Click-bait? Perhaps
I Lost $400K of My Retirement Savings in a Roth 401(k) — If You’re Not Careful, You Could, Too | GOBankingRates
My main issue - if the account was all after-tax, why is he calculating taxes on those funds?
The comparison is ROTH vs traditional IRA (or 401k). It all comes down to relative tax brackets - marginal tax brackets - when making contributions vs when making withdrawals.
With a ROTH you pay taxes up front, and invest the remainder. If you are in the 22% marginal tax bracket, that is 22% less going into the ROTH than the IRA.
With the IRA you pay taxes at withdrawal. The case is being made that your tax bracket during your earning years, when you are saving, is likely to be higher than your tax bracket in retirement, when you are living off SS, maybe a pension or two, and savings.
We can’t be sure of tax rates and brackets in the future. It might work out as the article suggests. However the more successful you are at saving and investing, the higher the chance that your tax bracket in retirement will be higher than the article suggests.
Let me describe my situation. I am retired, collecting SS and two small pensions. My savings is 79% in an IRA, 21% in a ROTH. Why did I let my IRA outpace my ROTH by such a degree? It used to be skewed even more toward the IRA than this. It got that way two ways. First, most of it started in a 401k at my employer. That included some matching funds, but gave me few choices for investing it, a limited selection of mutual funds. Also, when I converted the 401k to an IRA I took control of investing it, and it grew very nicely.
I will be facing mandatory RMD withdrawals in a couple of years. Based on my current IRA balance, that RMD plus SS and pensions will push me beyond the 28% tax bracket. (Rates are scheduled to rise by then unless Congress acts to change that.
So I do a taxable ROTH conversion from my IRA each year, up to my tax bracket (24%) limit. When I need money to live on I withdraw it from my IRA, and pay taxes. I don’t plan on ever taking money from my ROTH, that will be for my daughters some day.
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He paid taxes on the amount that he contributed. Yes, he would have paid taxes on those funds anyway, but his other option would have been to make contributions to the pre-tax 401(k) and not have to pay those taxes. So it’s a fair comparison.
That said - just using an average or median income to make calculations is a poor way to do an analysis for a specific situation, like YOUR retirement. For example, compare your retirement account balances to the average or median account balance for your age level. If your balances are significantly higher, then your income in retirement is likely to be significantly higher than the median income that the analysis used. If that’s the case, the assertion that he seems to be basing his analysis on, that you will pay little/no taxes in retirement is very unlikely to fit for YOUR situation, and you are unlikely to ‘lose $400k’ like he claims to have. I actually doubt that he really ‘lost’ $400k, although he doesn’t actually supply enough data to do any type of analysis.
I will also point out that he’s not including any analysis of making back-door Roth contributions, either to a 401(k) or an IRA. For those who can afford to do so, getting Roth tax treatment on money that they would have otherwise invested in a taxable account is definitely a tax savings.
AJ
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I’ve long heard this and never really analyzed it (just accepted it), but it doesn’t really make sense to me.
From the article:
“If you put your money in a traditional IRA, you’re deferring the marginal tax rate (the upper tier tax bracket) so you can pay the effective tax rate (the average rate) in retirement. In other words, you’re saving yourself 22% in taxes today if you agree to pay a 9.8% tax in retirement (assuming the same income and same tax rates). Ummm … yeah, I’ll defer taxes! But if you invest in a Roth, that means you’re paying 22% tax today so you can save 9.8% in retirement. No thanks. Bad deal!”
If my entire traditional 401k contribution would otherwise taxed at 25% (future tax rates) and I defer that, but in retirement, if my other non-IRA income puts me into the 25% marginal bracket, I am not actually paying the effective tax rate as that traditional 401k money is distributed, I am paying the 25% marginal rate for each additional dollar.
If I assume the same rates and income, as the article states, then there are no tax savings. There will ALWAYS be income* that is taxed at 25%.
*Ignoring the special tax nature of Social Security.
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I think the issue is a misunderstanding right at the top of the article.
A new survey … found that 92% of Americans think they should be investing in a Roth IRA.
I also believe most people should be using a Roth IRA (or Roth 401k). But I also believe that should not be your sole investment vehicle. You need both a traditional IRA/401k and a Roth IRA/401k.
Very early in your career - even pre-career - Roth makes the most sense. You’re in a low tax bracket, but anticipating a retirement that has more income than today. As you get into your higher earning years, the traditional IRA/401k accounts are more likely to be beneficial. You may be in the highest tax brackets of your life, so that is the time to take the tax break offered by the traditional accounts. Late career, perhaps you cut back at work but keep working. That may again be the time to contribute to Roth accounts. Or you might retire but delay social security and use that time to convert some money from Traditional to Roth at low tax rates. And any time during your career if you find yourself temporarily out of work, that’s again an opportunity to convert at lower rates because of the low income.
Each year stands somewhat on it’s own. Do I contribute to Roth or traditional accounts? And each year the answer can be different depending on the circumstances of that year.
With the benefit of hindsight - which this author seems to be doing - you can always see where your choice of Roth or traditional accounts may have been wrong. And it’s very likely that ending up with everything in one account or the other will turn out to be the optimal choice. But since we still lack time travel, you have to choose based on what you know at the moment.
The author does get into the right analysis when talking about marginal vs. effective tax rates near the end. But she glosses over the difficulty of that analysis. In retirement, you may have other sources of income - interest and dividends from after tax accounts, social security benefits, pensions. Any IRA/401k withdrawals stack on top of that. So you have to look at the whole picture. Plus there is the possibility of large medical deductions as we age. In a year with large medical expenses, that can help offset large traditional IRA/401k withdrawals.
But in general, it’s a decent article with a click-bait title that barely scratches the surface of the complexities in making the Roth vs. traditional decision.
The only real error you can make is choosing not to save at all.
–Peter
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Thanks Peter.
I think your points do a better job of capturing what I was struggling to capture without those time-value-of-money sketches drawn to model each situation.
@RHinCT - Your argument I understand.
At least, I’m interpreting
During the accumulation years - advantage: tax deferred accounts
During the post working years - advantage: Roth ac
Back end of accumulation years - look at moving funds from tax deferred to Roth ac.
I’m not so sure.
I would say, while you are in the lowest tax bracket or 2, use the Roth to its limit then deferred if you can afford to.
As you move to higher brackets in your earning years, the deferred accounts are more useful.
Post earning years, convert to Roth within the limits of your best tax bracket.
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I maxed the Roth.
Then, knowing that Traditional IRA, 403b and 401k are taxed as NORMAL INCOME at whatever your marginal rate, I put the rest into Individual (taxable) brokerage account where I could hold for long term capital gains tax rates.
ralph
Maybe I missed this up thread, but one advantage of a Roth over Traditional IRA’s is the Roth gains are never taxed, where as the Traditional gains are taxed when withdrawn.
Not exactly. If you meet the requirements, withdrawals from Roth accounts are not taxed. But not all withdrawals meet the requirements - so to just say ‘Roth gains are never taxed’ is not totally correct - they can be taxed if you don’t meet the requirements.
For instance, Roth 401(k) distributions do not follow the same ordering rules as Roth IRA distributions do - Roth 401(k) distributions always include both original contributions and gains. That means if someone is using the Rule of 55 to take Roth 401(k) distributions at an age earlier than 59 1/2, the gains portion of the Roth 401(k) distribution will be taxed because it is being withdrawn early. The penalty is waived because of the Rule of 55 - but the taxes on the gains are not waived.
I would also say that the statement that “Traditional gains are taxed when withdrawn” is not totally correct either. It’s not just the gains that are taxed - it’s the entire distribution that is taxed.
AJ
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@Neuromancer - given that I did tax-deferred (@ work) and Roth ac (personal), not going to quibble on the issue. As ptheland suggested upstream, it is useful to have some combination of the two.
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