Comment on 401(k)

[insead_hec]

angerona asked What do people think about the usefulness of having a Roth 401(k) account?

The summary of my comments is:

Roth 401(K) vs. 401(K):
Standard 401(k) makes sense if it is your only major investment now and you expect to remain in the same tax bracket or even get into lower tax bracket.

Roth makes sense in the following situations:
a) Pretty obvious: Your current tax bracket is below the one you expect to be in when you retire. Applies to young people starting their careers.
b) you want to diversify the risk of higher tax rates in the future (who knows, what will happen with tax rates in just few years)
c) Less obvious: You're relatively wealthy person, who in addition to investing (up to the cap) into retirement plans makes other investments. In this sense it makes sense to invest into Roth 401 K instead of 401(k) even if you expect to remain in the same tax bracket when you retire, because otherwise you pay taxes twice on any other (non-401 (k) type) investment.


The current annual limit of personal constribution is $ 15.5 K for both plans. This is imposed by IRS. For simplicity Let's say that the cap is $ 15 K, and that my current marginal rate is 25%. So, my $ 20 K pre-tax is equal to $ 15 K post-tax.

Suppose I have $ 20 K of pretax money to invest.
With 401(k) I invest $ 15 K pretax, pay $ 1.25 K taxes on remaining $ 5 K, invest remaining $ 3.75 K into a mutual fund, where I keep it until retirement (in reality if the mutual fund pays dividends, I'll pay taxes on this dividends immediately)). When I widthraw my pre-tax investment from 401(k) I will pay the taxes on both $ 15 K and all the capital gains. When I withdraw the money from the mutual fund I will pay taxes on capital gains/dividends again (I have invested money after tax!)!

If I choose Roth 401(k), then I pay taxes on $20 K and invest $ 15 K (the limit) in Roth 401(k). I will never pay taxes on this money and income on this money again.

If future effective marginal rate for me will be the same as my current effective marginal rate, then Roth 401(k) is strictly better.

Someone might say - "Roth is better - as I said." And for relatively wealthy people this is true.

However, almost all my future income will be coming from retirement account.

When I just started your career in the U.S., even with a decent salary, let's say the same hypothetical 25% marginal tax bracket I was facing the choice:
If I put my first $1 in Roth 401(k), it will be taxed at 25% immediately. 25 years from now it will give me 0.75xe^25r, where r is my annual rate of return.
I claim, that if I invest the same first $1 into 401(k), I claim that I will get 1xe^25r. Why? Because this dollar will be my only source of income and it will be 100% tax deductible.

Question to a tax expert - is this true? If it is true and the retirement income is subject to the same tax rules as an ordinary income, even if it comes from investments, then I should not start investing into Roth 401(k) until the pool of my retirement money won't become big enough.

Comments?

Comments

[saccovanzetti.livejournal.com]

Why would your regular 401k distribution be tax-deductable ?

[insead-hec.livejournal.com]

If my only income in that year is 1 dollar distribution from my retirement account, what will be the tax rate on it? Isn't it subject to standard deduction? I don't know the answer to these questions.

[saccovanzetti.livejournal.com]

Why is it just $1 and not, say, $20,000 a year (in todays' money, actual may be 5-10 times higher due to inflation) ?

[insead-hec.livejournal.com]

I guess you meant "return", not inflation, but never mind.

Suppose I expect to leave for 10 years after I retire. In order to have $ 20 K (nominal, not real) per annum for 10 years and assuming 10% annual return on my investment, I'll need about $ 135 K 25 years from now. If I invest $ 12.5 K in my 401(k), it will give me this amount in 25 years, and because of inflation (I do mean inflation) this amount will probably less than standard household deduction in 25 years, meaning that it is tax free. So, what is better to do now - invest 12.5 in 401(k) and get $ 20 K of after-tax annuity for 10 years starting 25 years from now or invest $ 9.375 K (after paying taxes on 12.75) in Roth 401(k) and get $15 K of after-tax annuity for 10 years.

Next year I will have to make the decision again, knowing that I'll have only 24 years of investment and that this money will come on top of the money already invested, so the marginal tax rate for this money might be higher than 0%, but most likely still less than current 25%.

However, there is a question I don't know the answer to, because I am a finance guy, and not a tax guy - when 25 years from now I will receive $ 50K distribution from my 401(k) account, what tax rate will be applied to it? And even a more complicated question - if part of this money will be coming from Roth and part from regular 401(k), how will it be treated?

Off-topic, BTW, it's a small world - only few people, whom I know in real life have an LJ account that I would know about, but one of them is your LJ-friend!

[saccovanzetti.livejournal.com]

The 401k distributions are just ordinary income after deductions, afaik. Roth 401k distributions are not taxed at all.

Let's assume for the sake of the argument that there is no inflation.

If you had been investing for 25 years 12.5% of your 100,000 salary, you would end up with about $800,000 at 6% annual rate of return.

To distribute that over 10 years, you would get an annual payment of 107,000. Since we assumed no inflation, it will be taxed at pretty high rate - higher than your rate now, actually, since your adjusted gross is 100,000 - 12,500 = 87,500 while you are working.

With inflation, calculation is the same, but you have to use something like 10.4% annual rate of return.

[insead-hec.livejournal.com]

I never said "invested 12.5 over 25 years".

This year you decide what to do with this year's plan. So it's not an annuity, but a future value of this year's contribution. Next year you have to make this decision again (theoretically speaking you can make it every pay period if your plan allows it, but it's too much), but adjusting for the fact that you will already have something in your retirement portfolio. It means that at some point Roth can become more attractive, then you'll switch to Roth. Maybe it depends on employer, but in my case you can have both 401(k) and Roth 401(k) at the same time.

[saccovanzetti.livejournal.com]

Makes sense now, thanks. You are right - if I stop contributing in 10 years for some reason, regular 401k now is much better.

[saccovanzetti.livejournal.com]

"Social Security benefits

There are other reasons you'll probably want to have at least some money in both types of accounts. Although Roth 401(k)s have the same withdrawal requirements as regular 401(k)s, by rolling over your Roth 401(k) into a Roth IRA, you can avoid having to make required withdrawals in retirement. And unlike withdrawals from a regular 401(k), withdrawals from a Roth 401(k) don't count when determining whether your Social Security benefits are subject to income taxes."

http://money.cnn.com/2008/01/07/pf/expert/expert3.moneymag/index.htm?postversion=2008011009

thanks!

[insead-hec.livejournal.com]

I didn't know that. Thanks, "Bart"! For me 401(k) is still better for now, but in the future - who knows?