When to contribute to Roth 401k?

Submitted by h_VM1_ t3_10016s5 in personalfinance

I started my career later than usual (28) and for the last 3 years I‘ve been contributing to both pre-tax and post-tax 401k via my company. Recently, I had a large salary increase to ~$136k gross/year and I contribute about 7% to my pre-tax account, 5% to my Roth account and I get 100% employer match at 3% which is about 15% total contributions. I understand the concept of why one should/shouldn‘t contribute to a Roth 401k, but I wanted to explain my understanding and get your advice. After running the numbers, I realized that, with inflation and continuing on my current path, my withdrawals in retirement would be in the same tax bracket that I am currently in (24%). Obviously if I continue on my current trajectory of increasing my salary until retirement, at some point I will be in a higher tax bracket than when I will withdrawal and at that point I should decrease the amount I put into my Roth 401k and put that into my pre-tax 401k, right? But what I’m wondering is if I should I do this already in 2023? In addition to that, I should be doing the backdoor Roth IRA method with the smaller amount I will continue to contribute to my Roth 401k, right? Or should I first focus on maximizing my 401k contributions first before I worry about any IRAs? For context, I am paying off student loans and trying to save up for a house so I am currently not maxing out my 401k contributions because that money is going into a HYSA.

Thanks all for your time!

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DeluxeXL t1_j2etykk wrote

Do you expect the highest tax rate during retirement to ever exceed 24%? If not, do 100% traditional 401k followed by Roth IRA.

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h_VM1_ OP t1_j2eu6yz wrote

Isn‘t there an inherent concern that the tax brackets may change/increase in the next ~30 years so that I should put at least a little towards a Roth 401k? Or is that where the Roth IRA comes in?

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DeluxeXL t1_j2euf07 wrote

That's where Roth IRA comes in.

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h_VM1_ OP t1_j2evb0u wrote

And to clarify, „100% traditional 401k“ you mean that I should first max out and contribute 100% of the money to a traditional 401k before I worry about the Roth IRA, right?

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MonsieurVox t1_j2extbi wrote

It's an inherently hard question to answer because we don't know what future tax brackets are going to look like. Future tax rates are a key variable and is one of the most important factors, but without a crystal ball we have no way to make that determination.

I can give you my personal take: I'm in the 32% tax bracket and max out my Traditional 401k to lower my taxable income each year because I don't think I will be paying more than that in retirement. If I do, oh well, I'll pay some taxes in retirement. It's a personal calculated risk that I'm willing to take.

From there I put everything else that I can into Roth and after-tax investments to get me to a ~25% savings rate. My after-tax account will be my bridge account for early retirement (hopefully) and sinking fund for large purchases like house down payments and cars.

What I would personally do in your situation to help guide my decision is this: Take your salary and investment rate and run it out until the age you expect to retire. Assume an 8% rate of return, and a 3% average annual pay increase. It'll be less than that some years and more in others (promotions, etc.). Once you have that number, take 4% of it (the safe withdrawal rate) and compare that to what you'll be earning before you retire.

In that scenario, is 4% of your nest egg more or less than your annual earnings before retirement? If it's more, assuming tax brackets stay the same, you'd be better off going the Roth route because you'll get a pay raise by retiring and it will be completely tax free. If tax rates increase between now and then (likely), even better. If 4% is less than your annual earnings, then Traditional would be the best route (again, assuming tax rates stay the same). If tax rates increase between now and then, it gets kind of fuzzy.

Ultimately there's not a definitive, clear answer. What is clear, though, is that if you consistently contribute 15-25%+ of your income from now until retirement, you're going to better off than 90% of the population. Getting hung up on minimizing your tax liability in 30+ years is a bit of a fool's errand because there's no possible way to know the data you'd need to make the right decision: your income, your rate of return, and future tax rates. You can make educated predictions based on the past, but this is a true example of a situation where hindsight will be 20/20.

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h_VM1_ OP t1_j2eyd0k wrote

This is very helpful and eases my worries. Thanks!

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pancak3d t1_j2ez516 wrote

At 136k income, every dollar you put into a traditional 401k, you're guaranteed to save 24 cents on your tax return.

People often think "well taxes might rise in the future so I could pay more than 24% in retirement"

There's almost no chance. Here's why.

When you pull out, let's say, 80k to live on during retirement

That's currently the 22% marginal bracket. But heck, maybe for whatever reason, congress decided low and middle class Americans (income 41k-89k) need to pay a lot more taxes. They up it to 30%. Dang, my traditional 401k was a mistake! 30% is higher than 24%.

But guess what. You don't pay 30% on all 80k, because that's not how taxes work. Ignoring social security here for simplicity:

First you get a standard deduction and pay 0% on the first 13k.

Then you pay 10% on the next 10k.

Then you pay 12% on the net 30k.

Then you start to pay the 30% on the remainder.

The effective tax rate you paid on that 80k withdrawal is around 15 cents per dollar. If you had used a Roth 401k you would have paid 24 cents on every dollar.

Congress would have to pass very significant tax increases on the lowest income Americans for the traditional 401k to become a bad option -- or, you end up with a bunch of ordinary income during retirement which skyrockets your effective rate.

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