulting in taxes of $44,786 a year, while the Roth would remain at $3,212 a year.

Now we are talking about a difference of $1,064,790 in taxes paid over the course of 60 years. In favor of the Roth.

Come at me bro.

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Mind you, his spendable income (Gross Income - Deduction - Taxes paid) over his 30 years of work would have been reduced by $182,403 with the Roth. Netted out, over the course of 60 years the Traditional IRA would have given him $118,743 extra dollars. Less than $2,000 a year.

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First off well done.

I will have to take a closer look at it certainly.

But, as far as the above. Why does total taxes matter? Who gives a shite about taxes? I care about net income. If my income is higher with one, that is absolutely the preference.

Do both. The cpa will say all reg401k because they are seeking immediate benefit, financial planner will lean towards Roth because they seek future benefit. But the younger you are the more you should contribute to the Roth. For example, you’re under 30 yo with 30+ years to go, you could prob assume you’ll only make more going forward. And then depending on the situation, as you make more $ you reduce Roth and increase regular. Ideally you want 3 buckets in retirement: Pretax, post tax, and a taxable brokerage account. That way you can spread your tax liability across Ordinary income tax, ordinary income tax,,0% on Roth, and capital gains on brokerage.

Why? The way reality actually works is people make a 401k election, max being $19,000 this year, which is withheld from their paycheck and deposited in their account. If it is a Traditional pre-tax contribution, their taxable income is reduced by the amount of the contribution, if it is a Roth election, their taxable income is not reduced.

That is how it works.

I would think you would have gotten tired of people showing how you are talking out your arse, but ok.

The only instance where that would be a consideration is if the client is maxing out their 401k election, has capitalized on a backdoor Roth if they can, and still want to save additional funds. Which would be the case in either election scenario for the example person.

People with an actual financial plan target a certain amount of savings for the year, calculated by a need in the future, add in a margin of error, and then save that amount. And then they enjoy the rest of their money.

“Save what you can” or “Save whatever is left” are not plans. Those are reactions.

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So I’d pay my tax in a lower tax environment depending on your circumstances.

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I don't disagree with the logical, but I think too often people don't consider the very real possibility of the tax law changing...

Just look at the history of the taxability of Social Security benefits if you need proof that income you thought wouldn't be taxable can become taxable. One of the best professors I had in college (who taught Tax Seminar) always told his students that he'd take the tax break NOW if given the choice.

For what it's worth, seeing how frustrations are rising, I don't recommend this either.

While it sounds like a great idea on the surface, the truth is, people do traditional now to *save* money on taxes so they can get a larger paycheck for spending, not so they can save more.

I wrote a script for it if you want to use it:

Advisor: "Mr. & Mrs. Client, I'd like you to up your 401k contributions to the max so we can save $8,000 in taxes per year. Then we'll take that money and invest it too. It'll be great for your future, but it's going to cost you $16,000 extra per year. What do you think?"

Mr. & Mrs. Client: "Hell no."

/scene

The latter, I agree with you. I don't think it was necessarily a bad point in principal by Baldona, but the reality is just as you explain it.

I've never had one person ask what to do with the tax savings.

The script was an attempt at levity, you can use it whenever you'd like.