I read through this entire thread in search for answers for how to split my $18k contribution limit between traditional 401k and Roth 401k. I understand the textbook answer regarding tax brackets now vs. retirement and the logic behind it, but can someone frame this in more practical terms?
Like what kind of analysis possibly goes into deciding whether my tax rate would be higher or lower at retirement, I don’t have a f. clue? I usually put 100% into traditional cause you can get tax deduction now rather than trust the government with how taxes will work out in the future and whether they’ll come up with some scheme to tax my Roth at retirement like VAT or some $hit like this. But I’m questioning whether it makes sense to go 50-50 traditional vs. Roth following some naive quasi-diversification approach? Or, if someone is actually employing any kind of analysis based on anticipating current vs. future tax rates in order to determine the split, what would that even be?
It is a crapshoot, because you are basically betting on tax policy. However, one input I use is whether I am making more now than I will need to live at retirement. To do this, you need to have a pretty good idea of what you want to spend annually in retirement, as opposed to the naive calculation most web-based retirement spending apps have of 80% of your current salary or whatever. If you are planning on spending significantly less than you make now in retirement, then you are better off using the standard 401k now. For example, while tax policy may move a lot at the extremes, if you are planning on spending 50% of your current take home pay in retirement it is unlikely that you will be taxed more on that than you currently are at 100%.
I max out my traditional 401k and backdoor the Roth.
I’d think about it in terms of utility hedging across life stages.
If you are in a high tax bracket when you retire in your 60s, then would probably be doing quite well financially, having earned a lot of money between now and then. You would be richer and therefore, more tolerant to loss of future income through taxes.
If you retire in a low tax bracket, you would be poorer, and would have less tolerance for taxes on your future income.
Therefore, if you cannot predict your future tax rate relative to today, you should favor tax deferral, i.e. the normal 401k. The tax you will pay on withdrawal will be a hedge to your financial success up to that point.
Anyway, this question is a bit odd to me, since I would think that most people here are in quite high tax brackets and would generally expect their income to decrease when they retire from finance jobs.
+1000 - this is exactly how I look at it. In retirement, I (hopefully) will not have a mortgage, kids’ expenses, etc. like I do today. So i’ll be able to afford to “make less money” than I do today without sacrificing much, if anything.
One other thing that I do consider is how I plan to fund my retirement, because, as I believe Ohai alluded to, this traditional vs. Roth discussion could all be moot. If I own real estate assets that throw off $1m in taxable cash flow annually, then it is likely that I would be better off with the Roth option. That is, unless I can use the preferential RE tax treatment to lower my rate…but that is why this is all so impossible. We do not know future tax rates and we have limited ability to influence them.
My advice to people who ask me is to max out all avenues of current day deductibility first, and only then make contributions to an after tax vehicle. The simple reason is that I don’t trust the government. Not in a conspiracy theory deep state sort of way, just that they’re going to need more money eventually and taxing already taxed pots of money seems like among the lowest hanging fruit.
Due to diminishing marginal utility (again), if you have high risk aversion to future tax policy uncertainty, then you would favor the Roth IRA, so as to minimize future tax exposure. However, under most realistic assumptions, I think the life cycle hedging I mentioned above makes more sense.
Let’s say you save $2 million in your retirement account, and are concerned about 20% total tax volatility, which could be derived from your income level, or from changes in policy. That exposes you to $400k of uncertainty.
However, the distribution of your total net worth in 30 years will likely be much larger than $400k, and this will be the dominant variable in your retirement lifestyle.
If interested, you could apply some decision analysis trees with your cash net worth at retirement under either retirement account, and with a realistic distribution of career earnings, and then apply a log utility function to determine the better action. I think the outcome will still favor temporal hedging, though.
if you’re in the top 4 tax brackets, 401k the whole way, if in the 25% bracket, it comes down to the odds of needing to access the capital. the lower two brackets, just go Roth and try to make more money.
the beauty with the 401k/tradIRA is that you can roll it over tax free to kids/grandkids. this is the reason why wealth/income inequality is so high in the US relative to other places. take advantage of it!
I’m asking Matt how you can perpetually roll money from a 401k into your kids 401k’s forever and ever and never have to take it out and pay any tax on it.
Not sure I understand. Going Roth presumably minimizes future tax exposure to the extent that there is no volatility associated with changes in policy. If the specific concern is that Roth may end up being double-taxed (once again at withdrawal) because of changes in policy, for instance the US changing to VAT tax system in the future - then I don’t see why the answer is to favor Roth.
^extremely good point. i say 401k/ira is preferable since you share the upside/downside with govt. also i dont think they’ll change your acct taxation speicfically, they’ll prolly grandfather those accts. and create the new rules for future contributions.
also another issue for roth. the upside is a non taxable event which is great. but say the investment tanks and you lose money, you dont get a tax deduction on your losees.
Sorry, I might not have been clear in explaining my thought. The assumption I made is that your Roth IRA withdrawal will be tax free no matter what. Therefore, you would not be exposed to tax rate volatility. My conclusion is not valid if you predict a meaningful change to the IRA system itself, such as a new tax on Roth IRA withdrawals.