Need investing advice

[TmBlackFlag]

I can't seem to find a good resource out there for choosing between the two.

I'm 26 years old and setting up my first 401k account. On one hand, I have been told a Roth 401k is better for me because I'm in a lower tax bracket now. I would theoretically make more money later in my life and cash out my 401k at a higher tax rate.

On the other hand, adding my contributions in tax deferred now would allow me to have a greater pool of money with the opportunity to compound more.

What would you guys do? One or the other, or maybe a mixture of both?

 

[jmcoreymv]

The general rule is fill your 401k up to the level of matching that your employer provides, then fill the Roth IRA.

 

[TmBlackFlag]

I appreciate your feedback. Would you have any links to articles or documentation to support this?

 

[ahurtt]

Originally posted by: TmBlackFlag

On the other hand, adding my contributions in tax free now would allow me to have a greater pool of money with the opportunity to compound more.

Get that idea out of your head. There's no such thing as "tax free" money. At least not legally. It's tax deferred.

The main difference between a roth and a traditional is that in a Roth 401K, your contributions go in after your taxes have been deducted from your pay (in other words, the contribution comes from your net paycheck amount). In a traditional 401K, the amount of your contribution is first subracted from your gross paycheck amount and then your taxes are calculated on what's left of your income after deduction. You will pay the tax on the contribution at the time you withdraw the money. I believe the advantage is that when you withdraw the money (assumedly when you have retired) you are probably in a lower tax bracket so you will pay less tax. You are probably in a lower tax bracket when you are retired than when you are working since you no longer have your full salary as income. Now you probably have only your pension and/or whatever other investments you might have as income.

The most important thing is that you start contributing. Definitely get 100% of your employers match on the traditional 401K if you can afford it. Not to do that is just throwing away free money. The future is not certain for most people so things can change over time that may negate a previous advantage you thought you had by picking one as opposed to the other. So just pick something and start contributing is the most important thing. You can always change it later but don't let indecision keep you from contributing to something now.

 

[TmBlackFlag]

Originally posted by: ahurtt

Originally posted by: TmBlackFlag

On the other hand, adding my contributions in tax free now would allow me to have a greater pool of money with the opportunity to compound more.

Get that idea out of your head. There's no such thing as "tax free" money. At least not legally. It's tax deferred.

You're right, I didn't word it properly

 

[coaster831]

Originally posted by: TmBlackFlag


On the other hand, adding my contributions in tax free now would allow me to have a greater pool of money with the opportunity to compound more.

This is somewhat of a falsehood. If your expected tax bracket in retirement is the same as your tax rate now, there is no difference (from a purely numbers perspective) between a Roth and a 401k.

As a general rule of thumb, I agree with jmcoreymv- the matching in a 401k is an instant 100% return on investment. You can't beat it. And, depending on your salary, it's probably also a good bet that young people won't be in a lower tax bracket now than they will be in retirement, so beyond that matching value, it is best to fund a Roth. After the Roth is filled, go back to funding the 401k.

If you can determine FOR CERTAIN that you will be in a lower tax bracket in retirement, 401k is better. If the opposite is true, Roth is advantageous.

There are other considerations regarding mandatory distributions, etc, but you may not be concerned with that right now.

Edit: Another big advantage for the Roth is you typically have a much wider range of investment options, since most 401ks have a limited number of funds you can invest in, sometimes with much higher expense ratios.

 

[Elganja]

Originally posted by: coaster831

Originally posted by: TmBlackFlag


On the other hand, adding my contributions in tax free now would allow me to have a greater pool of money with the opportunity to compound more.

This is somewhat of a falsehood. If your expected tax bracket in retirement is the same as your tax rate now, there is no difference (from a purely numbers perspective) between a Roth and a 401k.

As a general rule of thumb, I agree with jmcoreymv- the matching in a 401k is an instant 100% return on investment. You can't beat it. And, depending on your salary, it's probably also a good bet that young people won't be in a lower tax bracket now than they will be in retirement, so beyond that matching value, it is best to fund a Roth. After the Roth is filled, go back to funding the 401k.

If you can determine FOR CERTAIN that you will be in a lower tax bracket in retirement, 401k is better. If the opposite is true, Roth is advantageous.

There are other considerations regarding mandatory distributions, etc, but you may not be concerned with that right now.

Edit: Another big advantage for the Roth is you typically have a much wider range of investment options, since most 401ks have a limited number of funds you can invest in, sometimes with much higher expense ratios.

I think you have neglected one positive note about the traditional 401k. The interest gained on the money that would of been taxed for a Roth 401k.

This is the reason why I am thinking of splitting it up...I am currently investing all of mine in my Roth 401k with my employer match being in the traditional 401k.

I'll have to research this more. Hopefully more people will chime in...

 

[ahurtt]

Another advantage to the traditional 401K is directly related to the fact that the contributions are taken from your gross pay as opposed to your net pay. By taking the contributions from your gross pay, this lowers your taxable income amount. You've subracted some money form your gross pay before calculating owed taxes so it looks like you earn less. But you aren't really earning less, you're just socking it away for later. Effectively if you contribute enough to your traditional 401K you can lower your tax bracket NOW and then later when you are retired you are also probably in a lower tax bracket so you also pay less tax on the money when you withdraw it as well.

 

[ElFenix]

Originally posted by: ahurtt
then later when you are retired you are also probably in a lower tax bracket so you also pay less tax on the money when you withdraw it as well.

i bet taxes are going up in the future. i'd also like to be rich in the future, so higher tax bracket, here i come.

 

[coaster831]

Originally posted by: Elganja

Originally posted by: coaster831

Originally posted by: TmBlackFlag


On the other hand, adding my contributions in tax free now would allow me to have a greater pool of money with the opportunity to compound more.

This is somewhat of a falsehood. If your expected tax bracket in retirement is the same as your tax rate now, there is no difference (from a purely numbers perspective) between a Roth and a 401k.

As a general rule of thumb, I agree with jmcoreymv- the matching in a 401k is an instant 100% return on investment. You can't beat it. And, depending on your salary, it's probably also a good bet that young people won't be in a lower tax bracket now than they will be in retirement, so beyond that matching value, it is best to fund a Roth. After the Roth is filled, go back to funding the 401k.

If you can determine FOR CERTAIN that you will be in a lower tax bracket in retirement, 401k is better. If the opposite is true, Roth is advantageous.

There are other considerations regarding mandatory distributions, etc, but you may not be concerned with that right now.

Edit: Another big advantage for the Roth is you typically have a much wider range of investment options, since most 401ks have a limited number of funds you can invest in, sometimes with much higher expense ratios.

I think you have neglected one positive note about the traditional 401k. The interest gained on the money that would of been taxed for a Roth 401k.

This is the reason why I am thinking of splitting it up...I am currently investing all of mine in my Roth 401k with my employer match being in the traditional 401k.

I'll have to research this more. Hopefully more people will chime in...

The numbers come out the the same assuming the same tax brackets in pre/post retirement...

 

[coaster831]

Originally posted by: ahurtt
Another advantage to the traditional 401K is directly related to the fact that the contributions are taken from your gross pay as opposed to your net pay. By taking the contributions from your gross pay, this lowers your taxable income amount. You've subracted some money form your gross pay before calculating owed taxes so it looks like you earn less. But you aren't really earning less, you're just socking it away for later. Effectively if you contribute enough to your traditional 401K you can lower your tax bracket NOW and then later when you are retired you are also probably in a lower tax bracket so you also pay less tax on the money when you withdraw it as well.

This has less an effect than you think because the tax brackets are tiered- for instance, the cutoff number for the 10% bracket is $7825 this year. If you make $7900, your tax rate doesn't all jump to %15- just the last $75 is taxed at 15%. Sorry if you understood this, it didn't sound like that was what you were saying though.

 

[ahurtt]

Originally posted by: ElFenix

Originally posted by: ahurtt
then later when you are retired you are also probably in a lower tax bracket so you also pay less tax on the money when you withdraw it as well.

i bet taxes are going up in the future. i'd also like to be rich in the future, so higher tax bracket, here i come.

You are never going to move into a higher tax bracket by losing a source of taxable income (your salary for example). Now, there is the possibility that your income from salary is not sufficiently large enough that losing it would affect a downward move in your tax bracket if you are rich enough from other income sources. In other words, if your salary income makes up a very small percentage of your total taxable income. Then losing it might not cause a downward shift in your tax bracket. But if you are that rich you probably wouldn't need to be working anyway.

 

[coaster831]

Originally posted by: ahurtt

Originally posted by: ElFenix

Originally posted by: ahurtt
then later when you are retired you are also probably in a lower tax bracket so you also pay less tax on the money when you withdraw it as well.

i bet taxes are going up in the future. i'd also like to be rich in the future, so higher tax bracket, here i come.

You are never going to move into a higher tax bracket by loosing a source of taxable income (your salary for example). Now, there is the possibility that your income from salary is not sufficiently large enough that losing it would affect a downward move in your tax bracket if you are rich enough from other income sources. In other words, if your salary income makes up a very small percentage of your total taxable income. Then losing it might not cause a downward shift in your tax bracket. But if you are that rich you probably wouldn't need to be working anyway.

He's saying that if you invest all your money in a 401k, and you have a lot of money in your 401k at retirement, it's very likely that you will be in a higher tax bracket than you are now since 401k distributions are taxed as income AND a 401k has mandatory distributions. Thus, that money would have been better invested in a Roth. This can be especially true if you expect some sort of social security benefit, which can be severely impacted if you are in a high tax bracket in retirement.

 

[Dacalo]

I am doing 401k with employer match and also recently started Roth IRA.

There are some good info in this older thread.

 

[ahurtt]

Also I believe the traditional 401K plan has a higher allowed annual contribution limit than the Roth plan does. (Yes there are limits on how much the IRS allows you to contribute to each type of retirement plan on a yearly basis and it adjusts --usually goes up to account for inflation-- each year)

 

[ahurtt]

Originally posted by: coaster831

Originally posted by: ahurtt

Originally posted by: ElFenix

Originally posted by: ahurtt
then later when you are retired you are also probably in a lower tax bracket so you also pay less tax on the money when you withdraw it as well.

i bet taxes are going up in the future. i'd also like to be rich in the future, so higher tax bracket, here i come.

You are never going to move into a higher tax bracket by loosing a source of taxable income (your salary for example). Now, there is the possibility that your income from salary is not sufficiently large enough that losing it would affect a downward move in your tax bracket if you are rich enough from other income sources. In other words, if your salary income makes up a very small percentage of your total taxable income. Then losing it might not cause a downward shift in your tax bracket. But if you are that rich you probably wouldn't need to be working anyway.

He's saying that if you invest all your money in a 401k, and you have a lot of money in your 401k at retirement, it's very likely that you will be in a higher tax bracket than you are now since 401k distributions are taxed as income AND a 401k has mandatory distributions. Thus, that money would have been better invested in a Roth. This can be especially true if you expect some sort of social security benefit, which can be severely impacted if you are in a high tax bracket in retirement.

I don't think mandatory 401K distributions start until you reach about age 70. By that time, considering the OP is 26 now, social security will be bankrupt

 

[Special K]

diehards forum

Lots of good investing info there. I would recommend everyone visit there and read some of the books on their "recommended reading" list.

 

[coaster831]

Originally posted by: ahurtt

Originally posted by: coaster831


He's saying that if you invest all your money in a 401k, and you have a lot of money in your 401k at retirement, it's very likely that you will be in a higher tax bracket than you are now since 401k distributions are taxed as income AND a 401k has mandatory distributions. Thus, that money would have been better invested in a Roth. This can be especially true if you expect some sort of social security benefit, which can be severely impacted if you are in a high tax bracket in retirement.

I don't think mandatory 401K distributions start until you reach about age 70. By that time, considering the OP is 26 now, social security will be bankrupt

Personally, I don't think social security will be bankrupt by that time, although I can see benefits being reduced very significantly. If the benefits are reduced, who do you think they will be reduced the most for? That's right, people with high income coming from a 401k. Don't get me wrong, having a high income in retirement isn't the worst thing that could happen to you- but if you fund both a 401k AND a Roth, and can make withdrawals that maximize your ability to avoid taxes and get SS, isn't that the better play? And to take it a step further, even if there won't be SS benefits, all that matters is if you think you will be in a higher tax bracket in retirement than you are now.

Look, a 401k is an EXCELLENT investment opportunity. But for a young person today who is in the 15% tax bracket (and possibly even the 25% bracket), the Roth is the absolute BEST investment you can make apart from the 401k employer match (IMO of course).

I also second the diehards.org forum. Excellent advice over there- and the book "The Bogleheads' Guide to Investing", which is excellent, was written by some of the main contributors on that forum (Taylor Larimore and Mel Lindauer).