This is your Money. This is your Money on a Roth
I recently shared some thoughts on how to become Financially Independent in the shortest possible time by leveraging tax advantaged accounts such as the 401k, 403b, HSA, and Traditional IRA. Taking advantage of all possible tax deductions Today is a great way to Turbocharge Your Savings, accelerating Financial Independence by years
I even made some disparaging remarks about the Roth IRA. Some reader’s pushed back, which is always a good thing.
I will explain the reasons that I believe the Roth 401k and IRA are the least advantageous investment choices. Furthermore, I will provide an overall recommendation for where to save for Financial Independence
First a brief comparison
Dollars saved in a Traditional 401k / IRA are pre-tax. We pay no income tax on dollars going in, an immediate savings of up to 39.6%, the highest marginal rate. The invested funds are allowed to grow tax free, so all interest, dividends, and capital gains are untaxed until withdrawn from the account. Upon withdrawal, all funds are treated as ordinary income, similar to a paycheck.
Dollar saved in a Roth 401k / IRA are after-tax. We pay normal income tax on any money put into a Roth, but this is the only tax that will ever be paid on those funds. Any interest, dividends, and capital gains are tax free, forever
Ultimately the arguments for both types of accounts come down to one question: Will your tax rate after retirement be higher or lower than it is today?
Let’s explore a few scenarios
Median Income
Let’s look at the median income earner, a family making ~$54k/year. Because they are targeting early retirement, they are saving 50% of their after-tax income. (I outlined the median income earner family in the post on how to Turbocharge Your Savings.)
They heard general advise that young people and those with low income can benefit from a Roth 401k, and they thought, “That sounds like us!” Their highest marginal rate is “only 15%”, and some of the $17,500 savings would even be taxed at only 10%. “Surely our post-retirement tax rate will be higher!”
With a $17,500 contribution to the Roth 401k rather than the Traditional 401k, the family would pay an additional $2,502 in tax, an effective tax rate of 14.3%. I’ll be generous and consider the 401k match of 2.7% ($1,444) as part of the contribution, lowering the effective tax rate to 13.2%
Fast forward 16 years to the point where they have achieved financial independence, and decided to quit their job and travel the world. Maybe they’ll even do something crazy, like retire first then have kids. Sounds like a fine plan to me
Using constant 2014 dollars, how much would this family need to withdraw from the retirement account before paying the same tax rate of 13.2%?
$113,100! 5x their entire cost of living
Withdrawing their target spend of 50% of their after-tax working income, $22,700, they would pay an effective tax rate of 1%
Why the ROTH 401k Sucks for Early Retirement / Early Financial Independence
But wait, it gets better. Remember that $2,502 that Mr and Mrs Median gave to Uncle Sam 16 years ago, instead of investing for their own use? Had they invested those funds in their brokerage account as I recommended, their total savings would be 13% larger
Using the Roth 401k cost them. They must either work longer, or be comfortable retiring with fewer assets
90% Percentile
What about somebody that earns a little more, perhaps at the 90th percentile of all US families? With an income of $118k, this family is firmly in the 25% marginal tax bracket.
Being generous once again, counting the Roth 401k employer match as part of contributions, our example family elects to hand over $4,375 to Uncle Sam instead of investing for long term personal freedom. They too targeted an early retirement budget of 50% of the working year income, a bit higher since they could afford a few luxurious due to their high earning power
How does this look come retirement time?
90% Percentile ROTH Situation
If they continue with their target spending of ~$48k, 50% of working years after-tax income, they will pay a tax rate of 6.9%. And let’s not forget, had they chosen the Traditional 401k, those tax dollars would have been invested as well
That’s a substantial haircut off the 25% they chose to pay years earlier
To pay the same effective tax rate, they would have to make a serious effort to see how the 1% lives, withdrawing $385k in one year. Kobe beef steaks and lobster tails on the yacht, anyone?
The Last Dollar Principle
In both examples, choosing a Roth 401k over a Traditional 401k resulted in less wealth and more tax. Why?
Think about it this way. When we invest $1 in a 401k, that dollar is the last dollar we earned. It is taxed at our highest marginal rate. But when we withdraw $1 from our 401k years from now, it is our First Dollar. As we saw in the pretty pictures earlier, the First Dollar is always taxed at 0%
Now as spending increases to large levels, above ~$94k into the 25% marginal tax rate things get interesting.
This is where some start to argue about mathematics. We could pull out our college algebra textbooks and prove beyond a shadow of the doubt that a Traditional 401k and a Roth 401k are EXACTLY THE SAME as long as the tax rate is the same. This is true. 25% tax paid today is mathematically the same as 25% tax paid in the future after our funds have grown tax deferred
But math textbooks make simplifying assumptions which are often impractical in the real world (Hello quadratic equation, I’m talking to you.)
The odds of our Mr and Mrs 90% earning $94k in income from other sources (the lower edge of the 25% marginal rate), and every penny withdrawn from their 401k is taxed at 25% in the future is infinitesimally small
What matters the most is the aggregate tax rate, and for both of our examples this is lower than the marginal rate.
Pensions and Social Security
But there are other income sources. I believe Social Security is here to stay, and we will certainly be able to access those funds in 30 or 40 years.
There are also a healthy number of people with pensions, although this is becoming less common
Above $44k in total income, 85% of Social Security is taxed as ordinary income. 100% of a pension is taxed at ordinary income
Both Social Security and Pensions are in proportion to working income. In other words, the more you earned while working the greater the amount received from SS and a Pension
A typical federal government pension (a very generous program) will pay 1% per year of service, so someone with 30 years of service could replace about 1/3 of their salary. A high earner that works until Age 65 could expect SS to replace about 26% of their salary.
For a federal pension and social security to pay $90k in taxable income a year, working year income would need to be greater than $185k.
As this is firmly in the 28% marginal tax rate, this family would also benefit by using a Traditional 401k
Required Minimum Distributions
Starting at Age 70.5, Uncle Sam will require that you withdraw funds from your IRA and 401k. The amount is based on life expectancy, so the older you get the larger the minimum distribution. See Jim Collins’ excellent post on this topic for more detail
How much $ would we need in a 401k for the RMD to have a punishing impact? As we saw above in the case of Mr and Mrs 90%, a withdrawal of $385k has an effective tax rate of 25%
At Age 70.5, this equates to a 401k value of over $10.5 million
An individual that made maximum 401k contributions, with employer match, for 30 years could theoretically have this amount in their 401k. All it requires is an annual return of about 16% for 30 years. It’s not inconceivable, Warren Buffett did it
(If this is you, let’s blow this Popsicle stand and start a hedge fund)
When Is The Roth A Good Idea?
I’m glad you asked
The option to pay tax today and never again is of value, no doubt. If you have an effective tax rate today of 0%, not uncommon for students and others in temporary low income situations, a Roth 401k or IRA is a great idea
It is also not a bad idea if you’ve already maxed out your Traditional 401k and have additional funds to invest. When saving a high percentage of income, this SHOULD be the case. Instead of putting an extra $5,500 into a brokerage account, you could put them in a Roth
For many, however, a brokerage account is just as good. If during your retirement years you expect to earn less than ~$90k/year, staying below the 25% tax bracket, then all Long Term Capital Gains and Qualified Dividends are already taxed at 0%. At these income levels, a brokerage account effectively has a 0% tax rate for stocks, much like a Roth
The brokerage account also has the advantage of being able to harvest capital losses, and to spend dividends or gains anytime before Age 59.5
Conclusions
We have seen that for people with median income and above, taking advantage of the tax benefits of a Traditional 401k has long term tax advantages, allowing one to become Financially Independent in the shortest possible time
We also saw that the impact of Social Security, Pensions, and RMDs also favor the Traditional solutions over the Roth
In conclusion, the preferred investment vehicle is the 401k. The HSA is also great. Only when all other options have been exhausted does the Roth start to look interesting, except for families with poverty level incomes (ideally temporary)
For a rule of thumb, I would save funds into accounts in this order during the working years:
- 401k up to company match
- HSA
- 401k up to maximum
- Traditional IRA if tax deductible (subject to MAGI thresholds)
- Brokerage account
- Maybe $5k in a Roth (subject to MAGI thresholds)
- Maybe after-tax contributions to a 401k for Backdoor Roth (pros/cons)
Addendum:
Why a Roth last? As can be seen in the comments, this is a contentious topic
What if you have already maxed out a 401k, an HSA, are not eligible for a deduction on a Traditional IRA, and have quite a bit of money remaining to be invested. Isn’t putting $5,500 into a Roth better than putting those funds into a Brokerage account?
No
Because we aspire for a long retirement, our portfolio is stock heavy. As explained in our classic post, Never Pay Taxes Again, taxes on Long Term Capital Gains and Qualified Dividends is 0% for incomes below ~$94k.
This is the same tax profile as a Roth, but with one distinct difference
We can spend those capital gains and dividends whenever we want, whereas the earnings in a Roth cannot be touched until Age 59.5 without facing a penalty and taxation (you can only access the Contributions)
Let’s look at that in numbers for Mr and Mrs 90%
Over a 13 year working career (faster due to using tax breaks of 401k), putting $5,500/year into a Roth IRA results in about $72k in contributions. Using the FV function in Excel and a 7% annual return, when we retire early the account is worth about $110k.
If we had invested those funds in a Brokerage account instead, we would also have $110k. Since Mr and Mrs 90% didn’t sell any of their stock they generated no capital gains. And since they invested in their 401k reducing their marginal tax rate to 15%, they paid no tax on any of the dividends.
Of course with that stock being in a brokerage account, they have full use of the annual dividends. At a 2% dividend rate on the S&P500, that is $2200 per year in cash flow for our use with zero tax
Fast forward 10 years, assuming the same annual growth rate, the account is now worth about $218k and continues to pay dividends (isn’t it great when the market only goes up?) Speaking of the market going up, you can’t harvest capital loss in a Roth
Assume at this point we need access to $150k in future dollars to buy a large sailboat to fulfill our dream of sailing around the world.
If we had invested in a Roth and we try to access our Roth contributions at that point, we only have access to our original $72k investment. We need more money
While full access to contributions is often cited as an advantage of a Roth, those contributions lose to inflation with each year. While we can access our $72k in contributions, those funds are only worth about $53k in Jan 2015 dollars. The earnings are much more valuable
Because we didn’t have access to the dividends in the Roth during our decade of joyful living, we’ve been spending down the Brokerage account a little faster. Maybe we don’t have enough funds there to cover the difference
Now we need to either tap the Traditional 401k/IRA or the earnings in the Roth. Both result in a 10% early withdrawal penalty and full tax on the withdrawal. Such is the price of fulfilling our dreams
But what if instead we didn’t use the Roth years earlier? We have $218k sitting there in our brokerage account, ready to use at our leisure without restriction.
And that is why the Roth is last, and why there is a big Maybe for all Roth contributions
(Post Early Retirement, creating a Roth IRA Conversion Ladder as part of our overall tax strategy, is a great practice to minimize long term taxes. This is how we pay $0 in tax on our contributions and $0 on the withdrawals)
Jeremy, I liked this post, but I can’t help but think of the problem of withdrawing money from a Traditional 401(k) (or IRA for that matter) before age 59.5. How do you avoid paying early withdrawal penalties?
The Mad Fientist has written a great article about this that your other readers might enjoy too:
http://www.madfientist.com/traditional-ira-vs-roth-ira/
You might also like this one by MF:
http://jlcollinsnh.com/2013/12/05/stocks-part-xx-early-retirement-withdrawal-strategies-and-roth-conversion-ladders-from-a-mad-fientist/
I wouldn’t so much call it a problem, as there are so many different solutions to early access that the 59.5 age limit is really just a formality. I have a post half written on this topic, stay tuned
Looking forward to seeing that post!
What if you get fired and the new company that you went to has NO benefits, what would be your solution then, saying you plan on retiring in 5 years anyways?
Small pet peeve: there is no need to capitalize all the letters in Roth. It is a last name (named after Senator William Victor Roth), not an acronym. Roth IRA.
With a name that short, the guy deserves a few extra Capital Letters
It’s a bit of a depressing topic, but there are also advantages to a Roth IRA when it comes to estate planning. Who knows what the tax codes will look like in the future, but it’s currently a more efficient way (tax shelter) the estate for your spouse / beneficiaries. So I’d still advocate diversifying into having some (backdoor) Roth IRA contributions, instead of all after-tax brokerage… Too complicated to explain in a comment, but read up on it here: http://fairmark.com/retirement/roth-accounts/roth-distributions/inherited-roth-ira/
Steve is correct. As with any of this stuff, though, rules may change over the (hopefully many) years before you die. This article says that Obama’s 2015 budget aimed to remove this advantage of Roth IRA’s. http://www.marketwatch.com/story/want-to-leave-a-roth-ira-to-your-kids-beware-of-taxes-2014-09-09
@Steve, agreed. My beef with the Roth IRA is during the working years only, when the choice is between pay taxes now or pay taxes later.
You may have seen from our posts on big picture tax strategy that our goal is to Convert every penny from our 401k into a Roth IRA, doing so at the 0% marginal rate over 30+ years in a very long Roth IRA Conversion Ladder
https://gocurrycracker.com/never-pay-taxes-again/
@Robert, thanks for sharing the link, I hadn’t seen that
Our own ultimate estate tax avoidance strategy will evolve to charitable giving, but unfortunately we can’t decide the date
Very interesting read! I need your advice please. I’m 51 years old and have a 401k at work. I am contributing 7.8k per year atm. I opened a Roth this year and am almost done funding 2019(5.5k). Our work just gave us the HSA option this year, so I am gonna max that out. My question is that I am probably gonna have to work until age 62 because I currently only have 185k in 401k, so should i stop the Roth and try to max 401k?? Will I still be able to covert 401k and lump sum pension(250k) into the roth? Trying to figure out if I will have enough time to do the conversions without paying too much taxes…Thank you in advance if you’re able to answer.
Sorry John, hard to say with the limited info here. Please post on the forum and maybe we can figure it out.
Thinking of this in a retirement early thought process, I’m not sure if I entirely agree with the HSA being second, while I understand it saves you an extra 7% or so in taxes, my thought process is if you plan to retire early and use that money by flipping from 401k to IRA to Roth, you limit yourself the income available for early retirement as an HSA can only be used at 65 or for actual medical expenses. Unless you have a HSA work around.
The argument could be made though that if you are contributing only the company match and the HSA you are probably a ways off of early retirement and this wont matter a great deal.
Hi Steven
Yeah, my argument is that you fill up these accounts in order. If you are only contributing enough for company match and the HSA, your working years will be many
On the other hand, if you are saving 50% or more, you’ll fill up the 401k, the HSA, and put many dollars in the brokerage account
Your logic is sound, and I agree access to the HSA would be a problem if you wanted that to function as a source of (non-medical) spending in early retirement
Great point!
Jeremy
Jeremy,
I love the amount of articles you are pumping out recently! Always a great read, thanks for sharing your knowledge and insights. Best.
Thanks!
My Chinese class is winding down, and this final trimester of the pregnancy means we spend more time at home. And also no travel. So I have a bit more time to write
I’m also preparing for the book I’m planning to write :)
Thanks for this, your comment made my day!
Jeremy
The discussion on the tax rate now and in the future reminds me of choosing skincare products. There is always a debate on whether a woman should start using advanced anti-aging products at a relatively young age (like in 20s or 30s) or should they wait till they are in their 50s or 60s to do so. One fear was that there will be no products left to use when you get old if you have already exhausted all the options. This argument always fails to convince me. I would rather enjoy the benefits now and for later, I am sure the technology will keep advancing new products that do wonders. What is the analogy? I would totally go for the tax-benefits NOW. I am sure the technology on tax savings (thanks to inventors like GCC, MF, etc.) will advance to help me save tax later. :)
I never knew there was a debate about skin care products :)
I love the analogy
Why would you rank brokerage before Roth? What’s the upside of the brokerage besides greater liquidity before retirement?
Hi Wh
Good question
Partially to illustrate a point. We have no Roth accounts from our working years, only since starting a Roth IRA Conversion ladder for long term tax minimization
For ourselves and many aspiring early retirement, I view a Roth IRA and Brokerage account as quite similar. We pay 0% tax on Long Term Capital Gains and Dividends in our brokerage account, the same as in a Roth
The brokerage has advantages however. In a down market, I can’t tax loss harvest in a Roth. I also can’t withdraw earnings (dividends) before 59.5, only contributions.
The Roth has its own advantages. It is a good place to hold Bonds or REITs, as payments from those are taxable in a brokerage account. But I already have a 401k /Traditional IRA that I use to hold those asset classes
Let me know if this clarifies things or answers your question
Thanks!
Jeremy
Maybe someone already raised this, but we are in our ‘working years’ and can’t quite get our AGI below that 90K threshold you’ve mentioned, so we do pay taxes on dividends, etc. in our regular mutual fund accounts. In this case, I place the value of putting something in a Roth during wealth-accumulation years slightly higher. But I could be wrong.
No, you are correct
Taxes on qualified dividends would be 15%.
If, for example, you purchased VTI / VTSAX which pays about a 2% dividend, then you would pay a tax equivalent to about 0.3% of assets (15% of 2%)
On $100k that would be $300
Alternatively you could hold a diversified investment that does not pay a dividend, such as Berkshire Hathaway
But this is probably overstated, as we are only talking about $5500 / year / person, the maximum Roth contribution. A married couple might contribute $11k to their Roths, in which case the tax bill would be $11k * 2% * 15% = $33
well, since you put it that way.. ;)
Hey Jeremy,
Just learned of the FIRE movement and been reading on it for days. Cool stuff!
Right now I have 50% in brokerage and 50% Roth. Never had 401K access (in hindsight could’ve opened tIRA). If I were to start FI journey, should I just leave as is? Or could I withdraw all contributions from Roth and put in brokerage? Have maxed the last 4 years.
Once money is in a Roth, I would leave it there forever
Will leave it as is and start adding to tax-deferred accounts then. But my Roth is in retirement and US growth funds so will move them to Total Stocks. Since I’m not withdrawing anything, I won’t be taxed correct? Not even on short-term gains?
There’s no cost in taking contributions out and moving to taxable account. You’ve said you prefer taxable before Roth, so why do you recommend leaving in Roth?
>why do you recommend leaving in Roth?
It’s not so much that I recommend leaving funds in the Roth, it’s that making any change seems premature. You are still early in the journey (both savings and learning curve.)
The asset allocation changes you are making now (your other question) would be taxed in a taxable account, and maybe this isn’t the final change. You’ve also contributed for 4 years (?) so about $20k in contributions – in the big picture it doesn’t much matter where 2% of a full retirement portfolio is located.
The post Roth Hypocrisy may explain more. Learn more, make a long term plan, and then decide if pulling funds out of the Roth makes sense.
Can you explain how you arrive at your computations? Feel free to send me your spreadsheet, if you don’t mind. I want to understand how you claim someone earning $54k per year pays 13.2% but could withdraw $113k from their 401k (both taxed as ordinary income) and still pay 13.2%.
It’s great that you show charts and your conclusions, but I’d like to see the math and numbers driving the charts if it is ok with you. As you know, I’m probably your biggest skeptic but I’m just trying to understand. I’m pretty educated on these topics and I’m not saying you are wrong but I need more convincing.
Ryan and Go Curry Cracker,
I too have been trying to understand this; it is certainly a counter-intuitive, thought-provoking concept! I’m enjoying the discussion.
Ryan, I think it works like this (you don’t need a spreadsheet). He is using his Last Dollar Principle (LDP). Thus, he is comparing a marginal tax rate for the $17,500 401(k) contribution to an overall average tax rate for the distribution during retirement. Thus, he argues that the $17,500 contribution WOULD have incurred taxes of $2502 had it been kept as ordinary savings instead of placed in a 401(k) or deductible IRA. $2502/$17,500=14.3%, i.e., this is the marginal tax rate on the “last” $17,500 earned. If you include the employer match of $1444, then he calculates this as $2502/$18,944, or 13.2%. (I think this is incorrect if you also have an employer matching option on a Roth 401(k). You should stick with the 14.3% in that case, or better, if the match is taxable income, include that tax in the numerator).
As for the distribution, he’s just saying that a family would have to have taxable income of $113,100 before their OVERALL (not marginal) tax rate would be 13.2%. From his figure, that family is already well into the 25% marginal tax bracket, though, which started in the $97k range. I question the legitimacy of the Last Dollar Principle, and this example illustrates the point. If the family withdrew only $97,000 instead of $113,100, then they would have $16,100 less in taxable income–income that would have been taxed at 25%. So if one were withdrawing significant retirement income, the LDP seems incorrect to me. Maybe Go Curry Cracker can further clarify.
One Minor Quibble: A young family during earning years may have tax exemptions for children while older retirees typically do not, so a slight adjustment to the model could be made to account for that, particularly if a lower income family where the child exemption (and maybe even EIC) is a higher percentage of the overall income. This adjustment would make the case for a Roth account slightly stronger.
One Major Quibble: Go Curry Cracker, you discuss RMDs and cite the income at Age 70-1/2 that would trigger a high tax. But, I think that you need to look at all ages, not just 70-1/2. It seems to me that the key question is whether you have reached a sort of “escape velocity” in your investment income relative to your expenses (distributions). If you are withdrawing money significantly slower than your nest egg is growing due to investment returns, then the RMDs will get to be quite large and taxed at high rates. It isn’t necessary to earn 16% for this to be true; you just have to compound the growth for a few more years, i.e., don’t just look at Age 70-1/2 but also at 75 or 80.
For example, I have created a spreadsheet which I can send if you want that illustrates this effect using your scenarios. For example, assume the 90th percentile case. Following your example, I assume $96,000 of after-tax income resulting in $48,000 of annual expenses and $48,000 annual savings into 401(k)/IRAs/HSAs (assuming they can do that much). If we assume this starts at Age 30, and they retire after 16 years, and we acrue earnings only on an end-of-year annual basis, and assume 7% real rate of return (the U.S. stock market average over long time), and conservatively assume no real salary increases during 16 years, then at the end of 16 years they’ll have accumulated $1,338,627. In that 16th year (their Age 45th), their investment income would be $84,434, already almost twice their annual expenses. If they start taking distributions of $48,000/yr, their investment will still grow rapidly because their investment earnings are almost twice their withdrawals. They have exceeded “escape velocity”. But what this means is that by Age 70 they’ll have accumulated savings of $4,229,352 and RMD will be $154,356. Ignoring tax on RMDs (which complicates the calculation but isn’t necessary to make my point) and assuming they reinvest them since they don’t need them to live on, their taxable income will keep rising. By Age 80 they are up to $7,656,585 and RMD is $409,443. At Age 85 RMD is $706,941. Even if we adjust these downwards for the impact of tax on distributions, we still are looking at a high tax rate and huge tax bill. This is why a Roth IRA or 401(k) would help. It would not require RMD (under current law) and even if it did, the distributions would not be taxable. If this family doesn’t take (all of) the 50% distributions starting at Age 46 because they also happen to have a company-funded pension, then the case for a Roth is even stronger.
Don’t forget the estate tax advantages of a Roth account either. Especially if you have grown a large nest egg as in the above example, think how much of this money would go to Uncle Sam if you died and it was dumped onto heirs as taxable income during their own prime earning years.
Second Major Quibble: The Social Security “tax torpedo” can result in significant bumps in marginal tax rates during retirement. There is no inflation adjustment either, so it will get worse. This is a good argument for having at least a significant part of your money in a Roth. http://www.oregonlive.com/finance/index.ssf/2014/10/social_security_tax_torpedo_ho.html
Final remark: As noted in my other post, Obama proposed to force RMDs in Roth accounts. That would weaken the case for Roth but not destroy it, since those distributions would still be nontaxable. However, I think perhaps the most useful idea is to diversify the type of accounts as a form of diversification protection against future congressional actions (and given current US debt levels, these are unlikely to be favorable to taxpayers). I am only in my 50’s and plan to live another 40 years, but if I think back 40 years, the tax situation in the US was dramatically different. Think of all the tax law changes during the past 40 years, including the major overhaul in 1986. It seems reasonable to assume that changes of similar scale will occur over the next 40 years. We can’t predict what they will be or what strategy will be optimal for meeting them. For that reason, diversification into both 401(k)/IRA/HSA and Roth 401(k)/IRA accounts as well as taxable brokerage accounts may provide the best long-run after-tax returns.
Hi Robert, thanks for your great comment
You nailed the 1st $ / Last $ idea in response to Ryan’s question, thanks.
You also correctly point out that a family making large 401k withdrawals would face large marginal tax rates, 25% above ~94k and point out that if they withdrew $16k less they would have only a 15% marginal rate.
That was exactly the point I was attempting to make. A family spending $23k has substantial upside in their annual spending before coming even close to a higher marginal rate than they would have paid in their working years. Even $94k is 4x their current lifestyle. While $114k was the breakeven threshold, they are unlikely to ever come close
re: mQ1
Children, increased exemptions at old age, etc… agreed this will move the 0% tax threshold around. In general, if a family is paying a very low tax rate (e.g. 0%) then take advantage of a Roth now. I think I mentioned something similar in the conclusions
re: MQ1
Agreed, RMDs will increase with age. Would you agree that the probability of having an RMD at Age 70.5 tilt taxes in favor of paying high marginal rates years earlier has low probability? (e.g. 16% annual returns for long periods)
As RMD levels increase with age, this becomes increasingly likely. I agree. The question becomes: Should people choose to work 20% longer, paying taxes now, to avoid paying more tax at 80 years old? With all of the tools available for withdrawal of funds at low or zero tax rates before age 70.5, I think the answer is no
re: MQ2
I just browsed through a couple articles on the SS tax torpedo. Clever name, I suppose. They could also just call it paying a higher marginal rate. As it so happens, I have a post coming on Social Security and will add some thoughts on this topic. The author of the article should compare to the case of if the example Senior never saved in an IRA at all
Re: final remark
Agreed, tax law will change. “The only constant is change”
Note that my issue with Roths is during the working years only, when people choose to pay tax today instead of maybe paying tax years from now
For early retirees, a Roth IRA Conversion ladder is part of the arsenal for long term tax minimization, as we do
https://gocurrycracker.com/never-pay-taxes-again/
I too am enjoying the discussion. Thanks for reading and sharing your feedback!
Jeremy
Jeremy,
RE: re: MQ1.
No, I wouldn’t agree (not convinced yet, anyway). I’m saying that it is easy to generate high marginal rates if one is in a higher income bracket (such as your 90%tile example). Even lower income brackets still run into the issue. It is the power of compounding at work. If you are living frugally and earning just 7% on your investments, but start saving early, you’ll very likely run into the problem I described. That’s what my spreadsheet shows, anyway.
What I’m proposing is that there is probably an optimum ratio of traditional vs. Roth accounts that is related to the ‘escape velocity’ I described. Essentially, you don’t want ‘runaway investment balances’ in your traditional account, but are happy if it occurs in a Roth. So, you should optimize the ratio so that you’ll spend the traditional account money as fast as it earns income, while letting your Roth grow. This optimum ratio will vary depending on your age, accumulated savings, rate of return, and spending rate. It isn’t a question of having to work longer; it is a question of minimizing the overall tax burden, including impact of RMD and SS tax torpedo etc. so as to maximize wealth, which in turn minimizes your working years (if desired).
RE: re: MQ2
For a wide-ranging discussion of how to optimize SS benefits, including minimizing the tax torpedo effect, see https://www.iscebs.org/Documents/PDF/bqpublic/bq212f.pdf.
RE: Re: final remark
I probably wasn’t clear in the remark I made a day or two ago, but my problem is that I can’t possibly convert all the money I need to from a 401(k)/IRA to a Roth IRA. The investment has reached ‘escape velocity’, so the account balance is growing faster than I can convert it. i.e., if I convert enough to take my income up to the top of the 15% bracket, that may involve a $60,000 conversion. Yet, if my investments grew by $100,000 the same year, then I have fallen farther behind on the task of reducing my 401(k)/IRA balances. I’ll never catch up. And so I’ll eventually face RMDs and a big tax liability, and this will kick in about the time I take SS, so the marginal tax rate on SS income will be huge as well.
It becomes difficult to have a continued dialogue in the comments :(
The level for RMDs driving high marginal rates shouldn’t be dependent on income, just on the 401k contribution limit. $10 million 401k value at Age 70.5 would cause any other income to be taxed at 25% or above (~$94k RMD)
I proposed a case of max contributions for 30 years with 16% return hitting that number. It could also be 40 years at 11%
Either scenario is unlikely
I’ve thought through your escape velocity scenario for ourselves. We could think of it as having too much money in a 401k, for example. I think of it as the race against the RMD
I suppose if the account grows at $100k/year, that is a good problem to have. It could go down by $400k this year instead, and you could sneak some more shares into the Roth at reduced prices. Which is better?
I think crafting a perfectly balanced triumvirate of 401k / Roth / Brokerage accounts would be challenging, if not impossible
We can choose to pay tax today to get funds in a Roth, although this does extend working years (during which we also pay more tax.) Using the 4% rule, we know when we have enough to quit working, statistically
In some cases, those funds will grow to incredible levels, causing a case of high taxation later in life. In other cases, you spend your last dollar the day you die. On the day we choose to stop working, we don’t know which case will apply. In your case it sounds like the former
I think a detailed post about your scenario and the challenges to minimize lifetime taxes could be an interesting read
Thanks for the SS link, I’ll give it a read
Yes, it gets hard to continue this dialogue as the reply is no longer linked to your response. But anyway, responding to your reply at 2:14 a.m. 1/31/2015…
I think we have a factual disagreement, which is the best kind since we should be able to easily resolve it. I may be making a mistake, or it may be you. If I understand you right, you are saying that RMD for a $10MM nest egg would be about $94,000. I calculate a much larger number. The IRS tables gives a distribution period of 27.4 for Age 70. $10MM/27.4 = $364,964. That’s several times your calculated RMD. Correspondingly, to get to $94,000 RMD at Age 70 would require a nest egg of only $2,675,600.
In the scenario I outlined above, I said, “assuming they can do that much”. I think I was a little high since max per couple in 2015 is $36,000 for 401(k) and $6650 for HSA. But let’s be more precise here, and I’ll even be liberal and ignore the HSA part, plus also I’m not counting any employer match on 401(k). If I put after-tax income at $72,000 so that the 50% savings rate is $36,000, that equals the maximum 2015 401(k) contributions for a married couple where both work and are contributing the max. Assuming spending of $36,000 as well, and still assuming starting earning/saving at Age 30 (could certainly be earlier, so this is conservative) and working/saving for 16 years with 7% returns, I calculate that the nest egg at retirement is $1,003,970. By Age 70 (assuming both spouses are same age), the couple will have a nest egg of $3,172,014 with RMD of $115,767. That will be mean a significant amount of the RMD will be taxed at the 25% rate, and their SS will be taxed at a high marginal rate too. If they have a pension, it too will be taxed at high rate. By Age 80 the nest egg is up to $5,742,439 and RMD is now $307,082. And it just keeps getting worse. (Note, btw, that I’m not assuming contributions for 30 years, but only for 16 years, and at just 7% return).
Yes, it is a good ‘problem’ to have. But if the problem can be avoided, all the better. It needn’t lengthen their required working careers; by definition, if their retirement income is growing faster than their savings, then they saved “too much” (if trying to minimize working years). There are ways to pull the future investment earnings forward. For example, if they invested in a Roth, they could have started withdrawing principle.
And, I guess my philosophy is different than yours in that I truly want to minimize the amount of my estate that goes to Uncle Sam. (Unlike you, after I die, I’ll still be upset by him taking a large take! LOL). I don’t expect my estate to be so large that it will ruin my heir’s motivation. I’d be pleased to leave grandkids or great-grandkids enough to fund college education, start a business, etc. I also want to leave assets for charity, but we can escape taxes on that part, I think.
And on your (I think) somewhat facetious comment, I would of course rather have my account grow that drop. Paying more tax is good if it means you had more income. But, if in fact you could time things perfectly (and you can’t), it would be ideal to do 401(k)/IRA to Roth conversions at market bottoms. If the market would drop 75% now, I could get all my accounts converted. I just would need it to fully recover (and then some) shortly thereafter! LOL.
I’d appreciate your comments on where I made an error, if it was me.
We are in the accumulation phase now and trying to optimize pre-tax vs post-tax money. We put about $58000 per year in pre-tax (401k/IRA/HSA). We only aim for around 20k in after tax retirement income (so roughly 500k in retirement assets). Do the growth rates above include inflation? The tax free zone (standard deduction) and spending will grow with inflation. So, the impact of RMD would lessen if you factor in inflation. I don’t think we can count on 7% return after inflation. Typically, we assume 7% total return with 4% spending and 3% inflation. Am I missing something here?
>Do the growth rates above include inflation?
Of course. Else it would just be meaningless gibberish.
>I don’t think we can count on 7% return after inflation.
The total real (meaning inflation-adjusted) return of the SP500 since 1871 is… 7%.
Thanks for the clarification! I assumed it was less since it is common to use the 4% to estimate the portfolio size required. Also, the 10% ROI may be the overall average, but how do we know that is what any given 30 year+ timeframe will yield this result? If this is the case, then can the 4% rule be increased to 5% or 6% instead? By withdrawing a larger percentage, we could retire even sooner.
We fully utilize all ore-tax accounts and shelter around 58k per year which saves us roughly 10k taxes. We spend at or less than the standard deduction, so the plan is to be at zero % tax rate in FIRE (or very close).
One main issue we are trying to navigate for the first 5 year Roth pipeline is healthcare (will likely need some cash or post tax money to keep our MAGI low enough to qualify for cheap healthcare). Our MAGI will be higher than true spending during this time since we need to start the Roth pipeline. Thanks for the reply!
>how do we know that is what any given 30 year+ timeframe will yield this result?
You don’t. Thus 4%. 4% is the worst case for sustained withdrawals in the historical record.
See example: The Worst Retirement Ever
Also see how the 4% rule was made: What is Your Retirement Number – The 4% Rule
Not sure if this is true in all 401(k)-type plans or not, but as a government worker, even if I select the Roth TSP option, the matching funds automagically go into the Traditional TSP so that they are taxed eventually. Is this different in the private sector?
Same deal in private sector. Employer matching funds for a Roth 401(k) are taxed just like funds in a traditional IRA. It is taxable income, and subject to early withdrawal penalties as well.
Hi Ryan
I welcome the skepticism and critique. My wife tells me all the time about all of the mistakes I make, so I’m used to it hahaha
My spreadsheet is a mess, as I only made it for personal use. With that caveat, here is a copy: http://1drv.ms/1vik43H
Robert’s comment just below this one explains things very well. For funds contributed to the tax-deferred account, we pay today’s marginal rate. For funds withdrawn, we pay an average rate.
Let us know what you think after having a chance to dig into it
Thanks!
Jeremy
Good post and numbers, Jeremy!
BTW, you can still contribute to a traditional IRA even if you’re contributing to a traditional 401k. You get full deductibility with married filing jointly MAGI <98k, then partial, phasing out at 118k:
http://www.irs.gov/Retirement-Plans/2015-IRA-Deduction-Limits-Effect-of-Modified-AGI-on-Deduction-if-You-Are-Covered-by-a-Retirement-Plan-at-Work
There are a few people (I happen to be one) whose MAGI is above this but below the ROTH IRA limit for contributions of 183k, so it makes sense for me to put additional savings in a Roth IRA after maxing my traditional TSP and HSA. Roth limits here:
http://www.irs.gov/Retirement-Plans/Amount-of-Roth-IRA-Contributions-That-You-Can-Make-For-2015
Thanks Kendall!
Duly noted on the TIRA contribution deduction. I stand corrected and will make a change in the post
Agreed on the Roth IRA contribution at your income level. This is effectively #7 on the list of accounts to contribute to. If you can do it, there is no harm in contributing
Note that if you use that account to invest in stock, post retirement the brokerage account has similar tax treatment, with an effective 0% tax on Long Term Capital Gains and Qualified Dividends. The brokerage account also has the advantage of being able to harvest losses when they happen, and also allowing access to earnings (dividends) prior to Age 59.5
That said, with the $5500 limit +/-, you’ll still end up with both types of accounts
Cheers
Jeremy
That has been my thinking as well. My wife and I will be able to contribute to our respective Roth IRAs for a few more years, after which our MAGI will hit $191K and we won’t be able to contribute anymore (even taking into account as and when the limits are raised, as has been the case the past few years). Even if it means not going contributing the full amount for 401(k).
Thanks for a such a great and in-depth article!
At $191k+ MAGI, financially speaking you would benefit from maxing the 401k over contributing to a Roth
I prefer the brokerage account over Roth, but the 401k first and foremost
Actually, even when your MAGI exceeds $191K, you can still contribute to a Roth IRA via the “backdoor Roth IRA conversion”. The tax implications are really complicated, unless you have no traditional IRAs or $0 in your traditional IRAs to begin with. In that case, you pay no taxes on the converted amount as long as there is no gain. Fidelity has a calculator which helps you figure out all of this:
http://personal.fidelity.com/misc/widgets/IRA_Evaluator/IRA_EVAL.html
Yes, that is effectively #6 or #7 on the list, depending on how you do it
I am generally fine with the order of 1-5, but I would switch the order between 6 and 7. Roth IRA is still better than taxable even for an early retiree. First, taxable accounts are fully exposed in liability claims, while Roth IRA is generally (but not always) protected from creditors according to the Bankruptcy Reform Act of 2005. For early retirees who saved aggressive in working years, it is inevitable to have a large taxable account. Second, for estate planning purpose, if your heir inherits a Roth IRA, he or she has the option to receive tax free distributions over lifetime (restrictions apply). Doing so can prevent taxation of the earnings (including dividends) for many decades if not longer. If the heir inherits a taxable account, he or she will get a step-up in basis, but the dividends generated could still be taxed at 15% every year if the heir is a high income earner with a margin bracket of 25% or higher. Having taxable dividends will make MAGI unnecessarily large, which could disqualify the heir with other tax credits and deductions. Third, having a Roth IRA is good for diversification purpose. If one has tax deferred (401k), tax free (Roth) and taxable accounts at disposal, one can easily engineer the type of income mix needed in order to qualify for ACA subsidies while maintaining the same living standards, since most early retirees need to purchase health insurance over the exchange. Fourth, for FAFSA purpose, Roth IRA is not considered in the calculation, while taxable accounts are. This last one is trivial, since the kid is unlikely to be qualified for any need based financial aid when the parents are FI with lots of assets.
Thank you for the thought-provoking article!
Thanks LF
Judging from the comments, many people will agree with you :)
I don’t feel strongly one way or another if GCCjr has a higher tax bill due to an inheritance, so I haven’t studied it really at all. I’ll be dead. And I certainly wouldn’t pay taxes myself at a high marginal rate to allow our heirs to pay a lower tax. Unless the death is sudden, we’ll likely give away most of our wealth before that occurs anyway. I like Warren Buffett’s comment on this: “a very rich person should leave his kids enough to do anything but not enough to do nothing”
I’m also not particularly worried about liability claims. At least not beyond the value of perhaps a simple umbrella policy, and a 401k already provides protection in this area
I agree on the value of having an account with tax free gains and such, which is part of the reason that we are creating a Roth Conversion ladder. But I view this as a secondary benefit, a side effect of minimizing our long term taxes on withdrawals from the 401k
Thanks for the great comments. I can see others prioritizing these things differently
Cheers
Jeremy
“Traditional IRA if tax deductible (not the case if you have a 401k)”
^This requires correction. Participating in an employer-sponsored plan, like a 401k, does not automatically prevent someone from deducting their tIRA contributions. A single-filer 401k participant with a Modified AGI of $61,000 or less can deduct the full amount of their tIRA contribution. For MJF, the limit is higher. If you pass the limit, it is still possible to deduct part of your contribution, up to a point. At high income levels, the deduction benefit does go away.
see: http://www.irs.gov/Retirement-Plans/2015-IRA-Deduction-Limits-Effect-of-Modified-AGI-on-Deduction-if-You-Are-Covered-by-a-Retirement-Plan-at-Work
Thanks for the correction
You covered the most common vehicles – but what about those with SEP or SIMPLE IRAs as their workplace retirement plan? or those that dont have access to the high limits of a 401k (or equivalent 403/457)
Hi Jeff
In that case, replace Traditional IRA or 401k in the text with your tax-deductible tax-deferred plan of choice. The main focus is using the tax advantage today
Loved the post. I just had dinner with a buddy of mine 2 nights ago and we talked about early retirement strategies for 3 hours.
A couple of comments:
* The 0% tax rate on dividends + LT capital gains will persist in the future. This link shows that tax rates on investments change a lot over time.
* I think your advice that taxable brokerage trumps Roth IRA is debatable. Roth is better when you consider it a hedge to tax law uncertainty (see above bullet). Brokerage is better since you can live off of interest at any age (including early retirement), whereas with the Roth you can really only draw the interest when you’re an old man (principal is ok). Brokerage is worse due to tax law uncertainty + the dividend taxes during working years at 15%/20% depending on your income before retirement.
With Obama attacking 529 tax benefits a week ago (and apparently facing much resistance for it), I don’t think it’s unreasonable to be worried about how quickly these tax-sheltered investment vehicles can be revoked. The one thing I’m really worried about in the future is a wealth tax, which luckily nobody currently is talking about.
However, the strategy of simply living like a king below the poverty line in retirement (through frugality + outright ownership of home and elimination of mortgage, for example) is a strategy that is likely to pay off no matter what the political landscape is in 40 years. No party that I’m aware of is willing to throw “poor” people under the bus. I just don’t know when the US will wake up to the fact that living on $25k/year can be luxurious.
I agree that it would be nice to see the XLS file so we can pick it apart and add improvements. Between the readers of the blog, we can totally defeat the US tax code.
Dumb typo. Meant to say “The 0% tax rate on dividends + LT capital gains **may not** persist in the future.”
I would be surprised if the tax law didn’t change
I didn’t create the xls for general consumption, but here is a link: http://1drv.ms/1vik43H
A Roth has pros and cons. In addition to those you mentioned, in a down market you can’t harvest capital losses in the Roth
Good thought provoking discussion. Do not be so certain on the topic if you have not analyzed all angles. One important advantage of Roth 401k over traditional is it effectively expands your tax shelter. 17,500 when withdrawn from traditional 401k is taxed where as Roth is not so if you contribute 17,500 or 18K in Roth you are effectively expanding the tax bracket. The finance buff did a good article and provided a test spreadsheet and concluded that even if you get a bump down in tax rate after retirement saving in Roth 401k evens out with traditional 401k IF you can manage to max out Roth 401k.
Second I do not understand why would Roth be lower than a taxable account in any circumstance. As Roth allows you to withdraw the amount contributed without any penalty you have 16 years of your contribution that could be withdrawn before 55.
Let us create a spreadsheet and play with it.
A Roth can extend your tax footprint, but can restrict it as well
Losses in a Roth are not tax deductible, for example
Please share the article you mentioned if you get a chance, it sounds like an interesting read
Here you go
http://thefinancebuff.com/roth-401k-for-people-who-contribute-max.html
Thanks Pop
Looks like a good site, I read a few of his articles. His post on why most people should choose the Traditional 401k over a Roth 401k is a good one
The xls is analyzing the marginal dollar, basically the last dollar invested, and arguing that there is an advantage in some cases for a Roth 401k because you can tax shelter a greater amount of income
So far so good
But what about the $17,499 before that last dollar? The number used for “marginal tax rate at Retirement” should be the average rate, as some of the withdrawal will be taxed at 0%, some at 10%, and so on
Or using our example, and that of many early retirees, the marginal rate, cap gain rate, and dividend rate = 0%, which results in a 20-25% loss for the Roth
re: your question, why would a Roth be lower than a taxable account: See addendum to the post above
People often cite being able to remove principle as an advantage of a Roth, but why is everybody in a hurry to remove money from a tax-sheltered account? And why restrict yourself from having access to the earnings before Age 59.5 without a benefit? If I’m going to let the IRS tell me how and when I can use my savings, I want something in return
Roth Ira is not for everyone but most people in US can benefit from it. In our case, it is a godsend. It wasn’t for high income, I would have Roth 401k for TSP. My unique investment makes me love Roth Ira even more than others. Big tax benefits forever.
Hi Young, can you expand on your comment? What are the unique investments and how big is big?
Just wanted to mention, a Traditional IRA could still be deductible even if you have a 401K. It’s based on modified AGI.
http://www.irs.gov/Retirement-Plans/2015-IRA-Deduction-Limits-Effect-of-Modified-AGI-on-Deduction-if-You-Are-Covered-by-a-Retirement-Plan-at-Work
You also mentioned a Roth being a good idea when you’ve already maxed out your Traditional 401k and have additional funds to invest. However, the max contribution amount ($18K for 2015) applies to all accounts. So if you’ve maxed out your regular 401K, you cannot contribute more to a Roth 401K.
http://www.irs.gov/Retirement-Plans/How-Much-Salary-Can-You-Defer-if-You%E2%80%99re-Eligible-for-More-than-One-Retirement-Plan
Thanks Dave
Sorry, I was referring to contributing to a Roth IRA after contributing the max to the 401k.
Good point on the Traditional IRA still being deductible below the MAGI threshold. I’ll modify the post to reflect that
Cheers
Jeremy
Dave, there may be exceptions depending on where you work. At my place of employment, I can fully fund the traditional 401k along with catchup funds totaling $24K AND up to $10K in a Roth 401k company sponsored 401k program. I called my benefits dept. specifically to confirm this question.
You can do this while at the same time funding a personal Roth IRA account $6500.00 if your 50+ years of age.
Want to add one more thing…To Jeremy’s point, I agree, would prefer the pretax traditional IRA but cannot because income is to high for a single person and the traditional IRA. My only option is the Roth IRA with additional after tax dollars. :(
Hi Bob, the catch-up contributions you’re eligible for is due to your age, not your companies specific plan. Every company plan is subject to government/IRS regulations. They may limit or restrict catch-up contributions, but they can’t allow you to go over the maximums established by the government regulations.
Here is what the IRS says (notice it states “pre-tax AND Roth”):
===
The amount you can defer (including pre-tax and Roth contributions) to all your plans (not including 457(b) plans) is $17,500 in 2014 and $18,000 in 2015. Although a plan’s terms may place lower limits on contributions, the total amount allowed under the tax law doesn’t depend on how many plans you belong to or who sponsors those plans.
If you are age 50 or older by the end of the year, your individual limit is increased by $5,500 in 2014 and $6,000 in 2015 (the catch-up contribution amount). This means your individual limit increases from $17,500 to $23,000 in 2014 and from $18,000 to $24,000 in 2015 even if neither plan allows age-50 catch-up contributions (IRC Section 414(v) and Treas. Regs. 1.402(g)-2).
===
So I’d have to say the benefits person you talked to is wrong about you being able to contribute an additional $10K to a Roth 401K if you’ve already maxed out your traditional 401K.
I’ve talked to my benefits dept several times, and they are generally clueless about the actual regulations. All they can do is read the benefits documentation and interpret what it means. This stuff confuses the heck out of most people.
Almost forgot… Your statement, “You can do this while at the same time funding a personal Roth IRA account $6500.00 if your 50+ years of age” isn’t exactly correct…
True, you can contribute to a Roth IRA even if you participate in an employee-sponsored retirement plan.BUT, eligibility is based on income (modified AGI).
Here’s the official IRS page for this year:
http://www.irs.gov/Retirement-Plans/Amount-of-Roth-IRA-Contributions-That-You-Can-Make-For-2015
If you make really good money, you might not be able to contribute anything to a Roth IRA.
Dave. Thanks for the input. I will do some more digging about the work 401k and Roth 401k. On the personal Roth, yes I can have one.
I make too much for the tIRA but come in just under the salary cap upper limit for the Roth. I’m single (due to end this year) and 57 years old.
My money is in funds that pay a high dividend. These dividends are not a qualified long term dividends unlike the ones from stocks. the yield will be taxed as income in taxable account. 9 out of 14 funds that I own pay a special dividend. Year over year, an average annual rate(9.20%) + a fat special dividend = nothing but paying high taxes, unless I have these in Roth.
1) if a family of 4 has $54,000 in income I doubt they pay any federal income tax above social security.
In which case deductions for retirement contributions are worthless and a Roth IRA is desirable.
I also doubt that a family for four making $54,000 and saving $17,500 could live on $36,500 since as a single person I spend about $30,000 / year with only about $3,600 going to housing since house is paid for, I heat with wood I cut, and my electric is from off grid solar.
I forgot to add that I believe you should
1) contribute to 401k up to match.
2) Then max out a ROTH IRA. If a 401k Roth is available maxing that out is ok also.
3) Then contribute to a taxable account.
4) I would NEVER contribute above the match to a regular 401k.
You can spend down a taxable account tax free up to about 40,000 ( single) to 80,000 ( married) in GAINS before withdrawing from 401k / traditional IRA and then Roth.
You are welcome to use our income tax calculator to ease your doubts.
I forget to tell you what investments I have and how big that you asked. I will just give you a few examples. I own PDI 1200 shares, as of now pays 7.56% annual div. and $1.8362 paid in 2014 as a special div. PKO 800 shares, as of now pays 9.24% annual div. + $1.5939 paid in 2014 as a special div. PTY 1518 shares, as of now pays 9.28% annual div + $0.6498 special div. JRI 232 shares, now pays 8.06% annual rate + $1.1791 paid as special. DMO 1428/SH, as now 7.81% annual rate + $1.2161 special paid in 2014. I made a little over $7000 as a special dividend alone last year. JRI is in my Roth, I just didn’t have money to buy more shares, I could buy more in taxable account but I didn’t. 1/3 of our Roth is in CDs that are ready to be matured soon. I enjoyed having our Roth in CDs that paid over 5% annual rate for 7 years through all those tumultuous years of 2008,2009. As time goes by, Roth is going to be bigger but investments in taxable will be smaller. special dividend for 2015 will doubled of 2014, if it is not more. I invest most of our money in CEF(closed end fund) that are invested in long term bonds only and pay dividend monthly. I hope that I answered your questions.
Definitely holding these kind of funds in a tax advantaged account is the way to go.
Jeremy, thanks for another excellent article! I second the cheers for the increased posting volume — keep churning them out!
One question: In your ranking, why are after-tax 401k contributions for Backdoor Roth (#5) and direct Roth contributions (#7) ranked differently? These two are functionally equivalent, so on what basis did you draw a distinction between them as far as priority over taxable brokerage investing?
One possible answer is that with after-tax 401k investing, you can let the earnings grow (tax-deferred) inside the 401k for the duration of your working career and then, upon retirement, split them off into a traditional IRA to become part of your Roth conversion ladder. But I wasn’t sure if this is necessarily what you were getting at…
Thank Brooklynguy!
I suppose part of the answer is because I thought I was going to get enough flack for putting the Roth at #7 :)
My initial thinking was that the limit on after-tax contributions to the 401k is much larger than for a regular Roth contribution, but all of the comments made me think about this a lot more and now I think I’m more inclined to moving backdoor roth to #6.
Yeah, I think you either have to bump up “brokerage” one spot or give in to the flack and push it down one spot, because there’s no principled distinction between # 5 and #7 — it doesn’t matter whether you take the “front door” or the “back door”, both options take you to the same place (unless, as I described above, you hold off on using the back door in the after-tax 401k option–i.e., you don’t take in-service distributions–for the duration of your working career, which allows you to fold the earnings into the Roth conversion ladder instead of keeping them locked inside the Roth account).
Also, on the Roth’s benefit that others have raised of protection against future changes in the tax laws: just to be clear (and to put it in the same terms you used to describe your preference for Roth over Traditional during the working years), in exchange for the benefit of guaranteed penalty-free early access to the funds, you are choosing to “maybe pay taxes later” instead of “definitely not paying taxes later” (because the Roth insulates you against changes in tax laws that have the effect of defeating the purpose of all your careful tax planning, such as elimination of the 0% rate for LTC gains + dividends and/or the other features of current law that promote leisure over labor).
I agree, and have made a change to the order, putting the back door Roth at the bottom
re: tax law, I think there is only one thing we can be certain of, and that is that future tax law will be different from present tax law
We could certainly make assumptions about what changes are likely. I think it fair to assume that taxes on “the wealthy” will increase. This could include increases in taxes on dividends and capital gains. But it could also include taxes on “too much” in tax-deferred accounts, including a Roth
I would also assume that there will be efforts to not increase taxes on the middle class, so taxes on dividends and capital gains for those who Live Well for Less, as we do, is less likely than for the 1%
But anything is possible. Taxes today are at historical lows, and deficits and debt load continue to increase. The government will need to get funds from somewhere
Excellent points, thanks brooklynguy!
Although I would never call anything impossible, I think the possibility that a future version of Congress will cause the government to effectively renege on its obligation to hold up its end of the deal being entered into with today’s Roth account-holders and retroactively deny them the core benefit of the bargain is *far* more remote than the possibility of the realization of any of the myriad potential changes in tax law that would have the effect of rendering taxable accounts the suboptimal alternative.
One additional consideration that I don’t think has been raised so far is that for people who live (and plan to stay) in a state with income taxes (especially high income taxes) that does not provide the same favorable 0% tax treatment for low income brackets as the current federal scheme (like my home state of New York), the state (and, in my case, local city) tax benefits of Roth investing may also tip the scales in favor of Roth accounts even assuming no changes in tax law.
Finally, now that you’ve moved Roth investing to the bottom of your hierarchy, it may make more sense to simply remove Roths from the list altogether and add a note at the bottom that the rule of thumb rankings recommend no Roth investing at all (that’s essentially what they’re doing now, since there is no limit on the amount of taxable investing a person can do and nos. 6 & 7 will therefore never be reached).
Thanks for the excellent discussion! You’re giving the Mad Fientist a run for his money as the most tax-savvy FI blogger out there.
Wow, that compliment is a big one, MF is a very intelligent guy and I really like his blog. Thanks Brooklynguy!
I agree an outright elimination of the contract is unlikely, but means testing on SS could have the same effect for example. Recent conversations around eliminating the Roth backdoor are underway, it wouldn’t surprise me if more were to follow.
I agree, State taxes need to be considered. I found moving to WA to be much preferred over my home state of MN, but I guess some people like snow (and high taxes) and somehow continue to live there quite happily
Can you explain where the 385k numbers came from?
With no other income, if a Married Couple Filing Jointly were to withdraw $385k from a 401k, they would pay an average tax of 25% on that withdrawal
This comes from the tax table. The first ~$20k is taxed at 0%, due to standard deduction. The next ~$20k is taxed at 10%, the next $50k at 15%,and so on. Some of the funds are taxed at the 33% rate, but the average comes to 25%
I’m new to this blog so forgive me if you (likely) already address this, but how is the first $20k per person 0% taxed? The standard deduction is much less than $20k. What am I missing?
Hi Susie. It wasn’t stated as $20k per person, but as $20k for a married couple filing jointly. Standard deduction in 2014 was $12,400 + 2 personal exemptions of $3,950 each for a total of $20,300
Saving within a concessionally taxed environment should always be preferred. We have a similar approach here in Australia, where superannuation contributions are generally only taxed at 15%, compared to up to 46.5% for income tax.
Definitely an incentive to contribute!
Great article, Jeremy. It definitely made me rethink my strategy of stuffing my Roth IRA with as much of my investable dollars as possible (through mega-backdoor as well as backdoor contributions).
One question for you… Even if in early retirement, I plan to be in the 15% tax bracket and not pay taxes on capital gains, while I’m working (which I will be for the next 10 years), I’m in the 28% tax bracket. Doesn’t keeping my money in my Roth prevent me from paying taxes on the dividends? If I were to put these funds in my taxable accounts, I would owe lots of taxes now. Also, rebalancing can be difficult in a taxable account, since it can trigger capital gains taxes, but no so in a Roth. Though I definitely hear your argument for tax loss harvesting, unfortunately(thankfully?) there hasn’t been much of an opportunity to do so lately.
Maybe I’m missing something? Thanks again for the great article! Really love all your posts on taxes as well as the MF’s. You guys are the best.
Thanks Emanonrog
Everything you said is true. You will owe tax on dividends and if you re-balance by selling, you will also owe tax on the gains. Also if you choose to own bonds or investments that pay non-qualified dividends, those will be taxed at your marginal rate in a brokerage account and 0% in a Roth
Maybe we can compare with some numbers
If you are at the 28% marginal tax rate, and can’t lower it any further then any qualified dividends or long term capital gains will be taxed at 15%.
Assume you purchase VTI/VTSAX as your investment vehicle, and it pays a dividend of 2%. A 15% tax on that 2% would equate to a load on the fund of about 0.3%. If you have $100k invested, this would be about $300/yr or about $25/month. Don’t forget to include State tax
It is more than $0, but $300 probably isn’t going to derail your early retirement plans. Many Mutual Funds have larger expense ratios. It is a tradeoff
For Capital Gains, since you are continuing to save a large percentage of income, you could fix your asset allocation by using new funds to purchase the asset that is currently below your allocation target instead of selling an accumulated asset
I agree, there haven’t been a lot of opportunities to harvest capital losses recently. For somebody saving aggressively this is probably negative, as the best thing that could happen to accelerate your early retirement is a major market correction
https://gocurrycracker.com/reminiscing-about-the-glory-days-of-2008/
Thank you very much for reading and your very kind comment. It is hearing things like this that inspires me to keep writing, I appreciate it
All the best
Jeremy
On tax loss harvesting (TLH), don’t forget that TLH only really benefits you during the accumulation phase. Once you’re in retirement, continuing with the assumptions that you are “living well for less” and tax law remains as is, TLH won’t save you any money because you’re not going to have any tax liability anyway (TLH can help you manipulate your income and allow you to withdraw more of your funds tax-free and/or accelerate your Roth conversions in the Roth conversion ladder, but it won’t actually save you dollars the way it will during the working years).
Agreed. My primary motivator is for TLH to help us in the race against the RMD. While it won’t save us any $ in the year of the loss, it may save us $ from Age 70.5 and beyond due to accelerated Roth conversions
Thanks for your quick reply!
You make a great point on rebalancing through new contributions. I’ve always set my contributions equal to my target asset allocation, and rebalanced at the end of the year. But since I’m early in the accumulation phase, my contributions are large relative to my portfolio and I could easily maintain my target AA through new contributions.
Here’s hoping for a repeat of ’08!
Happy travels.
Jeremy,
I can’t thank you enough for your blog. I just wish I had the information you and
your commenters present when I was your age. You are definitely wise beyond
your years. I wish I knew how to get your blog in front of every 30 something I
know and all the ones I don’t. Your two cents is worth millions!
This kind of discussion should take place in the financial press, which is, for the
most part, devoid of useful information.
Wow, thanks Warren! I really appreciate your very kind comment
I wouldn’t mind if you tried to share GCC with everybody via reddit, twitter, etc… :)
I think the best part of this post and several others is the conversation that happens in the comments. It’s a constant learning process
Now stay tuned for a nice guest post from Jim Cramer! lol
Hi!
Thanks for this post! I’ve also read through the comments, but still have two unanswered questions I was hoping you might be able to clarify. First, is there a limit on the IRA conversion from 401k? Can you rollover any amount you like per year? Second, does your employment status impact this at all? After FI, I may still do some freelance work for the current employer. I wasn’t sure if you are required to leave employment in order to do a 401k rollover?
Typically you would rollover the entire 401k to a Traditional IRA, there is no limit. I’ve seen some cases with a TSP (Federal employee 401k account) where they do a partial rollover, but can’t think of any real advantage of doing the same with an employer. It is best to have your employer transfer the funds directly to the IRA Custodian and never touch the funds yourself
Once you terminate employment, you are free to do a rollover. Doing freelance work after the fact you are likely a 1099 employee, i.e. a self employed contractor (I presume.) But yes, you must terminate employment to do a 401k rollover
Thoughtful post for sure. I’ve been struggling lately with most efficient way to reach FIRE. I keep going back and forth on whether I should devote my savings (above 401k max and HSA max) to taxable or Roth accounts.
Being 39 and having only ~ 20k in taxable investments currently, I’m really going to need to crank up the taxable account contributions in order to reach early retirement between 50-55 years old. Question is whether I do that at the expense of Roth accounts. I will need access to the funds to bridge the gap between retirement date and age 59.5.
I’ve also been thinking that perhaps I don’t need to be maxing out my 401(k) for too much longer. While I only have 20k in taxable accounts, I have ~ 8x that amount in a mix of 401(k), IRA and Roth accounts.
I am in the 25/28% tax bracket now and plan on beginning the Roth conversions as soon as I retire. By the time I’m old enough for RMD’s, I either want all of my balances already converted to Roth or to have the balances so small that the impact is minimal.
I currently have the ability to save ~ 70% of my take home pay, adding back 401(k) deposits. Now is the time to make hay, as they say! But, I’ve just not decided where to park those funds!
Thanks GG. Great name!
There is a middle ground, perhaps. Since you are saving 70% of income, you can likely contribute full amount to 401k, HSA, Roth, and still end up with a lot of funds in a taxable account.
Since the gap between your target retirement age and Age 59.5 is relatively short, you could consider doing an SEPP to access your 401k funds without penalty.
As discussed here I would recommend continuing to fund 401k and HSA to reduce tax paid at 28%. Basically, take the tax deduction now
Just a couple quick question regarding SEPP and FI since I have never heard of a Roth Conversion Ladder used at the same time. If I was to set up a SEPP would that prevent me from pulling money out of my 401k and into the Roth without increasing my tax liability? I am currently 35 and just started my journey to FIRE. I plan on having $600k in 401k, $55k in Roth IRA, and $125k in Vanguard to help float me the 5 years for the ladder once I hit FI in 9 years. Unfortunately my income is too high for a traditional IRA and my company doesn’t allow for after tax contributions or in-service disbursements. So if I am correct in your explanation, Getting that $55k into the Roth won’t really help me in any way in starting my conversion ladder at FI?
This article is fantastic and I click on your website multiple times a day hoping for another one of your adventures. You both are an inspiration.
Warmest Regards
Thank you kindly, Thor! It always brightens our day knowing that people benefit from reading GCC
Money withdrawn from a tax-deferred account is taxable no matter how it is done. So if you were to setup a SEPP you probably wouldn’t want to do a Roth Conversion as well. They are just 2 different strategies for accessing tax-deferred accounts before Age 59.5, each with their own pros/cons
In your situation, you can do the conversion ladder whether you have another Roth or not. We had no Roth when we retired, and only created one for our ladder
The question is would you want to have access to the earnings on that $55k or not? The tradeoff is paying tax on any dividends during the next 9 years
If you have $55k invested in VTI / VTSAX at a 2% dividend, and pay 15% tax on those dividends, you would have a tax load of $165/year in the brokerage account and $0 in the Roth (plus any state tax)
But then after you stop working, you can use the $1100/year in dividends federal tax free if in the brokerage, but can only withdraw contributions from the Roth
Awesome! Thanks for the response! I find this all incredibly eye opening. I would gladly pay $165 a year in extra tax to have access to those additional funds once I retire at 45. It looks like you have successfully won your case with me as I will be opening a Vanguard traditional IRA and a taxable account this week. Wishing you all the best and congratulations on the baby.
“Since Mr and Mrs 90% didn’t sell any of their stock they generated no capital gains.”
Executing a basic fixed-asset allocation investment strategy requires regularly selling stock. At the income levels of Mr. and Mrs. 90%, wouldn’t this mean they pay some capital gains?
Hi Caleb, I would rephrase
Executing a fixed-asset allocation investment strategy SOMETIMES requires selling stock
Depending on how much your asset allocation is out of whack, and the overall size of your assets, it is often possible to adjust the allocation just by using new funds to buy the down asset
An overly simplified example:
Target allocation is 50% stock / 50% bonds. On Jan 1 you have $100k total, and at year end Stock is up 10% and Bonds are down 10%.
You’ve saved $10k during the year and want to adjust allocation, so you buy $10k worth of bonds and you are now back at a 50/50 split.
Alternatively, Mr & Mrs 90% could adjust allocation in the tax-deferred accounts, bringing total assets back into alignment with the target allocation while leaving the assets in the taxable account untouched
If the situation is more complicated than that, then any long term capital gains would be taxed at 15% and short term capital gains at the marginal rate
Lots of discussion around this topic for sure!
I have recently come to agree with this process and have moved the Roth IRA down my list. I have not moved it below the taxable account yet, but am now considering it. I need to go read the MF articles again and then reread this one to digest it all. I appreciate the analysis and making me have to think more about it. This is a good example of why no one has ever said early retirement is easy!
Indeed, it is complicated. The discussion has really helped my own understanding
I wouldn’t be offended if you kept Roth above Brokerage on your list :)
FYI, the POTUS is looking to slam the back door closed
http://blogs.wsj.com/totalreturn/2015/02/02/obama-would-block-strategies-to-pump-up-roth-iras/
I love these articles! So fascinating the way you can reduce taxes. Quick question for you. If you are a single filer, doesn’t it get a bit more dicey when you are a high income earner? I’m 23 and made around $60k last year. When I take off the 401k deduction and HSA, and traditional IRA I am currently below the threshold for the 15% (so I wouldn’t have to pay any capital gains or dividend taxes). In two years, I will likely be making around $130k and will still be filing single. I could contribute to a roth IRA still after taking off the HSA and 401k but obviously won’t be able to deduct a traditional IRA contribution. Since I won’t be selling anything, and I use itot (ishares total market), I will only be taxed 15% on dividends (at 1.78% yield, even $500k in investments would only cost about $1335 in taxes). Would you still put brokerage above roth for high income earners? Would it only be beneficial if the high income earner planned to retire early?
I did a quick back of the envelope calculation for this even for 25 years working and maxing a roth IRA vs putting that money into a brokerage account. Without any harvesting and compounding at 7% per year, you end up at the end with $17k more in the roth IRA (putting in $5500 per year). At the end of that though, if I retired at 50, I’d have about $7k per year in dividends from the brokerage account and I could only use the contributions from the roth. If you harvest losses and are able to harvest $2000 per year on average after say the 5th year (completely made up and to give you time to take advantage of market crashes), At a 25% tax bracket, you would actually be ahead with the brokerage account by $10k. Very interesting
Good analysis Nate.
Another option to consider would be investing in something broad market that doesn’t pay dividends. Berkshire Hathaway comes to mind (that is where I had a big portion of our brokerage account during our working years)
Or Vanguard has Tax Managed funds (one example is VTCLX.) It compares favorably to VTI / VTSAX with lower yield (but also higher fees.) With dividend yield as low as it is these days, I would personally just stick with VTI
Robo-funds are also gaining popularity, which do auto tax loss harvesting for you (for a fee.) Betterment is one example. If the robots can match the performance of an index fund, and the tax loss makes up for the fees and then some, it might be a good option
Wow. Great post! It’s beyond my intellect on the first read but I’ll reread the post and the comments in the near future.
My question is this: My returns on my 457(b) plans never seem to match the returns on the self-managed Vanguard Roth account even though I try to keep everything at a 75/25 stock/bond split. This is annoying, which is one more reason I like my Roth more than my 457 account. Does anyone else have this experience with returns? What would happen in the model if level rates of return were not assumed?
I have to assume that the funds in your 457b have a higher expense ratio than the funds you select yourself? If you had the exact same funds in a 457b, a Roth, a Traditional IRA, or even a brokerage account the return should be exactly the same
Jim Collins has a good post, Should You Avoid Your Company’s 401k? Some companies have really crappy fund options, but even then the tax advantages make it a better choice than not contributing, especially if there is a company match.
You might also check out the Personal Capital 401k Fee Analyzer to see how your 457b compares
Jeremy,
Very interesting post. I’ve come to expect excellent posts from you, but this one is really going to make me think about the Traditional IRA vs. Roth vs. Taxable. Thanks for all the work you put into this site!
Now, I’m somewhat nitpicking here, but assuming there are a number of readers out there who aren’t as financially savvy, I think it’s important to remain consistent mathematically when making comparisons. In your addendum regarding Roth vs. Taxable, you come up with a $294k figure, and I think it’s deceiving.
Correct me if I’m wrong, but the $294k would require you to continue to contribute $5500 each year. While this may be realistic for some in early retirement based on outside sources of income, I think it’s unrealistic for others to keep contributing this amount (especially to a taxable). I realize you said “assuming the same growth”, but I think most would take that to mean a continuing 7% growth only.
Additionally, you discount the $72k in the Roth because of inflation, but I think it’s also necessary to do that for the $294k since you’re actively comparing the two options. Based on my calculations (with 3% inflation), that would put you in the ballpark of $219k in 2015 buying power. And if you take it a step further to make it more realistic, you wouldn’t use the $5500 yearly contributions for years 13-23. At that point, discounted for inflation, you’d have about $161k in 2015 buying power.
So ultimately, the conclusions are the same (161k > 53k, taxable account provides greater access to resources before 59.5), but it’s not as much of a slam dunk mathematically. I think it’s a bit misleading for less experienced readers.
Good catch. I didn’t triple check my math in the addendum
I updated the $ number to reflect that Roth contributions don’t continue in ER and also changed the phrasing around the inflation adjusted value of the Roth contributions to better emphasize the point I was making: Contributions lose purchasing power to inflation, and therefore having access to the earnings is more valuable
Thanks for the correction EyeTowardsFI!
Jeremy or readers, ideas please… I have a 403b with limited options, no employer match or contributions. I will be eligible for a pension. Invest in 403b? Invest in Roth? Invest in ETF or other investments not within a structured plan? Thank you all, would love to hear ideas and opinions!
Hi LM
Read through all of Jim Collin’s stock series. It will help you understand what to do, and more importantly why
Cheers
Jeremy
Jeremy,
I max out my 401k, but still have extra $ to invest. My mortgage rate is adjustable due to a past blemish and can’t be refinanced anytime soon. With rates so low it’s been no problem, but it’s very likely that rates will be going up soon…the unknown is how high will they go and how fast….so what would you do with the extra $ to invest? pay down the mortgage or put in a taxable account?
I’m leaning towards the mortgage just because there is no guarantee what the market will do in the short term and if it happens to be down then not only will my mortgage payments be higher (assuming interest rates go up and having not paid down any mortgage), but I could also need the $ from the taxable account to assist with the new monthly payment.
I know it’s unlikely that the interest rate jumps from 3.25% to 8% or 9% in a couple years, but it is possible. I also know that it’s been quite a good run in the market the last 5 years or so and that we are due for a correction…not trying to time the market, but to me it seems possible that the market will be down for the next 5 years. Historically if you look at any 5 year stretch there is about a 25% chance it will be down over any 5 years stretch…but then there are possible advantages about it being down such as tax loss harvesting. There probably isn’t a right answer as no one knows what the interest rates and stock market is going to do, but statistically is there a better option??
we end up in the 15% tax bracket after deductions/exemptions if that helps.
what would you recommend??
thanks,
Brian
Hi Brian
A good rule of thumb is if you need money in the next 5 years those funds should not go in the stock market, which sounds like it may apply to you?
Jeremy,
Thanks for the response! I think you are right, but I have heard more than a few people advise me to put it into a taxable account and then if I need the $ to use the taxable account, but that short time frame made me nervous…going to keep doing what I’m doing…I don’t have many in my inner circle that I can bounce ideas off of so I do appreciate the feedback…and seriously you have a fantastic blog!
You probably hear this often, but in my opinion your “Never Pay Taxes Again” is the single best blog article out there…and there are some good ones out there from MMM, JlCollins (the stock series is pretty freaking good too), MadFientist, Doneby40, ERE, etc.
Anyways thanks again and I hope you’re still blogging in a few years once I’m FI…buy you a beer with my tax free retirement $. : )
Brian
Wow, thanks Brian. I really respect all of those guys so it means a lot for you to say that
Good luck man
Thank you for helping us all to think through the options available to us. I had no idea about any of this before I stumbled across some of FI blogs (you, Jim Collins, MF). It has literally changed my life and put me on a path I never thought possible but always wanted. Thank you, thank you!
I’m contributing to a work sponsored pre-tax 403b, but I was putting my $5500 contribution to my Roth so I just went and changed it to Traditional (since I would still benefit based on my MAGI). My question – I have only been doing the Roth contribution for the last 2ish years. Would you recommend that I take the initial contribution and move it to a brokerage account and just leave the little bit of earnings in the Roth? I would think I could still benefit from the flexibility you mention in the article by moving it now. Does that make sense?
Hi TravelForLife
Once you have funds in a Roth, I would recommend never taking them out. That income will never be taxed again, so let it grow
If you get a tax deduction for the Traditional IRA now, then I would take it and invest the tax savings as well.
Make sense?
Yes, it does – that’s what I will do! Then if I understand your post correctly – if at some point the Traditional IRA no longer brings a tax deduction, then I contribute that money to a brokerage account instead.
That is what I did, and don’t regret it
As you can see from the comments, some really smart people disagree. If at some point the Traditional IRA is not tax deductible, it is because your income is high. In which case, you are probably able to contribute to a Roth AND put money in the brokerage account.
I read your post and the comments but I’m landing with you on this one. It doesn’t seem that the difference is significant enough, and I’d rather have the flexibility of money in a brokerage account.
I’m going to be at Chautauqua during your week and really looking forward to it! Thanks for all your hard work on these articles and commenting to help all of us.
Cool! We can get it all sorted then
The Chautauqua is going to be great!
First off, I’m new to your site and I wanna say great job. So i’m 35 right now and just paid off all my debts but don’t have any money saved in retirement accounts. I have a pension that will be variable depending on if i stay at my job or not (as I am considering doing other things) as it stand right now if i quit today i’ll prob get about 12,000 a year from my pension and about 12,000 from social security bringing my non capital gains income to about 24,000 in retirement. If I quit 5 years from now it would be closer to 27,000. considering I need to stay below around 37,450 to get a capital gains of 0% does it make sense for me to just use roth IRA (unlike what you are taking about vs using the regular IRA or just a brokerage account (should i be worried I can’t get enough income from the IRA without starting to get taxed.. Also, if I stay until age 55 I’d be looking at an income of way over the 37,450 (more like 65K with social security and pension) so a roth would make real sense in that case. Please advise if possible. Thanks.
Hi Aaron
If your income today is such that you will be taxed at the 15% or higher marginal rate, you would most likely benefit more from contributing to a Traditional IRA over a Roth (See this post: https://gocurrycracker.com/turbocharge-savings/)
Assuming no change in tax law, the edge of the 15% tax bracket (the $37,450 number) will increase with inflation over the next 30 years, so when looking at retirement age be sure to adjust upwards
Does that help?
Cheers
Jeremy
Hey, thanks for taking the time to respond. Just wanted to clarify what you are saying.
(1) 35,000 income at age 35 now you would suggest to maximize 401(k) or traditional IRA and then brokerage if I was to work until age 55? I have health insurance through work and pension plan that is very generous. I’m looking at 65% of final rate of earnings with pension, but I’ll only average about 2.5% raise the next 20 years. If i was to stay at work I have the option of putting 10% of my income every year after tax into something that pays 7.5% interest which is also a possibility if I stay until retirement.
(2) 35,000 income at age 35 with the idea of leaving my job in the next 5 at age 40 years to work for a company I create (in the future i’d get 35% of my Final rate of earnings at age 55) and social security at age 62+. Would you still suggest to use a 401k or traditional IRA for the next 5 years and then when I have my own company I should form my own solo 401k and then possibly use a HSA if I can?
If I get you right, then in scenario 1 would i start to convert my IRA to a roth ira from age 55 on?
If I was to use scenario 2 when would be the time to convert to roth? would that be when I’m truly not making any money from the company I’d create?
I’d like to say thanks for taking the time to answer my question the first time around and that your site has really allowed me to make great sense of how to guide myself to a decent future.
Hi Aaron
You convert to Roth whenever you have no earned income, whenever that is.
$35k income is still fairly low, and you might get to 0% marginal rate with deductions, at which point a Roth IRA is the way to go (0% tax going in, tax free forever)
thanks again. I’m always better with standard deduction (no house, kids or spouse) and exemption so i’d never be under 25k income which means i’m still paying 10-15% tax on around 23-25k ATM. IF you make a post on how single people can get down to 0% marginal rate I am all ears.
Jeremy, what if you qualify for the credit on Form 8880? (Credit for Qualified Retirement Savings Contributions)
Does that make it worth it to use a Roth if your AGI is below $19.5K single / $39K married? It means $200 to $1,000 off your tax bill.
Jeremy,
Just found your site. Thanks for the excellent article about investing for retirement. You bring up a really good point about the traditional IRAs being taxed as the first dollar upon withdrawal. I can definitely see the benefits of investing first in 401k’s followed by traditional IRAs. However, for people at an income level at which traditional IRAs are no longer tax-deductible, wouldn’t it make more sense to do a back-door Roth conversion (after maxing out the 401k, of course)? If you’re not going to get the tax deduction up front AND have to pay taxes upon withdrawal, why not at least do the conversion so that you don’t pay taxes upon withdrawal? I wrote about this on my site here in more detail.
Also, as you can only withdraw contributions from a Roth prior to retirement age, why wouldn’t you be able to withdrawn those as dividends up to the level of the contribution. I call this dividend harvesting. This way you wouldn’t actually touch the underlying capital, rather just the dividends that the account generates. Or are the contributions somehow earmarked as contributions and it has to be those exact dollars that are withdrawn?
Thanks! Keep up the good blog writing!
Hi Scott, welcome
I don’t think it makes more sense to do a backdoor Roth (*)
#4 on the list of order of investment is Traditional IRA if tax deductible (subject to MAGI thresholds.) If not tax deductible, skip it and keep going down the list. #6 is a Roth (which is equivalent to a Backdoor Roth)
See addendum for why
Once you have a Roth, you could certainly withdraw an amount equivalent to the dividend income, at least up until the contribution amount. Dollars are fungible, and $1 withdrawn from an account is still $1, no matter the source. But I would only do this if the brokerage account was empty. Better to let everything in the Roth continue to grow tax free
* Caveats
If you live in a State that taxes dividends, receive benefits that are based on MAGI (such as ACA subsidies), have an effective tax rate of close to 0%, or are planning to retire around Age 59.5 or later, or you strongly believe that the 0% rate on dividends and long term capital gains is going away, then a Roth is a great idea
* Another Caveat
We are really only talking about $5500/yr/person. In the grand scheme of an early retirement portfolio, it is a small amount. If after reading this post anybody thinks a Roth is better than a Brokerage account, I wouldn’t argue. If this post made you think, mission accomplished
Thanks Scott, great comment
Jeremy
It really is “marginal vs. marginal,” not “marginal vs. overall.”
In other words, the answer to “Using constant 2014 dollars, how much would this family need to withdraw from the retirement account before paying the same tax rate of 13.2%?” is $38,450. At that amount (assuming standard deduction and 2 exemptions) they are paying 15% on every dollar they withdraw, the same rate they saved on every dollar they contributed.
For further example, take a single person in the 15% marginal bracket who can contribute at the end of each year $12K/yr to a 401k or $10.2K/yr to a Roth 401k. After 6 years at 5% annual growth the traditional account would have $81,623 or the Roth would have $69,380.
If he stops contributing at that time*, after 5 more (total of 11) years the account balances would be $104,174 or $88,548 respectively.
Now assume he withdraws everything over a period of 5 years, taking 20% the first year, 25% the second, then 33%, 50%, and 100% in years 3-5. Withdrawals come at the beginning of the year, the balance continues to earn 5% annually, and taxes are paid using $6300 std. deduction and $4K exemption.
E.g., in the first withdrawal year, $20,835 would come from the traditional and $1,119 would go to taxes (note: 15% marginal bracket) for a net of $19,716. The Roth account would provide $17,710 – so traditional is better than Roth in that year, and in all subsequent. Over the 5 years of withdrawals, traditional provides $10,031 more than Roth.
*However (and this is the nut of the argument), what if he had continued to contribute in years 7-11? That would be an extra $60K to traditional or $51K to Roth. In that case, the total withdrawals from traditional would be…the same $10,031 more than Roth.
In other words, once the taxable income was in the same (in this case, 15%) marginal bracket as the deductions, the choice of traditional vs. Roth is immaterial.
As others have noted, Roth becomes preferable even at equal marginal brackets if one can contribute the maximum allowed.
At least – that’s what my spreadsheet calculations showed….
Hi MDM
In your spreadsheet, when comparing the case of max Roth vs max Traditional, what is done with the dollars saved in taxes in the latter case? Are they spent or invested in a brokerage account?
The only reason a Traditional should be superior to a Roth for less than max but inferior at the max, is if the tax savings are wasted/spent
re: “Using constant 2014 dollars, how much would this family need to withdraw from the retirement account before paying the same tax rate of 13.2%?”
There are two ways to look at this. One is the way you are looking at it, where you state that the point of equivalency is $38,450, due to the associative property of multiplication. 15% tax savings going into a TIRA is the same as 15% tax paid coming out.
This is 100% true. But by focusing on this marginal rate threshold, it misses the big picture of minimizing total taxes paid
The other way to look at it is the Last Dollar Principle
It really makes no difference to me if I pay tax at 15% or 25% or 33%, as long as my total tax bill is lower in absolute terms. Mr & Mrs Median would pay a tax rate of 13.2% on their 401k contribution of $17,500. If they withdrew less than $113k, they pay less than 13.2%. That is a win
By the same math, withdrawing $38,450 + $1 would result in a tax rate of 2-3%, significantly less than the rate that would have been paid on the contribution, even though $1 would be taxed at 15%
If interested, the spreadsheet is available at https://drive.google.com/file/d/0Bxe0EgraZFRBREQzVEIzRHFkZzA/view?usp=sharing.
Inputs go in shaded cells. Other cells are calculated.
It can be configured to reproduce the discussion above, but is saved with somewhat different inputs – specifically, a single year’s investment followed by 10 years of investment growth, then withdrawal over 5 years while investment returns continue.
By starting at 0% and increasing the investment return, one can watch the advantage of traditional over Roth (cell O24) increase, then hit a maximum, then decrease until at very high investment returns Roth is better.
Col. L shows the marginal bracket for each withdrawal year, and col. M has the overall rate. The traditional advantage starts to flatten when one withdrawal year hits a 25% marginal rate (same as the assumed rate in the contribution year), and hits the maximum when all withdrawal years have a 25% marginal rate.
The advantage of traditional over Roth starts to decrease when one withdrawal year hits a 28% marginal rate (note that all overall rates are still less than 25%), and drops to zero when the overall rate for taxes on all withdrawals is 25%.
Note that this in no way suggests that huge investment returns are likely. The same result (comparing traditional to Roth as the withdrawal tax rates increase) can be obtained by contributing more years at more reasonable returns. It was simply easy (easier?) to change the one variable and see the results.
MDM, I emailed you directly to discuss
This was a great article, totally new prospective that I really enjoyed mulling over! One thing I often think when prioritizing my own Roth is that government debt and deficit are at all time highs ($16 trillion!!?) and will be close to impossible to fix without serious cash infusion. So my thinking is that taxes could ostensibly go waaay up when I’m of average retirement age (over the next 40 years) as an easy(ish), direct way for the US gov’t to start addressing national debt. Would love to hear your thoughts there…
(Thank you for this blog, I eat, sleep and breath it while dreaming/working toward my own ER)
Thanks Stephanie, very kind of you
Debt is high (although higher in WWII) but so are total assets.
Better is to look at total US government net worth, assets minus debt
http://en.wikipedia.org/wiki/Financial_position_of_the_United_States
The overall financial health of the US is a lot better than the drama shared on TV
GCC,
Excellent thought provoking post!
I started at the beginning of your blog and have just made it here today. (I’ve been trying to keep myself from reading the most recent post on baby arrival so as to avoid any spoilers for myself, lol.) Keep up the excellent work.
Have read through this and most of the comments and it’s sparked some great conversations with my spouse about our investment strategies and the tax code, in general. I actually shared this article with some commentary of my own with my much younger siblings. In my 20s, I was under the impression I should be making every effort to fill my Roth IRA while I could. That was a good decision as a lowly college student making almost no money, but I see now that continuing to fund it at the expense of my 401k was the wrong decision once I started earning post-college. I contributed some to my 401k but didn’t max it out until about 6-7 years ago, or so. (Early 30s now). Hoping the sibs can learn from my mistakes.
We started doing backdoor Roth contributions last year (after a few years of no Roth because of income limits). Spouse and I are now high earners and expect to be making over $94k/year in retirement so I think in that case it makes sense for us to fund the Roth despite the decreased flexibility as compared to a brokerage account.
Congrats on your accomplishments and the successful blog!
Hi DMoney, thank you, your comment is greatly appreciated
If this post made you think, then mission accomplished. As you say, the Roth is great when you have low income / low marginal rates. Since this is usually also when you are quite young, the Roth is a fantastic way to get a few decades of tax free compound growth
Then when income grows, the 401k / TIRA help minimize the tax burden both now and later
Congratulations on your success
Jeremy
Why do you recommend 401k up to maximum (#3) over Traditional IRA if tax deductible (#4)? Fees and expense ratios should be lower with a Traditional IRA at somewhere like Vanguard or Fidelity compared to almost any 401(k).
If fees/expense ratios are lower, then go the TIRA route
Some 401ks (like mine) have access to Institutional funds with even lower e/rs. I have a S&P500 index fund at 0.02%
Gotcha. Unfortunately your 401(k) seems to be the exception rather than the rule.
Hello,
Newbie here, should I worry about effective income tax rates rising over time? (http://www.cbpp.org/research/federal-income-taxes-on-middle-income-families-remain-near-historic-lows) and thus my Roth conversions will be taxed higher over time? Or is it such that with converting only small chunks of my IRA to a Roth IRA in the future, even if the effective tax rate goes up over time, I’m still in that lower tax bracket as compared to now in my prime earning (and taxing) years? Many thanks… I’m getting there. :)
Even if rates increase over time, without a complete revamp of the tax system you will still have deductions and exemptions and thus a tax rate of 0% or at least lower than your current marginal rate. That’s the idea
An easier tax law change would be for the elimination of Roth IRA Conversions all together. But shutting off sources of revenue seems unlikely
Ok, I understand and agree. Off to another one of your articles! Thank you for the help. :)
I can’t imagine that my situation scales very well, but putting money into a brokerage or Tax-Deductible account before a Roth doesn’t make sense.
As Lucas and others mentioned above, there is a number of people that can take advantage of the Roth quite well (IMO more than what you have alluded to in your post, maybe as many as 60% of US households [upper threshold of 3rd quintile in 2012 was $65,000]). Our family will make around $55k this year and we have a large number of adjustments/deductions/exemptions. Roth contributions are also considered for the Saver’s Credit – brokerage contributions are not. The Saver’s Credit applies for Married Filing Jointly up to an AGI of $61k for 2015. By putting money into the Roth (in April), I will be eligible for an amount in the saver’s credit that will bring my effective tax rate to 0%. If I paid into a brokerage account, I would be paying an unnecessary 10%. If I paid into my tax-deductible retirement accounts with available funds instead, I would be giving up the advantage of the tax-free gains. Does that make sense?
Considering that everyone’s tax situation is different, it is interesting that blanket advice is suggested here – might be best to suggest that people dive deeper into the tax code instead and apply their knowledge to fit their situation.
Indeed, there is the distinct disadvantage of not being able to lock in capital losses in a Roth account, but I do believe Roth type accounts are safer from tax code adjustments than the possible future adjustments that could be made to the LTCG and qualified dividends from investments in brokerage accounts. What are your thoughts?
re: 0% effective tax rate
See above, under the section titled, When Is a Roth a Good Idea
> If you have an effective tax rate today of 0%… a Roth 401k or IRA is a great idea
re: Saver’s credit
In the Conclusion section above, I proposed a priority ordered list for retirement savings for people seeking early retirement. #1 is to contribute to a 401k up to the company match. These contributions qualify for the Saver’s Credit. No 401k or no match? Continue down the list.
re: tax law
I assume tax law will be different in the future, but I have no crystal ball. Will qualified dividends or LTCG be taxed for low income citizens? Maybe. Will the US get a National sales tax? It has been proposed.
re: blanket advice
Thanks for the advice. But I have to ask, did you actually read any of this post?
Can anybody suggest a good place to get start an HSA account if you don’t have one with your employer?
There is some good discussion on this post by The Finance Buff
http://thefinancebuff.com/best-hsa-provider-for-investing-hsa-money.html
How about your local credit union?
The downside of brokerage account vs roth in retirement is your brokerage account counts towards how much your Social Security benefits are taxed, and your Roth doesn’t. This can lead to a few thousand dollars in tax per year in retirement.
Maybe
https://gocurrycracker.com/social-security-tax-torpedo/
One consideration in the Roth vs. after-tax debate which was not mentioned is that if one has children, when those children head to college, “most” people will fill out a FAFSA to qualify for scholarships or financial aid. To a university (using the FAFSA tool), a family with $200k of after-tax investments has $200k available to spend on junior. On the other hand, a family with $0 of after-tax investments and $200k of 401k/IRA/Roth IRA/etc. has $0 available to spend on junior’s education (just considering the assets part of the equation, not income). In other words, retirement assets are shielded in the financial aid formula; after-tax investments, education investments, money-market funds, income, and even home equity is not shielded. Some colleges will consider Roth laddering as income as well (so you need to check on this).
Some people will dismiss this saying that you have to be dirt poor to qualify for financial aid, but this is not true. With many schools costing as much as $65k/yr, even some families with 6-figure incomes can qualify for financial aid.
For the purpose of deciding between Roth and Brokerage, I would also add that income from Roth conversions and dividends/gains held in a taxable account instead of an IRA will impact ACA subsidies.
In the context of this post, a deductible Traditional IRA takes precedence. So the decision of Roth vs Brokerage is for families earning more than $98k per year in 2015 (the top 10%.) That would put them in the 25% marginal tax bracket or higher, so it is definitely a 6 figure household problem.
We are still 17 years away from college age, so I’ve not done the deep analysis, but here are my first thoughts on this…
For the FAFSA, a family with $200k in after-tax investments doesn’t have $200k to spend on junior’s education. They have $11.2k (assessed at 5.6%) per year, maybe less with safe harbor. That is a substantially lower amount than 25%, but still more than zero.
By contrast though, income is assessed at ~50% (and 401k/HSA contributions aren’t excluded.) So if gaming the FAFSA is the goal, the strongest point of leverage is to have no earned income. Then in the year prior to applying (now two years with new rules) to do no Roth IRA conversions. The brokerage funds will come in handy more so than Roth contributions for cost of living in those years (same as sailboat purchase example above.)
What do you think?
One minor thing to consider. Doing the Accumulation period, dividends in your brokerage account may end up being taxed as income. If you can’t get your MAGI low enough that’s a 15% tax. So effectively the Roth vs Brokerage debate can also be expressed by differences in CAGR, Which over a long enough time frame may matter.
Second, I like to use my Roth as my trading account for that horrible practice of trying to beat the market. All the short term gains I accumulate are tax free, while leaving my broker for long term.
Third, I think it’s just a good hedge against tax-income-policy changes.Give you multiple sources to pull money from. and Like said above, impacts FAFSA and inheritance.
Fourth, I question the Roth being First dollar taxed in retirement. If you were on the conversion phase of the plan, moving the maximum ladder over, and had a sudden expense (winter storm roof damage). Roth funds are going to be at your current maximum marginal tax rate. By not transferring more from your IRA you keep MAGI low.
Finally, sometime we act like we are talking about the last 5500 available to save. But in reality it may be the last 15,000. Asking if it is 100% in brokerage or 66%. I would split the money just for the free diversifications listed above.
Lots of great points here, thanks.
1) We can do the math on this, as done in previous comments. With 2% dividend yield on a fund like VTSAX, the total load for taxes would be 15%*2% = 0.3%. On $5.5k contribution/year that is $16.50. Over 10 years the gain would be 3% less.
Or you could buy a diversified fund like Berkshire Hathaway and have zero dividends and zero load.
2) Speculation is fun. If you lose, capital losses in a brokerage account are tax deductible. In a Roth they are not.
3) Having a blend of pre-tax/post-tax/taxable Traditional/Roth/Brokerage does provide some hedge against tax changes. Although a hedge, by definition, reduces potential risk by chipping away at potential gains.
4) This is what insurance is for. Or go ahead and spend funds from your brokerage account with zero tax and zero tax penalty for early withdrawals.
Thanks for the feedback, too bad I couldn’t get back and respond quicker.
1)$16.50 for the first year, compounding. My mind interprets it like a reduction in the CAGR from 7% to 6.7% (Assuming 5% capital growth and 2% dividends: 1+0.05+0.02*0.85). I built a quick excel sheet, 10 years of 5,500 contributions, followed by 20 years of compounding after FIRE. Nets 276,510 and 296,798 (brokerage and Roth respectfully) that’s 20k or a whole years expenses. (Actually i’m at 24k.)
And I like the Berkshire Hathaway idea. I may do that when the market calms down. Another thought is Small cap vs Large cap since smalls tend to be cap gains and have low dividend.
2) Losses when speculating? That never happens…. I did say it was a horrible habit.
As others have said bonds/REITs are a good hold in Roths (see point 1), but that also applies here. If one is going to have bonds – as opposed to 100% stock – then the risk of losses and resulting harvesting is minimal.
3) You say “reduces potential risk by chipping away at potential gains.” I think that’s about right. The first part is dead on but I would submit that point 1 may mollify part two and what you give up may not be gains, it may be flexibility. Like you said elsewhere, if you FIRE and want to go buy a boat, you can’t tap a Roth to do it like a brokerage. Much like bonds the other thing you buy is stability. Capital gains and dividend taxes have changed in 1998, 2001, 2003, 2008, and 2013 (barely), but the tax rate on a Roth should stay 0%. Yes even that could change, but as we saw with the 529 attempt, it would be very difficult.
4) I see I wasn’t clear enough, my fault. I had assumed one was transferring the maximum from their IRA to a Roth each year working a ladder. [This would actually be a good conversation for a post I’ve not seen anywhere about how one actually does, and budgets a ladder. Someone probably has and I’ve just missed it. I’ve seen a basic 5 year flow table, but not a how-to]
For my example, assume someone filing single, trying to convert as much as they can from a Traditional IRA to a Roth each year. Probably to avoid RMD later one. Annually, Lets say 10,000 of dividend income from a taxable account, so they choose convert (i have 2016 numbers in front of me) 27,450 from TIRA to Roth. Therefor they will own a little federal tax (2,733 back of the envelope, $9,225 deduction and exemption) and no capital gains.
So on January 1st of the year [this is what the blog point I would like to see could cover, do you have to do it all at once? do you wait until Dec 31?] they convert 27,450 from TIRA to Roth, as always, and start drawing the amount they put in 5 years prior. Then in December something happens. Now I said “sudden expense” earlier. Not everything can be insured, and even then insurance companies aren’t always supper prompt. But lets just say the Genie Pig has spend all but their last month’s living expense and now needs 5 grand.
Assume, they don’t have enough cash set aside, or this exceeds it. which may be the case if they stay as invested as possible, but does raise a good point about how to keep reserves. How could they raise the money? The only three options coming to mind are Sell Stocks, Pull more from Roth, take on Debt.
Now debt is an interesting option, if it’s late enough in the year, and one had enough debt headroom, one could take on the debt, then January 1st of next year, sell some extra stock to pay it off and adjust the ladder. But I don’t have 5k of headroom, and it could always been more. Plus who wants to pay fees and interest?
Selling stocks in the main point I was trying to make. If one simply sold 5K of stocks to pay off the bill they would cross the $37,450 threshold to pay cap and dividend taxes. So they would need $5882 to pay the bill. Oh wait, they would actually also need to pay taxes on the 10,000 of dividends so that’s another $11,764 sold. Total tax bill,$ 2,647.
Option 3 Pull extra money out of the Roth contributed in earlier years. Done.
Now first off, this is quite a contrived example. It started off fairly easy in my head 4 months ago, but I had to cover a fair bit of alternatives and contrivances to put this poor person in a bad spot. I think where the Roth helped in this example is in a way to provide better buffering of cash flow in FIRE, if that makes since. Not being FIREd myself I don’t know how difficult it is, and I see several alternatives to the Roth that could be used as alternatives (Cash being King, not spending so much, I mean come on! 37k! I’d die of gluttony trying to spend that much).
But Things like this happen, I was just happening to talk to a friend last week about taxes, and he had a mutual fund do a late December distribution which caused him to have not enough set asides for the tax, and he had to go sell and incur a hit. Same result, different course of events.
I guess what my brain was really trying to circle was “What are some best practices when FIREd to deal with unexpected events?” Having a Roth seems like a prudent measure.
I remember when I opened mine, it was right out of college when I got my first “Real” job and I started in September. With only Sept-December in income I had 0% marginal Tax and decided a Roth would be great. Then I didn’t contribute to it for a few years, until I recently discovered I could contribute to both my 401k and 457 (Separate not combined caps) thus crashing my Marginal tax rate back to 15%. Oh and I will have a pension, which added to SS and Dividends will put me close to that 37k number…..
Thanks for the excellent work helping all of us along on our goals to be FIRED!
Sorry to double post. But this is a new point. (Nothing about this post is going to coherent, it’s late here, sorry)
In my long winded example above. The guinea pig ended up suffering a 2647 tax bill for 5,000 in funds, that’s a 53% marginal rate.
Circling back to the idea of First Dollar and Last dollar. I don’t view Roths as first dollar funds. Social Security, Dividends, Pensions, and RMD are first dollars. You have to take them. with a Roth you have a choice and that means you take Roths at the marginal rate. and as the example above demonstrates sometimes the marginal rate of a choice is quite high. Thus there is the basic principle of opportunity cost. The opportunity cost of taking money out of a Roth is the marginal rate of the funds it is replacing. What do we give up to have the advantages of a Roth?
MF calls the HSA the “Ultimate Retirement Account” because it’s triple tax advantaged, Not taxed in, growth not taxed, and distributions not taxed. But if distributions not being taxed isn’t a big deal like the Roth, then this is a bit of a mute point. So HSA’s are basically identical to TIRAs and MF says so.
Now they don’t have the same withdraw rules. But theoretically for a young-healthy person, one could enter FIRE without many medical expenses and thus the full value of their HSA isn’t even accessible. Yet they are a hallmark of FIRE. Complaining that Roths have poor withdraw rules is a mild double talk. FICA, a powerful reason to use HSAs, wasn’t even in MF’s original post but added as an Addendum.
I’m sorry if anything above sounds rude. I don’t mean it too. I’m just really tired. I hope to hear what you think.
Hi Jeremy,
I am trying to follow along with your reasoning and apply it to my specific situation as a 24y/o, single individual with a large percentage of my income as non taxable (military). I am having some difficulty though due to the changes in tax rates and many differences from the scenarios you used.
For my example, let’s say total income is about 60,000 (42000 taxable and 18000 nontaxable). Due to the military pension plan, there is no matching on the TSP (military 401k), so I haven’t contributed anything into it. Instead, up until this point, I have been following conventional advice and maxing out my Roth IRA before dumping whatever is left into taxable Vangaurd index funds.
After reading several of the FIRE blogs, I am trying to determine the best way to move forward with my investing strategies for a target retirement in 10 years. My specific questions are how much does having a large portion of your income as non taxable weigh in favor of the Roth IRA over traditional? Should I be maxing out TSP contributions solely for the 18000 tax deduction despite having no matching? Would you still advise the same investing strategy as you did in your original post?
Thanks!
The major factor in deciding between Traditional/Roth/Brokerage is marginal tax rate.
If you are paying 25% tax, then the Traditional is best.
If you are paying 0% tax, then the Roth is wonderful… 0% tax paid going in, 0% on withdrawals.
Note that you should also have a Roth 401k option.
In between those rates, it is a matter of debate/preference. But I wouldn’t hesitate to contribute the full amount into a Roth or Traditional TSP, even without match, as those investment plans are among the best in the world.
Thanks for the reply! My follow up question would then be if there is a way to guarantee which dollars are going into a Roth? If I can guarantee they are the untaxed dollars going into the Roth then that choice would be obvious.
Not really, unless there is some nuance of military tax free income that I’m now aware of. I assume at tax time it should look like you just have $42k income.
You can play with tax caster to see how IRA / TSP contributions would impact your taxes
https://turbotax.intuit.com/tax-tools/calculators/taxcaster/
If you are going to get a pension or government health care in retirement, I would lean towards Roth over Traditional.
“If you are going to get a pension or government health care in retirement, I would lean towards Roth over Traditional.”
I imagine this is because those things will put me in a higher tax bracket during retirement? In your article you mention Roth IRAs not being distinctly advantageous over brokerage accounts with long term capital gains. Wouldn’t it be the same for Roth 401ks without matching?
Is it relatively uncommon for people to split their 401ks between traditional and roth? I.E. invest in traditional down to 15% bracket then roth the rest.
Your pension will be taxed, raising the tax paid on Traditional withdrawals and providing less opportunity for tax free dividends and capital gains. You need to compare current marginal rate vs expected future marginal rate to determine which is best.
Choosing Roth or Traditional based on marginal tax rates is pretty standard. So no, not uncommon.
Can you expand to why we should go Roth if we’ll get a pension? I was prepared to go all-in on traditional until I read this.
Depends on size of pension – if pension replaces a high percentage of salary, then pension and Social Security will fill the lower tax brackets. Any withdrawal from Traditional accounts will be taxed at higher rates, potentially higher than the rate you would pay today
But at 25% you make too much money to count the traditional as a tax deduction, no?
Hi Go Curry Cracker – I understand that by using a regular 401K, you save the difference between your current marginal and future effective tax rates compared to a Roth 401K. However, a major flaw in your analysis (graphs) is you’re treating the Roth 401K as being used INSTEAD of a 401K as opposed to WITH it. The Roth should be used to supplement a 401K so that any income withdrawn over your current marginal tax bracket in retirement should be withdrawn from the Roth instead of the 401K!
I assume tax rates are the same in the future (adjusted for inflation of course) to make things easier. If you do it this way, you find that the breakeven point is much lower! It equals the difference between your current marginal and future effective tax rates above your current marginal tax bracket, which is not hard to imagine at the 15% tax bracket). So at a current 15% marginal tax bracket, it is not hard to imagine you would retire into the 25% tax bracket. And at a current 25% marginal tax bracket, it is still not too hard to imagine you would retire into the 33% tax bracket, especially if you are still young and upwardly mobile.
Please update this page so as not to mislead people.
Thanks,
Bob Ross’s Muse
*Please ignore the second paragraph – I made a mistake in the math. Use the Roth for only the amount that your future marginal rate is greater than your current marginal rate. The rest should be taken from your 401K. So your future marginal tax bracket has to be above your current marginal tax bracket for a Roth to make sense. It’s not hard to imagine if you are at a 15% tax bracket that you could retire in the 25% tax bracket. Or if you are at the 25% tax bracket, you could retire in the 28% tax bracket, especially if you are young.
Hello Mr. Muse, thanks for commenting.
What you are referencing is not a flaw, and is not misleading.
This site is for people interested in retiring early. It is difficult if not impossible to imagine any early retirees being in a higher tax bracket post-retirement. For example, our tax bracket is 0%.
You might enjoy reading about how we plan to move $500k from our 401k to a Roth IRA over the next 30+ years, all with zero tax.
This may have been addressed in another question, but my work retirement plan is a simple IRA (100% match on first 3%) and I think it has around an 18k limit. It’s a good mutual fund I’m in, but there is a 5.75% front end load which I don’t like. Would you still recommend this path?
In the investment world, we don’t call that a good mutual fund. We call that total shit.
Your work retirement plan is part of your compensation. In this case, your employer thinks you should make 2.75% less than you actually do. I would find a new job. And let your employer know why. btw, the latest job report looks stellar.
Thanks. I have found out that the 5.75% is full retail, and we are actually getting a discount and paying 2.5% soon to drop to 2% front end load. And like I said, they match 100% of 3% of my income. What would be my best savings option short of quitting. I also have been Maxing my Roth IRA for years, (which I know you don’t like). Any advice appreciated, Thanks.
I’m sure by now you realize that they actually match 97.5% of
your income, making sure they get their money before you lose
or gain anything. I would discuss with your employer that they
might find a company that doesn’t “tax” your retirement plan.
I know its not an easy conversation, but there are good
benefit suppliers out there. I have never had my benefits taxed,
having worked for several employers.
It’s not that I don’t like a Roth IRA, it is that there are better options for someone who wants to retire extremely early.
We all have a relationship with our employer. If your employer chooses to screw you on your 401k, they are also likely to screw you on other benefits, overall compensation, etc… That is the nature of abusive relationships. That sweet fund with a 2.5% load probably doesn’t have a 0.05% annual expense ratio like a good Vanguard index fund.
Maybe take a look at Jim Collins’ post on this
http://jlcollinsnh.com/2013/06/28/stocks-part-viii-b-should-you-avoid-your-companys-401k/
Hi, been following you for awhile and you’ve got me looking at best ways to save as much as possible…i.e. bordering on obsession.
Wife (51) and I (46) have a MAGI of about 135k after the maxxed out 401k for me. From reading online we can contribute the max (6500/5500) to a Roth even with my retirement plan. She has a pension plan (2 actually) but doesn’t contribute. Would you recommend doing a brokerage account (don’t have one…yet) over maxing out the Roth? We can do the brokerage account and Roth at this point of our lives.
Why wouldn’t you contribute to the pension? You are still firmly in the 25% tax bracket.
In the grand scheme, contributing to the Roth is just $6500. Each. Since you can also contribute to the brokerage account, adding funds to both gives you a balance of pre-tax/post-tax/taxable. That is not a bad place to be.
But I would still look at tax deductible contributions through your wife’s work plan first.
Sorry, should have mentioned in the original post, she’s not allowed to contribute but she is 100% vested with the company. I’ll definitely look into the brokerage account because the goal is to max out the 401k, Roth and do the brokerage account while we are making good money.
I’d rather use some of the cash we have on hand to earn a good percentage instead of 0% in a savings account.
Thanks for the response and look forward to future posts/ideas.
I am late for this but I am curious to peoples’ thoughts on contributing to Roth when one is taxed at 10%. I only partially contribute to my and my wifes Trad/Roth ($5500 x2) during the year. I contribute to the Traditional IRA until I hit the 10% rate and then finish with the Roth. My rational is that I’ll pay the 10% rate now as I will likely won’t get that rate later. I do max my 403b and HSA and fund a brokerage acct as well. I do understand the rational laid out by GCC but I expect my wife and I to work part time in our 40s and maybe early 50s. She is self-employed and makes good money. I enjoy my job and might be better off working 20-24 hours a week.
Thoughts?
I think paying 10% tax now on Roth contributions is a reasonable choice.
Depending on what you expect for future income and how large of a 403b you have, it could even be reasonable to choose to pay 15% tax today.
Your articles are so great and stay alive for years through the comments (and your responses to them). I enjoyed the conversation about FAFSA in the comments. I have a son going off to college next year so FAFSA is important to us. Although it really sucks for us when they moved up the application date and look at returns from 2 years before the school year. I took a layoff package from work this year and retired early! Because the severance package was so good. he is not going to qualify for any assistance his freshman, sophomore or junior years. Technically I got laid off so I think the university can manually do a calculation. We will see if that pays off. For 2017 we will live mainly off the brokerage account to make the FAFSA numbers for his senior year look good.
But on to my real reason for posting. Could one consider another advantage of the Roth over a brokerage account is retirement accounts are a little more protected from lawsuits? I’m not a lawyer or a financial adviser nor do I use one. I’m also not an insurance salesman. When these guys give their pitch they talk about managing risk (most likely an excuse for poor returns). If you are looking for ideas for articles, I don’t see very many FI blogs that dive into deep analysis (like you do) on risk management and the different tool/vehicles to manage risk. Just a thought
Sorry about the layoff, but congrats on the package!
There is some difference between IRAs and brokerage accounts in case of a lawsuit where you lose and are found liable. So don’t do that. Or buy an umbrella policy.
Hi guys! I haven’t read all of the comments, though I’ve read a good chunk of them, and I didn’t see mention to the so called, “mega-backdoor Roth” where one makes after-tax contributions to their 401k and later rolls the account to a Roth IRA. This requires a *401k plan with certain features that are not commonly available, but do exist. Assuming one has access to one of these, and has high enough earned income where he gets nailed with the 3.8% Net Investment Income Tax, I think the mega + regular backdoor Roths are a great idea, after maxing out any and all tax deferred options first. It allows one to shelter more dividend and interest income from 18.8% tax rate (15% LTTG, plus 3.8% NIIT) while working. Each of these roll-outs to the Roth IRA require the 5 year ‘seasoning’ before you can access the funds, so if access to these little green men is part of your early retirement plans, you will want to have a large taxable account balance as well. In this admittedly limited case, I think the mega and backdoor Roth are a great choice. That being said, I agree with you that one still needs a very sizable taxable account, and maxing out the tax deferred choices first is a no-brainer.
I’d like to also congratulate you on running a very informative and entertaining website! I’ve silently stalked this site and several others for quite a while.
*Disclosure: My company does have one of these great plans which I take full advantage of, but of course I first max out all tax-deferred options.
Hi John
Front door, back door, big or small, it is all still a Roth, so it’s all bundled in last place on the contribution list.
I’d be impressed if somebody maxed out the mega back door every year ($53k minus 401k contribution) and still amassed a sizeable taxable account.
I’d still rather pay a small load (15% tax on a 0-2% dividend yield is <0.3% load) on the brokerage account and have unrestricted access in the years before 59.5. ymmv, and I wouldn't argue with someone who preferred to to have the $ in the Roth accounts.
Thank you kindly,
Jeremy
hey jeremy
not to resurface an old thread, but i’ve been using this article over and over again to push folks to leverage this knowledge and wanted to clarify a few things
one scenario i think of that i struggle with are high income earners who live in HCOL areas. thinking folks who earn 200k plus in a NYC/ATL/LA setting where even though they are making lots of money, their cost of living is still relative
as you look at the brokerage option, and you realize you’ll need to take out 40-50k just on rent/mortgage, you can see how that pushes you much faster through things. you likely didnt have a tIRA option, so you were limited to 401k only. so your burning through that 0% capital gains tax pretty damn quick
in those scenarios, do you see benefits in back-door roths, or heck, even mega-backdoor if available
i think you mentioned ‘if you plan on needing more than 95k (adjusted now to 105k, i think) in retirement, that a roth starts to make sense?
anyway, want to be consistent in my messaging as everyones situation can vary
Hi Greg, sorry, I don’t fully follow your question.
If you are making $200k and you want to put $6k into a Roth, sure go for it. It’s only 3% of your total income, so doesn’t matter much in the grand scheme of things. If you are aggressively saving for an early retirement you could fill the 401k, Roth IRA, and still have a bunch of $ in a taxable account.
On the withdrawal side, if you are spending $200k a year you have a portfolio worth at least 25X that (so $5 million.) If you retire relatively young, a lot of that will be in taxable accounts due to the contribution limits mentioned above. Then when you do spend the money from the taxable account, only a fraction of it is taxed (just the gains.) So if you pull out $50k to pay your mortgage, if your stock or index fund has doubled since you purchased it only half is a gain. Using that same figure, you could pull out $200k in spending money with only $100k capital gain which would pay zero federal* income tax (assuming no other income.)
* State taxes, ACA taxes, etc may still apply
hey sorry, wish i got some level of notification you replied, didnt mean to leave you hanging!
sorry. i guess what i’m getting at is, if you are a high income earner, and live in a HCOL, a lot of the yearly earnings will prevent you from having access to much past a 401k. i think we all agree, t401k is the only logical conclusion there due to the tax bracket you are likely in
however, pending you had access to backdoor, your right, the paltry 3% i suppose doesnt exactly hurt to grow tax free. even roth maxed for 30y is only about 600k (180cont,420growth), but isnt that worth it considering how much you may still need in retirement?
and then if you were able to stash an additional 35k through a mega (i know not everyone has this ability), wouldnt that then start to look pretty enticing compared to a brokerage?
i suppose a lot of the answer is: it depends on if you are targeting early retirement or not?
Yessir, it depends. If you are going to spend a lot of time withdrawing funds for living (cuz you retired early) access is super important. Putting “too much” into Roth accounts is disadvantageous in that case. If you plan on retiring after age 59.5, sure go big on Roths.
See this post for more: Roth Hypocrisy
If you are making close to 200k and have hundreds of dollars socked away in a Traditional IRA, how could you move money between accounts in a tax efficient manner like you say? Surely there must be a reason why Warren Buffett and Peter Theil have used Roth IRAs to sock away millions of dollars in a Roth IRA.
If you plan to have Warren Buffett or Peter Theil levels of wealth, paying for expert financial advice tailored to your specific situation will be more effective than playing whataboutism in comments on random blogs
I have a question. In the graphs, why do the marginal tax rates (and thus the taxes paid) remain 0 up until the $20,000 mark? I thought initial income was taxed at a 10% rate up to $18,500.
The first ~$20k of income for a Married Couple Filing Jointly is not taxed due to the Standard Deduction and Personal Exemptions. Divide by 2 for Single filers.
Hi! I’m 23 years old and this blog has been tremendously helpful in figuring out how to navigate all these accounts. It’s been enlightening. Thanks so much GCC for your awesome posts. I hope to see more! And I love your posts with your family! Hope they’re doing well.
Perhaps this is a dumb question, but if I have a 401k from my job and I decide to contribute to a traditional IRA through Scottrade or some other broker, that would mean during tax time I would claim these contributions as deductions. So, today I technically have less money in my bank account until tax time comes around. Isn’t a dollar today worth more than a dollar tomorrow?
You can have less taxes withheld from your paycheck by adjusting your withholding to account for deductible IRA contributions. See Form W-4.
Thanks I appreciate it.
If you’re contributing to a 401(k) or other employer plan, you can open a traditional IRA as well, but you may or may not be able to deduct that chunk of savings from your taxes, depending on your income. try this link https://www.irs.gov/retirement-plans/ira-deduction-limits
In the first example – if they withdraw 22,700 at retirement and pay 1% that is less than the 13.2% they paid up front to get there money into the roth. But then they pay that every year for ever – after 13.2 years that is the break even point (ignoring growth on the original 13.2). But assuming some rate of inflation like 2 or 3% they will need more every year too so i think its a good estimate. And of course you may have your healthcare 80% paid by your job now that is giving you the 401K and when you retire early you pay the full 100% of that so you need more income for that.
Anyway the comparison of 1 year of taxes at retirement to the 13.2% you paid one time for the rest of your life doesn’t make sense to me and maybe others.
> But then they pay that every year for ever – after 13.2 years that is the break even point
That’s not how it works. See commutative property of multiplication.
I really liked how you explained the last dollar principle. What I like the most about the Roth is that flexibility it gives you and how you can use it for almost anything you want. It’s like the Swiss knife of bank/retirement accounts: if you need the money you can get your contributions back, with the IRA you can build the ladder, if you need to lower taxable income (for ACA subsidies or whatever) you withdraw from it instead of an IRA. And you can even build there for your estate (if you are lucky), I read somewhere it is the best way to leave to your heirs.
Roths are great retirement plans. But the benefits come at a cost (taxes now.)
Ideally people would contribute to (& convert to) them when marginal tax rates are low (0%, 10%) and use Traditional accounts for high marginal rates (25%+.)
This same comparison of marginal rates applies for inheritance as well. Again Kitces provides a solid explanation. I will never inherit anything, but if I were to do so I think I would prefer to inherit a larger Traditional IRA over a smaller (after-tax) Roth since my tax rate is effectively zero.
It’s good to see your comment about “comparison of marginal rates.” As Kitces notes, [url=https://www.kitces.com/blog/roth-vs-traditional-ira-the-four-factors-that-determine-which-is-best/]You contribute at marginal rates and withdraw at marginal rates. Marginal rates are how all tax strategies at the margin should properly be analyzed.[/url]
Given that, might you edit the article to avoid giving people (who might not read down this far) the idea that one should use effective withdrawal rates in the traditional vs. Roth comparison?
Nope. Everything in this post is great just the way it is.
I think I was initially tempted by the Roth because I could get the contribution out without trouble, and back then I didn’t know there were ways to get money out of an IRA before 59.5. I was still contributing to the 401k to get the match but not maxing out, so that was a miss… I understand the point in the article (thanks for the link). Later on I maxed out both IRA and Roth but still my Roth is only about 15% of my retirement accounts so I am OK with it. I also missed the importance of the HSA, so now I contribute there to catch up and since I don’t have earned income.
Thanks again.
Being able to withdraw the contributions is a nice feature of the Roth accounts. But it’s a terrible choice to actually remove the contributions before retirement unless it is a life or death situation.
What do you mean when you say:
“I maxed out both IRA and Roth”
You are legally allowed to contribute a max of $x (5500 in 2016) per year to all IRA accounts, whether they be Traditional or Roth. You can’t max out both.
I meant I maxed out 401k and Roth, sorry for the mix up. I haven’t withdrawn anything from either yet, but rolled the 401k over to an IRA.
OK, that makes sense. Thanks.
Hello GCC. Great article and excellent blog! A question on this article (apologies if already answered as I am joining the discussion very late). Would you still recommend following your advice (and order of funding) about not using a ROTH IRA or ROTH 401K for someone who is a high earner and not retiring before 59 1/2 (11 1/2 years to go to age 59 1/2). I have both traditional and Roth 401K options (including a company match), after-tax contributions to my 401k and in service-withdrawals. I do not buy and hold indefinitely but place at least one or two short term trades a year in my accounts.
Thanks in advance!
Depends. You’ll want to look at the tax rate you pay now vs in the future and use that as a deciding factor.
Howdy GCC — Love the blog. Awesome stuff and very digestible. Quick question: Would it *ever* make sense — in prep for early retirement — to move Roth contributions/principal to a taxable account to reap the benefits of eventual tax-free dividends and long-term gains? My apologies if I’ve missed a discussion on this either in the comments or in another post. Wife and I have ~$800k in 401k/IRAs, about $110k in Roths, and $35k in taxable. Looking to be FI in next 6-10 years (at around age 50) and feel I need to start bulking up/kickstarting the taxable accounts per your “never pay taxes again” post. Bad idea? Thanks for the insight.
Hi JS,
Hrmm, maybe…
One of the core tenets I outlined is that access to earnings is more valuable than access to contributions for very early retirement. But that value declines with age; once you hit Age 59.5 you have unrestricted access to both.
I would look at how you plan to support your cost of living for those 9.5 years, and decide how to proceed from there. A SEPP can provide access to the 401k/IRA funds, and Roth contributions or $ in the brokerage account can cover the rest. With a combination of pre/post/after tax accounts, you can tune withdrawals to get the lowest tax bill.
“While full access to contributions is often cited as an advantage of a Roth, those contributions lose to inflation with each year. While we can access our $72k in contributions, those funds are only worth about $53k in Jan 2015 dollars.” For someone in a 25% tax bracket, they would’ve been left with, approximately, $54k to invest after taxes and then have to pay taxes on gains and dividends until retirement (assuming 0 tax rate in retirement). In this case I see more advantages in contributing to a Roth.
I do agree with you that maxing out 401(k) is a better option. We first max out our 401(k)s, then Roth IRAs and then invest in brokerage because we’ll be in a much lower tax bracket while in retirement.
I’m also game for legally postponing taxes for as long as possible. ;)
Sorry to see this is not an international blog anymore…almost nothing lately is applicable for non-US residents.
Switching over to Millennial-Revolution..She has way more international content
This post is 2.5 years old…
Be sure to check out my guest post on Millennial Revolution. It’s very International :)
Brand new to your blog and loved this old post :) Sorry to dig this up!
Quick question and maybe I’m missing something but I didn’t see this answered anywhwre so here it goes….
Does a Roth 401(k) always operate on Last Dollar principle? For example, if I get a large bonus at the beginning of year and contribute max to Roth investment vehicle (let’s say 17500) at the years beginning and contribute nothing the rest of the year, would I be taxed at marginal (and effective) tax rate closer to 0%, or would this still operate on last dollar principle and basically still get taxed at my 25% for those contributions? (after I submit my tax returns for that year is where I believe I would see the difference….). I can see how one would assume that they either contribute to Roth at years end or through payroll deductions, but I was curious if one could circumvent this by contributing at the beginning of the year! :)
Not sure if my questions makes sense, but I can definitely elaborate if more is needed. Thanks again Jeremy. All the best, Sean
It doesn’t matter if Roth contributions are made on January 1st or December 31st, they are effectively taxed at your highest marginal rate.
Have you run any numbers on how inflation will affect the future/current buying power value of your accounts, and how taxation now vs. later affects this buying power?
To illustrate the concept:
Imagine you put away $1,000 today, and pay the 2018 marginal tax rate of 22% on that contribution ($1,000 – $220 in tax= $780 invested). This would be your Roth option. This $780 grows to $1,918 in 10 years. That is worth $1,427 in todays dollars, for an inflation-adjusted after-tax return of 42.7% or $427.
Imagine you put away $1,000 today pre-tax, and it grows at the same 9% annually for 10 years. $1,000 grows to $2,459 or so in 10 years at 9%. $2,459 in today’s dollars is $1,829. Blended future tax rate for a married couple withdrawing $50,000 annually is 6.7% or so. After-tax and inflation real returns are $2,459 – $164 tax = $2,295 Inflation adjusted is $1,707. After-tax inflation adjusted return is 70.7%.
Am I missing something?
Inflation is the same for both.
Active duty military physician, firmly in the 24% tax bracket for 2018-2020. Will not stay 20. Currently contributing 50% traditional / 50% Roth TSP. Any compelling reason why I should do 100% traditional? Keep in mind I am undecided where I may take a $500K/yr civilian job OR live on <$100K in rental real estate income. Thanks!
Thank you for your service.
Since you have income that fills in the lower tax brackets (rentals, pension?) then you need to do a more complicated evaluation, which does require making a somewhat educated guess of the future. Your first dollar of withdrawals from traditional accounts will be taxed at something other than zero. If that is >24%, then you are better off contributing to Roth now; 24% is the lowest rate you’ll ever pay.
I currently max out my 401k, max out a Roth IRA, and put some in a few Vanguard taxable accounts. My employer started offering a HSA for 2018, and have started contributing to it. Would it be wise to stop contributing to the Roth IRA and open a traditional IRA? Not sure at this point it is a good idea. I am hoping to retire in about 6 years.
Thanks for the blog. Lots of good info!
I agree with 1. 401k up to company match followed by 2. HSA (since one would expect to have a lot of medical expenses to cover out of pocket without employer coverage in early retirement). However, I would go with 3. Brokerage account next (and the amount in the brokerage should be more than the amount in the HSA, so arguably it should be brokerage before HSA. I plan on doing both at the same time but in the correct proportion). I don’t see the benefit in tying up additional money in retirement accounts (401k up to maximum or traditional IRA), since this only adds to the amount that you will eventually try to convert to a Roth IRA. I’m targeting early-ish retirement at age 43 (20 years of working, house paid off that year). With 8% going into my 401k to get the full 7% match (which will become 8% match at 10 years), I already anticipate having more in my 401k at age 43 than I can possibly covert to a Roth IRA by age 70 (to avoid RMD) if I only roll the 0% tax amount each year ($24000 in 2018, indexed for inflation using my estimation). I’m using 12% growth and 3% inflation for my math. This means I will already have to pay some taxes during my Roth conversion ladder, so I don’t want to add to this by contributing extra to my 401k or a traditional IRA while working.
Plus, my income between 43 and 60 will be long term capital gains from my brokerage account. So I need enough in my brokerage account to last 17ish years, and by 60 my 401k (which by this point will be partially a Roth IRA) will be available without the 10% penalty. The only way I see value in contributing extra to a traditional 401k/IRA before a brokerage is 1) You don’t yet have too much in your 401k to do a Roth conversion ladder from early retirement age to age 70 using only the 0% tax amount each year, and 2) You have another source of income to cover you from early retirement age to age 60 so that you won’t have to rely only on your brokerage account.
Granted, I am oversimplifying in a few areas. First, even if the Roth conversion ladder from 43 to 70 using the 0% tax amount doesn’t get me down to $0 in my 401k, if it at least gets me close, then the RMD will not be a big hit. Technically, the question is what balance in a traditional 401k/IRA at age 70 will result in an RMD equal to the 0% tax amount that year? That is the actual maximum balance you would want so that you could continue your Roth conversion ladder beyond age 70 without taxes. For simplicity, I’m targeting $0 at age 70.
Second, my brokerage account does not need to last all the way from 43 to 60. Roth contributions are available before 60, and my Roth conversion ladder already locked in some gains as “contributions”. For simplicity, I’m targeting a retirement age where my brokerage account will last until 60, which for me is 43. If my math ends up being off a bit or the market takes a badly timed dip, I know I will have my Roth conversions available before age 60 anyway. Using today’s numbers, if you only roll $24000 each year to a Roth, it will realistically take some time before you would want to start withdrawing from that Roth anyway. So it still takes a decent amount in your brokerage or another source of income to bridge the gap.
Using GCC’s list, it really comes down to how much money you have in each of 1 through 5. If you have plenty in 1 through 4 but little to none in 5, then you will need another source of income to bridge the gap between retirement and 60 (or some age less than 60 if you plan on accessing your Roth conversions before 60).
I’m curious to see if anyone agrees or disagrees with my logic.
I’m kind of concerned about RMD. In your example with 10M at age 65 we could start Roth conversion but may still have a lump sum at age of 70 that could put us in higher tax bracket than now. Also, if one of the spouses passes it may put other into even higher tax bracket. Have you thought about it? I would like to hear your opinion on it.
I’ve thought about it a bit. See here and here.
The RMD itself doesn’t really become burdensome until after the mid-80s. At age 70 1/2 if is a measly 3.6%.
The change from married to single can have a big impact on total tax due. “I might pay too much in taxes” is a high net worth problem, so we could minimize tax impact of this change by passing the deceased spouse’s IRA to children or grandchildren.
Hello, I have been pondering this topic for a while. Here is my situation, I am currently in the 12% tax bracket. When I turn 60 I will be getting a military pension of around $2900 per month, then add social security, and the fact that I plan on having $10,000 per month cashflow from rentals, and I should also have a lump sum pension around $1,000,000, or around 5k per month if I choose the annuity. Which path makes sense for me? I must also note, that if the rentals become a success, I def plan on retiring early. Thanks.
Ryan
Not exactly sure what your question is but if it is whether or not to go annuity I definitely NOT do that. One million in lump sum or $60K year is 6% which you can get over a long period (average annual) and at the end of it all you still have your one million.
No annuity. That’s a 100% no.
Sorry if I wasn’t clear, I am pondering if Roth or traditional is better for me? I read the article but thought my situation was slightly different.
At 12% I’d be tempted to go Roth.
A bit confused on the tax rates. I pay zero taxes (offshore private work) and have a 403b for retirement (company sponsored). If I spend a good bit of money in a Vanguard brokerage that is not a roth or retirement account is the total of my funds going to be screwed on withdrawal? In a zero tax situation it seems better to set the vanguard to a Roth, but I don’t think brokerage accounts can just be switched like that.. Thanks for the info, great read by the way.
With a 0% tax rate today, all contributions should be to Roth or brokerage accounts. 403b contributions should be Roth.
Withdrawals from brokerage won’t be penalized. They’ll just be taxed, but that tax rate could be 0%.
great post, However, after reading through the comments, I would still appreciate your input on my specific situation. My wife and I are currently maxing out a 401k and 403b, HSA, 2 Roth IRAs and putting about 13k in a taxable account each year. Would you still recommend to not contribute to the Roth and put those funds in the taxable account instead? We are firmly in the 25% (now 22%?) bracket. Hoping to retire in 10 years at 42. Thanks for the input.
Yes, correct.
Thank you for the concise and timely reply.
I should have also included (not that I think it will matter) that, currently, I would be the one retiring at 42. My wife currently works two days per week making 40,000/year at a job she loves and would likely continue to work for some time past my planned retirement. Would that affect the Roth vs taxable since there would still be some earned income? Thanks again.
You can have ~$100k income and still pay 0% tax on long-term capital gains and qualified dividends, so… no.
Curious about decision when the rate is 12%. The 12% being after 403b and HSA contribution, last dollar principle.
I have a question for you. If I do a back door Roth contribution, can I pull that contribution out of my roth the following year, tax and penalty free since it was an after-tax contribution. Or is it in the 5-yr fermenting period with other IRA-Roth conversions and I have to wait 5 years to pull out the basis?
5 years
Yes, using a backdoor Roth your contribution amount may be withdrawn from the Roth account immediately, or whenever, with no tax or penalty. This differs from the taxable amount involved in a “normal” traditional to Roth conversion.
Thank you
I strongly prefer the Roth IRA and Mega Backdoor Roth IRA over taxable accounts for people trying to retire early like myself. Many people would argue that if you’re trying to retire very early, a taxable account is better in terms of having access to all the money including gains. Although I agree with this aspect of taxable accounts, there are several big disadvantages to choosing a taxable account over the mega backdoor Roth IRA for extreme savers like myself. I am an extreme saver with the ability to fully max out the Mega Backdoor Roth IRA. I cannot save much beyond a 401(k), HSA, regular Roth IRA, and Mega Backdoor Roth IRA, so my taxable account is small relative to my entire net worth. The number one reason that I choose the Roth over the taxable account is the flexibility that the Roth provides in controlling future early retirement MAGI. By keeping my future early retirement MAGI at a low enough level below 150% of FPL income, I will qualify for a large ACA subsidy. If I choose to put every dollar into a taxable account instead of a Mega Backdoor Roth IRA, I would have dividend income that would likely be above the 150% FPL income level and I wouldn’t be able to realize much capital gains or perform Roth conversions without causing a huge increase in ACA premiums. In other words, the Mega Back Door Roth IRA enables me to control MAGI in early retirement, which allows me to reduce my ACA insurance premiums significantly, and realize long-term capital gains or do Roth conversions while still qualifying for a large ACA subsidy.
The big Roth approach has merits. The Roth eliminates any need to cap gain harvest (while eliminating opportunity to cap loss harvest) and will simplify tax time as things like non-qualified dividends won’t mess up your Roth conversion space (while eliminating option to claim FTC on non-US funds.)
The value of earnings vs contributions diminishes with age, as you have fewer years to draw down before 59.5 and fewer inflation years. People retiring at 35 might value earnings more than somebody retiring at 55.
At what age are you targeting retirement, and how many years of spending will you have in Roth contributions?
It isn’t necessary to get involuntary dividends in a taxable account. See Berkshire Hathaway.
I am 37 years old now and I estimate that I will have enough taxable account assets to last me at least 10 years if I retire at 45. Therefore, not having penalty free access to Roth earnings before age 59.5 is not a factor and I estimate that I will have more than enough roth contributions and conversions through the mega backdoor strategy that will last at least 5 years and are penalty free at early retirement.
I chose not to invest a large percentage of my net worth in one stock like Berkshire Hathaway. Concentrating my net worth in a single stock is not how I invest.
Another point that I want to make is that if I was just starting out my first job today and had access to the mega roth strategy, and a roth ira, I would choose to maximize those accounts over a taxable account, and I wouldn’t retire early until I had more than enough penalty free roth contributions, rollovers, and conversions to last me until age 59.5. This strategy could save people a lot of money in taxes over a life time. My preference of accounts to maximize are as follows:
1. Tax-deferred 401(k)
2. HSA
3. Roth IRA
4. Mega Backdoor Roth IRA
5. taxable
Yup, has merits. If I was aiming to retire at 45 instead of 35, I’d be more Roth inclined.
I agree with your strategy, except for the 90% percentile scenario.
Only $3,000 of losses can be claimed per tax return. The rest is carried forward. This is important for your 90% percentile income scenario.
At that income level, many readers will be contributing enough to brokerage already to max out the allowable loss deduction. Hence, the incremental tax benefit of forgoing Roth IRA contributions in favor of tax loss harvesting won’t materialize for years to come, if ever at all.
Didn’t you neutralize your pilled up capital losses once you started harvesting your gains at 0%?
Other considerations: VTSAX’s dividends aren’t all qualified, hence some of it is taxed at the marginal rate. Also, most states have income taxes, so that’s on top of the federal tax rate.
I’d be curious to hear more about the dividend-free portfolio you are mentioning. In particular, its performance compared to VTSAX after accounting for expense ratios. Is that a single ETF that can be bought and sold for free, or does it involve a multi-fund strategy that will add additional fees to tax loss harvesting / taking gains?
It’s best to look at the numbers.
VTSAX dividends are 95% qualified. NQDs taxed at 22% changes effective tax rate from 15% to 15.3%. That is an effective load on 1.8% yield of 0.27%. Add 5% State taxes and load is 0.37%. On a $5500 Roth contribution that is <$20. Relevant? Depends on how long before you stop working and personal choice.Berkshire Hathaway is dividend free. 10 year performance is basically equivalent to S&P500. 5 year perf is greater.
I prefer to use tax-efficient ETFs like VTI and MGK in a taxable account over a single stock like Berkshire Hathaway. If I chose to avoid roth accounts in favor of taxable accounts and wanted to avoid dividends in my taxable account by buying and holding Berkshire Hathaway, my net worth would be highly concentrated in a single stock.
Berkshire Hathaway is a holding company.
So I’m recently accepted my first job. it happens to be abroad and I don’t think I’ll be moving back to the U.S. any time soon.. I don’t have any financial accounts except for a U.S. one.
And I am going to be taxed at the second highest tax bracket.
Is the Traditional IRA still for me?
Depends. You could post more details on the forum if you want some feedback.
I am always so confused by this topic..which has caused me going back and forth year to year or even splitting contributions half Roth 403/half trad 403b and doing my husbands IRA roth and mine traditional.
I manage our early retirement plan and will quickly agree that I am no math expert so I tend to follow a lot of advice given by the top early retirement bloggers.
Our current situation is income around $50,000. Married with two children. We max out the Roth 403b/IRA/and contribute up to our deductible in our HSA (3,000). The 403b choices aren’t great (Guidestone Financial) and again I’m no math expert but i’m pretty sure the fees are terrible (personal capital tells me that all the time haha).
We did get a $4,000 tax refund back which was more than we paid in taxes (we paid around $7 for fed taxes, and a couple hundred state taxes). I’m sure that was because of all the credits we qualified for (2 children) So does that mean we should continue contributing to the Roth 403b or would we save even more going the Traditional route?
Thank you
Hi!
I recently stumbled upon your great blog and since then been hooked. There is a lot of info to digest, understand, crunch numbers and I am making my slow progress to make sense of it.
Looking for some guidance. We are married filling joint in 24% bracket and will be there for at least few more years. Over the past 5 years we are maxing out our 401(k)s and the past 3 years we were able to to RothIRA too. This year MAGI rule did not allow us to that and we may have to figure out the back door RothIRA option. We do not have anything in our traditional IRAs.
My work allows me to contribute to 401(k) roth option too and there is where I am trying to figure out how to use it? In one way it makes sense to do traditional 401(k) since we are in 24% bracket at the same time I feel like I can contribute 19500 in 401(k) Roth instead of (6000 x 2 in traditional Roth) if we keep our MAGI down with traditional 401(k).
Also, in my work 401(k) most funds are around .5% Expense ratio. In traditional Roth I always have our dear Vanguard funds:)
Any thoughts are highly appreciated.
Regards,
A GCC Fan
If you are contributing less than the max combined 401k/IRA limits (~$32k), then you can contribute enough $ to the 401k to get the maximum employer match and the rest to IRAs to save a small amount on the er.
If you are contributing the max then you’ll pay the expense ratio in the 401k no matter what. Same same.
With those contributions, some can be Traditional some can be Roth (even within the 401k.) Mix and match to get your target MAGI. If that isn’t possible (income is “too high”) then backdoor Roth. Or when I was in this situation I just invested in my taxable brokerage account instead.
At 24% marginal rate, rule of thumb is to do all Traditional (24% rate doesn’t apply until retirement income exceeds ~$200k.)
Hi Jeremy!
You are right we will have to earn the same if not less to kick into the 24% bracket if all the current tax rates apply when we retire:) I was lost thinking about your 0% tax pay blog post. I appreciate the prompt response. I hope all is well and thank you for inspiring thousands of us if not millions:)
I’ve been following this thread for ~6 years, so just wanted to offer my experience as it all played out.
Having just retired, our retirement income is $9k less than when we were working. 2 pensions plus investment income put us almost in the same ballpark. Whenever we take social security and our forced RMD’s, we will have earned income way higher than our working years.
We wished we would have done some Roth contributions just because our RMDs will be so high, easily pushing us into the next tax bracket. As it is, we will do some Roth conversions over the next 10 years before we take SS, but that will only address a small portion of our taxable 401ks.
Sad to think about, but if (when?) one of us dies our taxes explode as we go from filing jointly to filing single. The survivor will still have 1.5 pensions (survivor benefit) plus the same RMDs.
I guess from my perspective, you are probably right not doing Roth as it gets you to FIRE faster, but dealing with higher taxes in retirement isn’t fun.
If you have pensions, this article doesn’t apply.
So if we will be getting a pension, do you recommend Roth?
Depends – see this comment thread
Nice blog. Cannot find this answer anywhere. My idea is to take advantage of the tax savings of an IRA currently but at same time build an emergency fund and possible tax free income later with an Roth IRA. My question is, can i contribute the max (lets say 6k) to a Roth IRA through out the year (i can always withdraw contributions at any time, hence the emergency fund) . But what I want to do is withdraw the 6k in contributions each year in March and put it in a traditional IRA for the tax savings. Any dividends, growth etc would remain in the Roth. So slowly my earnings only would grow in the Roth and be tax free withdraw in retirement. But can i still claim the 6k in tax savings? Can i contribute to Roth, withdraw contributions and put in traditional IRA for tax savings? or is this considered contributing 12k and i cant do that?
Contributing to a Roth and then deciding later in the same tax year that you instead want a Traditional (for the tax savings) is called recharacterizing.
You are required to also move all earnings in the process (dividends, growth, etc…)
Thanks so much for this article (6 years later). It makes me so mad reading other Roth vs Traditional articles because so many just talk about your tax bracket now vs later in the decision. They say nothing about your MARGINAL tax bracket now vs AGGREGATE tax bracket later, and the difference for most people is huge.
It’s like doing the math on where a rocket is going to land. You could take into account curvature of the earth, wind speed and direction, air resistance, temperature, humidity, etc, and you would get a good answer. Or you could just use simple assumptions and you will still end up in the right place. Using the marginal rate that all of those articles suggest is the former, and going the complicated route is unnecessary for most people.
There is actually a special case on Roth you missed. You can over contribute to a 401k (post tax) up to 58k if setup. If you immediately roll over the ~40k if you were to over contribute the max, you will have already paid the taxes on the 40k, but now can grow that 40k in the Roth and not pay taxes on it once you have hit 59.5
That special case wasn’t missed, actually.
I am currently investing in the traditional TSP. Based on my reading it looks like I would need to do a traditional TSP to tIRA conversation then to a rIRA? Does that sound right? Of course, while balancing a pension and wife’s income. I am crunching these numbers to see if I should switch to Roths. Let me know if this is more of forum content. Thanks.
Some nomenclature – moving from a Traditional TSP to a Traditional IRA is called a rollover. Moving funds from a Traditional IRA to a Roth IRA is a conversion. A conversion is a taxable event.
You can decide whether or not to switch current contributions to Roth based on the tax rate you would pay now vs later. If tax rate is higher now, use Traditional. If higher later, use Roth.
I didn’t read all the comments, so this may have been mentioned earlier. I’d like to suggest that Roth contributions are a good idea for nontaxable income. For example, VA disability compensation and military combat pay are not taxable. That would make the contributions tax free in addition to the growth and distributions. Admittedly, this may not apply to many of your readers.
I’m enjoying exploring your blog and learning from it. Thank you.
I think you make a lot of great supported points.
However there one thing which stuck out to me. You make the assertion that a taxable account should be placed ahead of a Roth IRA due to the tax position one sees a5 time with withdrawal.
That is fair, but you didn’t acknowledge a key property of the Roth IRA which is its tax advantageness of growth. Growth within the plan is tax free, whereas with a brokerage it is not. Tax drag has significant effects on growth.
Did you find from your research that tax drag is not significant enough?
Not significant, no. There are quite a few comments where this is discussed, and this post goes deeper.
If you are making over the 204k (joint filing) for 2022, doing a Backdoor ROTH is the only thing that makes sense. You don’t get deductions for anything, so you may as well escape the tax man of the future in full. I keep another regular IRA open and .01 in it just to use as a funnel for the ROTH annually.
So… since there is a penalty of 6% for those who take money listed under the Foreign Earned Income Exclusion and invest it in any type of IRA, would it not be better to invest in a Roth 401(k) or Roth 403(b) or even a regular investment account and then live off the funds tax-free under the generous capital-gains tax rates??
good summation
Hi Jeremy! I’m 22, just got my first job (48k per year at the moment, so not that high paying), I am 45k in student debt after finishing my masters degree, and just learning about the FIRE community. I have been using a Roth IRA for the past couple years, but after reading your posts I’ve stopped those contributions for now, and increased my contribution to my company 401k instead (from 6% to 26%). I’m curious if you think this is a good strategy, as I want to reach FIRE as soon as possible. Open to any suggestions!
Hey Gabi. On the spectrum of possible strategies… this isn’t necessarily the best one. At 22 you have a couple decades of career ahead of you… your greatest ROI is likely to be via salary increases from being a star employee.
As for the question of whether Traditional or Roth is better, this is always based on your marginal tax rate. With $48k income your marginal tax rate is 12%… a fairly low rate (more than 0% but less than 22-24%.) Roth is fine here. The company 401k is great for company match and if you have a company Roth 401k you can put extra there.
Those student loans also need to go. Depending on the interest rate you have to decide how aggressively to pay them down.
Hi Jeremy, I (22f) made 30k this year, will make 60k this coming year, and 250k the year after. Based on this, what accounts should I fund each year? My intuition tells me a Roth IRA is a good choice for this year and this coming year, but I would like to hear your thoughts.
That works. It’s a fine choice to pay 12% on Roth IRA contributions… you are likely to pay more than that in 50+ years.
At 32% then Traditional is the clear choice.