401K vd Brokerage Account

[beanmaestro]

Makes sense. My only concern is that it seems that this transfer is making a tax wager that your *marginal* tax rate now will be lower than your *average* tax rate in retirement, when you may very well have less (relative) income and more deductions than you do now.

Although I agree income taxes will probably go up, I have trouble believing they would go up that much. For instance, we now pay marginal (state + fed) income taxes of 34% vs. average taxes of about 20%. Now, this might be a fantastic idea if I leave my job and take a year off, allowing the conversion at a very low tax rate, but it seems dubious at the full rate.

[beanmaestro]

Makes sense. My only concern is that it seems that this transfer is making a tax wager that your *marginal* tax rate now will be lower than your *average* tax rate in retirement, when you may very well have less (relative) income and more deductions than you do now.

Although I agree income taxes will probably go up, I have trouble believing they would go up that much. For instance, we now pay marginal (state + fed) income taxes of 34% vs. average taxes of about 20%. Now, this might be a fantastic idea if I leave my job and take a year off, allowing the conversion at a very low tax rate, but it seems dubious at the full rate.

[New Guy]

Another vehicle to be considered and is relatively new is the Roth 401(k). It works very similar to a Roth IRA with a few exceptions. The Roth 401(k) is issued through your employer and is NOT subject to income restrictions like a Roth IRA (i.e. individual income max of $108K or whatever the threshold is).

An employee can also contribute up to $15,500 of after tax dollars to this account which grows untaxed throughout its life and is untaxed at withdrawal exactly like a Roth IRA (assuming you withdraw at 59.5 or later).

An employee can contribute to both a traditional 401(k) and a Roth 401(k) however the total of the two accounts can not exceed $15,500.

Most employers do not yet offer this but it is becoming increasingly popular. In fact my employer is introducing the plan effective 1/1/08. I would would recommend pushing your human resources to offer this vehicle as it offers amazing tax saving potential.

[New Guy]

Another vehicle to be considered and is relatively new is the Roth 401(k). It works very similar to a Roth IRA with a few exceptions. The Roth 401(k) is issued through your employer and is NOT subject to income restrictions like a Roth IRA (i.e. individual income max of $108K or whatever the threshold is).

An employee can also contribute up to $15,500 of after tax dollars to this account which grows untaxed throughout its life and is untaxed at withdrawal exactly like a Roth IRA (assuming you withdraw at 59.5 or later).

An employee can contribute to both a traditional 401(k) and a Roth 401(k) however the total of the two accounts can not exceed $15,500.

Most employers do not yet offer this but it is becoming increasingly popular. In fact my employer is introducing the plan effective 1/1/08. I would would recommend pushing your human resources to offer this vehicle as it offers amazing tax saving potential.

[beanmaestro]

Well, okay, let’s take your above scenario, but I’ll use a 30% marginal tax rate, since this seems more accurate for us.

I start with $30k in cash, and $100k in a 401k/Trad IRA.

Scenario 1:
Convert the $100k to a Roth IRA, pay the $30k in taxes.
Wait 25 years at 10% annual return, balance 1083k

Scenario 2:
Keep the $100k in 401k, put the $30k in an index fund
401K: Wait 25 years at 10% annual return, balance 1083k
Index fund: Wait 25 years at 8.5% after-tax return, balance $231k
Total: $1314k before taxes. An average tax of 17.6% will result in a wash. For comparison, if my my wife and I only needed to withdraw enough to pay our current bills, we’d be looking at around a 10% average tax.

Analysis: I’m not convinced my average taxes would necessarily be that high in 25 years. Even if marginal rates are up, I’ll only be withdrawing what I need to pay my bills, I’ll have a house to write off, and I can tap my normal Roth each year to reduce exposure to the nasty tax brackets. And the $231k has already been partially taxed, and will owe less than full cap gains tax when it’s redeemed.

Now, the clever way around this is to do these conversions in a year when you are intentionally unemployed, so your marginal tax rate is very low for the conversion to Roth. Then you pay almost no tax at all. You just have to hope that you can find a job when the year is up.

Of course, this all assumes we’ll have a tax structure that faintly resembles our existing system. The house write-off might not exist. There might be an extra deduction for the elderly. We might have a flat tax, or a VAT tax instead. There may be no cap gains tax, or it may be treated just like income. We might live in burbclaves that don’t care about 1040’s and Roths and just collect a flat head tax.

So, on balance, it’s probably good to put more than $4k a year into Roth-type accounts, but I’m far from sold on doing this with a large chunk of it. And I’m still curious about the rules for accessing converted principal.

[beanmaestro]

Well, okay, let’s take your above scenario, but I’ll use a 30% marginal tax rate, since this seems more accurate for us.

I start with $30k in cash, and $100k in a 401k/Trad IRA.

Scenario 1:
Convert the $100k to a Roth IRA, pay the $30k in taxes.
Wait 25 years at 10% annual return, balance 1083k

Scenario 2:
Keep the $100k in 401k, put the $30k in an index fund
401K: Wait 25 years at 10% annual return, balance 1083k
Index fund: Wait 25 years at 8.5% after-tax return, balance $231k
Total: $1314k before taxes. An average tax of 17.6% will result in a wash. For comparison, if my my wife and I only needed to withdraw enough to pay our current bills, we’d be looking at around a 10% average tax.

Analysis: I’m not convinced my average taxes would necessarily be that high in 25 years. Even if marginal rates are up, I’ll only be withdrawing what I need to pay my bills, I’ll have a house to write off, and I can tap my normal Roth each year to reduce exposure to the nasty tax brackets. And the $231k has already been partially taxed, and will owe less than full cap gains tax when it’s redeemed.

Now, the clever way around this is to do these conversions in a year when you are intentionally unemployed, so your marginal tax rate is very low for the conversion to Roth. Then you pay almost no tax at all. You just have to hope that you can find a job when the year is up.

Of course, this all assumes we’ll have a tax structure that faintly resembles our existing system. The house write-off might not exist. There might be an extra deduction for the elderly. We might have a flat tax, or a VAT tax instead. There may be no cap gains tax, or it may be treated just like income. We might live in burbclaves that don’t care about 1040’s and Roths and just collect a flat head tax.

So, on balance, it’s probably good to put more than $4k a year into Roth-type accounts, but I’m far from sold on doing this with a large chunk of it. And I’m still curious about the rules for accessing converted principal.

[Raybyrnes]

Very interessting concept. I will not try to point out any problems right now because it seems that you have this game well thougtht out.

Part of the reason I have chosen to leave money in previous 401K’s is becasue I have have had access to some quality Mutual funds and felt that when I rebalanced or chang funds I avoided paying comissions. I try to rebalance 2 times a year. I have attempted to aggregate my portfolio excluding only the 529 which I opened in my parents name because they get the tax deduciton in NY. By aggregating everything together and then reallocating it oftem times means that there are a number of trades going on and by keeping them in the 401K I avoidhaving to commissions while simultaneously allowing me to take on a level of risk i am comfortable with.

[Raybyrnes]

Very interessting concept. I will not try to point out any problems right now because it seems that you have this game well thougtht out.

Part of the reason I have chosen to leave money in previous 401K’s is becasue I have have had access to some quality Mutual funds and felt that when I rebalanced or chang funds I avoided paying comissions. I try to rebalance 2 times a year. I have attempted to aggregate my portfolio excluding only the 529 which I opened in my parents name because they get the tax deduciton in NY. By aggregating everything together and then reallocating it oftem times means that there are a number of trades going on and by keeping them in the 401K I avoidhaving to commissions while simultaneously allowing me to take on a level of risk i am comfortable with.

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