Switched my 401k Contribution to Roth 401k

I am already on track to max out my 401(k) for 2008 at $15,500 in annual pre-tax contributions. However with the significant stock market declines I was thinking about how I could step it up a notch.

I decided to switch my remaining contributions for the year from pre-tax 401(k) contributions to Roth 401(k) contributions. While I will lose the tax deduction and technically I will be investing the same amount, this will allow me to net more from these investments, since I won't have to pay taxes on them. This should be magnified even more since I expect the returns on these investments to be higher.

If you assume that these investments (post-correction) will ultimately return more then previous investments (pre-correction) because they were invested at a much lower price point then switching to Roth 401(k) makes a lot of sense. Since these new investment returns would be significantly higher I should go ahead and pay income tax on them now, so I can reap the higher returns tax free.

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Comments (13)


what's the difference between a Roth IRA and Roth 401k?

That seems like a good move.

If you haven't already, there's still some time left to beef up your IRAs.

I have a few comments to make on this.

Firstly, there is nothing that says you cannot contribute to a Roth in addition to your 401(k.) Is 15,500 some magical number for you, or is it just budgeted that way for the year? I am attempting to contribute additionally to my Roth, since I am on pace, like you were, to reach the 15,500 threshold by year end, but I don't know if moving from 401k to Roth is necessarily the best option.

You are making assumptions about your retirement income and the income tax rates you will experience in retirement that is, at best, a total guess. The only thing for certain is that the Roth gives you options... It is not to have the option of money in an account with no tax due, as well as no minimum required distribution per year. Look at your Roth as a 'diversifier' to handle income tax rate changes or retirement income changes. It gives you options, and that is its strong point, since you cannot predict the future tax rate or your future retirement income in any meaningful way.

derringer - He's talking about a Roth 401k; not a normal Roth IRA or a traditional (pre-taxed) 401k. And 15500 is the max you can contribute to a 401k plan (traditional or otherwise) in a given tax year.

"And 15500 is the max you can contribute to a 401k plan (traditional or otherwise) in a given tax year."
Clarification: 15,500 is the max that the employee can contribute. If you are a single owner company and have a solo 401k, the employer contribution can be up to 25% of your salary.

The absolute first good investment decision he's made in the last 6 months.

The Roth not only adds flexibility, but allows him to buy equities or options and take long / short positions with retirement income. Not paying taxes while being able to leverage all that flexibility is a great way to hedge sagging long positions in volatile times like these.

Personally, I contribute $$ to max my Roth IRA ASAP after the calendar year begins and THEN change over to contribute to my 401K. To each their own.

I would think with 2mil's high income, a traditional 401k would be a better move.

Yes I am talking about Roth 401(k), not Roth IRA. We already contribute equal dollar amounts to our Roth IRA to max them out. I have just switched our remaining contributions from the traditional 401(k) contributions to Roth 401(k) contributions.

CPA1298 - Yeah i am not sure. I guess it depends on what you mean by high income? My situation has change significantly over the last few years (with a wife who currently has no income for 2008). Given the complexities of the international assignment tax situation/equalization provided by my employer I decided not to overthink it. In theory if their was no international assignment I would have less taxable income than previous years since my wife hasn't worked this year. So I decided to test the waters.

2mil - I thought you were making around $100,000/yr, which is pretty solid. Your move is probably a decent one with the non-working wife, as I think over our working lifetimes (I'm 28) income tax rates are sure to rise. However, I would not be surprised to see Roth balances become taxed at some point in the future (as Social Security benefits became taxed within our lifetimes)

I don't think it's worth the hassle of changing from an employer 401K to a Roth 401K...I must not have been paying attention when I read this the first time.

I don't know about IBM's 401K investment selections, but being tied to an employers vehicles means you have less options for your investment decisions.

I was thinking he had decided to fund a Roth IRA outside of work and cease his 401K investment for the current time.

A self-managed retirement account in E*trade or another brokerage would yield greater flexibility.

Mathimatical calculations can be quite complex with regard to roth 401k vs normal 401k. There are some reasons to invest in a roth 401k vs normal 401k. However, I don’t follow you how “high expected return” makes the roth 401k preferable to a normal 401k. Perhaps you can provide an example to illustrate? I will illustrate:

Scenarios with $1000 investment and assumed 25% tax bracket. (all variables are constant except rate of return and 401k type)
1) 401k with 10% gain
2) 401k roth 10% gain
3) 401k with 20% gain
4) 401k roth 20% gain
Scenarios results after all tax paid.
1) 825 (1000*1.1*.75)
2) 825 (1000*.75*1.1)
3) 900 (1000*1.2*.75)
4) 900 (1000*.75*1.2)

The difference with a Roth vs. a Traditional 401k is only really noticable when you retire and begin to draw upon that money.

With a traditional 401k or IRA, you will build up money a bit faster (since taxes are not being deducted up front, so you can afford to deposit more in the beginning). However, when you withdraw the money (and you are forced to take withdrawals at age 70.5, even if you have money elsewhere that you could live off of without touching these funds) the government will take out taxes.

With a Roth 401k/IRA, you will often have a bit less to invest initially (due to taxes being taken out up front) but you are not forced to take a withdrawal at a specific age, and any money that you do withdraw is not taxable.

If you expect to pay the same or a lower tax rate when you withdraw your money, a traditional IRA is probably the better choice. If you believe that your tax rate may end up being higher, you are better off to invest in (or converty to in this case) a Roth account.

Given that the federal debt is over $35,000 for every man, woman and child currently alive in the US, and it is growing rapidly, I happen to expect taxes will have no place to go but up by the time I retire. At some point the government is going to have to start cutting back on expenditures (read: Reduce payments to people receiving assistance such as Medicare, Social Security and Welfare) and increase income (more taxes) to pay it down. With million of people set to retire and begin to draw heavily upon Social Security (the Social Security trust fund is owed almost 50% of the government's debt) and to cash in Bonds and T-bills, the government will be hard pressed to continue to borrow as it has been.

I agree with Robert's comments that the choice between Roth 401k and Traditional 401k depends to a large degree on whether you expect your future tax rates to rise or fall.

Austan Goolsbee (University of Chicago professor and one of the chief econ advisors to the Obama campaign) wrote a good article about the tax risk with traditional 401k plans several years ago in the NYT, and the link is still available here:

http://www.nytimes.com/2006/11/09/business/09scene.html?ei=5090&en=2e5d7dd43f395805&ex=1320728400&adxnnl=1&partner=rssuserland&emc=rss&pagewanted=all&adxnnlx=1226703708-CGDLq2iZOZ5ReezqpiBjzg

The Roth 401k helps you avoid the "political tax risk" he mentions (unless the rules change!)

Another important difference is that you effectively have a higher contribution limit with the Roth 401K because the $15,500 is after tax. So, it cost you more current income to max out your contribution because you must pay the taxes first, but you will have more after tax money at retirement than you would with the $15,500 pre-tax contribution in a traditional plan.

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