My tax bracket

[Guest Wedge1]

I make a little over 36,000 per year. I started working for a large corporation last year after leaving behind a successful family-owned business. I have a masters degree in operations management and 30 years of work ahead of me before retirement.

I am single, no children, but would like to marry some day.

I recently switched my contributions from my company's 401K to a Roth 401K. I do know that I am taxed more than a married man with children, so I am unsure if I made the right decision to contribute only to the Roth 401K. I would have more money going into the 401K if I chose that option. But I feel that later in life my tax bracket will be higher than it is now, and that the Roth will be more beneficial.

Can anybody elucidate the things I should consider in making this decision? I want to be sure that the Roth 401K is best for me.

[J Simmons]

Wedge1,

It's not just a comparison of the tax burden later in life compared to now, but more precisely the tax burden you expect during that phase of your life when you'll withdraw and use the retirement savings as compared to the tax years you save into the plan.

If you expect that your tax burden on these dollars you're saving into the retirement plan this year will be greater at the time of withdrawal than the tax burden on the dollars going into the plan this year, then for this year's retirement savings the tax burden factor would point towards Roth'ing this year's savings into the plan. Because your tax burden likely changes from year to year, you should re-evaluate this factor each year when making the decision to Roth or not your retirement savings.

Also consider that if you do pre-tax savings for retirement, you yet have a powerful Roth option later: converting the pre-tax benefits to be Roth.

Once you have the option to withdraw your benefits from the employer's plan, you can manipulate the timing and circumstances of the tax on non-Roth benefits (either through exercise of your right to leave the pre-tax benefits in that plan for a time or through rollover to an IRA). For tax years you meet some qualification rules, you can convert the pre-tax retirement benefits to be Roth IRA benefits. The upshot, you can pick from among a number of years to pay the taxes on those benefits, and can try to pigeon-hole it into the year you will likely have the least tax burden.

You might wait until the market value of the benefits dips--you'd be paying taxes on a lesser amount, and the market value rebound post-Roth conversion would all be tax free if not withdrawn until permitted under the Roth qualified distribution rules. What if the market goes down even further after you convert to a Roth, under certain limitations, you can once do a Roth do-over and perhaps be taxed on benefits valued even at the lower market value.

You might wait until right after a tax cut takes effect. Tax rates inch up over years, but usually drop dramatically when a tax cut is enacted. Generally speaking it's better to pay taxes at the low rates right after a tax cut than when higher as they inched up over years that you were saving as Roth 401k.

Also, where will you be a resident at the time of conversion? Maybe you are working and earning the money while in a high taxing state and city, but plan to retire to Nevada or some other state where there's no state income tax. If you save into the plan on a pre-tax basis, you avoid those high state and city taxes where you are now living. Then wait until after you've truly established residence in the state with little or no income tax and pull the Roth conversion trigger. You could save a bundle. But residence for this purpose is not necessarily changed just by getting a new address, bank accounts and driver's license. Those matters factor in, but it's whether or not you are living in that state with the present intent to stay there indefinitely. Get an attorney's opinion of where your residence is before choosing the Roth conversion.

In short, saving in the Roth mode is not as flexible and doesn't present as many opportunities for tax savings as saving in the pre-tax mode does because of the Roth conversion option later--but depending on your individual situation, saving in the Roth mode might yet be better for you.

[Guest Wedge1]

Could you point me to a web site or text book that engages this decision process in detail? I understand some of what your saying, but not all. You are referring to a 401K as possessing a benefit of having a certain portion that might later be rolled into an IRA, and that is brand new to me. Obviously, I have a lot more to learn about this and any literature that covers this topic would be most helpful.

[wsp]

Could you point me to a web site or text book that engages this decision process in detail? I understand some of what your saying, but not all. You are referring to a 401K as possessing a benefit of having a certain portion that might later be rolled into an IRA, and that is brand new to me. Obviously, I have a lot more to learn about this and any literature that covers this topic would be most helpful.

benefit = balance.

The thought is to begin contributing to a 401k now because it gives you options. You aren't having to make the choice because you can always contribute to a 401k now and convert that balance to a ROTH down the road simply by choosing to pay taxes on the account. But you can't do the transaction in reverse if it turns out that the 401k would be better. Think of it as 401k contributions having a 'Y' in the road somewhere ahead. When you reach the 'Y' you can choose to convert to a ROTH or leave it as a tax deferred option. However, if you go down the ROTH road then you don't have the luxury of changing your mind.

When you convert to a ROTH would be dependent upon the factors that j simmons states: Tax rates in effect at the time, possibility of tax cuts in the short term future, market timing, state income tax, possibility of the discontinuance of the ROTH option and many other reasons. It's up to you and your tax advisor to determine when/if the time is right for you.