Choosing a Roth IRA or 401k for investment purposes Part 2

This is part 2 of a two-part series for choosing a Roth IRA or 401k for investment purposes. Part 1 is available here.
This part uses math to reason out why we would want to choose a Roth as the primary retirement account as opposed to the 401K.
One additional reason that i didn’t mention in the first part to have a Roth instead of a Traditional IRA or 401K, is because Roth IRA distributions currently do not affect your Social Security checks1. In other words, if you use Roth IRA to fund your retirement prior to or after you have started your Social Security withdrawals.

After analysis of our tax situation, we feel it is in our best interest to try and fully fund a Roth IRA for each of us. The reason for it is rather simple. Our effective tax Federal tax rate is very low for at least the next 5 years. While the tax savings could be 53.37% less than our tax rate at the minimum amount necessary to get the company match in the 401K, it is still pretty minimal.

Below is a table which shows the effect on our taxes at the different rates. To simplify this, I simply used the current taxes we paid for 2013, and modified my W-2 information that was in TurboTax. All I had to do was to adjust the Box 12C value (retirement contributions) up or down to reflect the change necessary to show either more or less 401K withdrawals from my paycheck, and adjusted the Box 1 values (Wages, Tips and other compensation) up or down as necessary to reflect the change of putting away more, or putting away less into the 401K. In case anyone needs clarification, when I increased the Box 12C value I decreased the Box 1 value.

Contribution rate Effective
Tax Rate
401K Roth2
4% 100% 3.26%
5% 91% 3.14%
6% 82% 3.00%
7% 73% 2.87%
8% 64% 2.74%
9% 55% 2.62%
10% 45% 2.45%
11% 36% 2.31%
12% 27% 2.16%
13% 18% 2.00%
14% 9% 1.84%
15% 0% 1.69%
16% 0% 1.52%

As you can see in the table above, contributing more to the Roth IRA in our case shows that we will be paying 53% more in taxes (effective tax rate 3.27% – 1.52% = 1.74%). However, the 1.74% is well worth it if we are successful in getting our Roth IRAs up to the amount that we believe is easily achievable in the coming 15-20 years. If one could get anywhere near $500,000 or more and if you could sustain earnings of 6%-8%/yr and withdrawing that much each year, one could completely avoid paying taxes altogether on the withdrawals from the Roth and not affect your Social Security checks if they are still there to receive.

Here is the same information presented in a graphical format, since some folks work better with pictures.

Effective Tax Rate versus 401K contributions for our specific tax situation

Effective Tax Rate versus 401K contributions for our specific tax situation

Footnotes:
1 A couple of links that show SS income is not lowered based off of Roth IRA withdrawals: Fidelity, Fairmark
2 Percentage of maximum allowed to put into a Roth in 2013 is $5,500 for single (or married filing separate), or $11,000 for married filing jointly. The rate is rounded off to the nearest percentage, so 90.9% is simply adjusted to 91%.

Choosing a Roth IRA or 401k for investment purposes Part 1

This entry was posted in 401k, financial directive, Income or Pay, Income Tax, IRA, Retirement Savings, Roth IRA, Social Security and tagged , , , , , , . Bookmark the permalink.

11 Responses to Choosing a Roth IRA or 401k for investment purposes Part 2

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  7. Ben says:

    One more positive about the Roth…unlike a traditional IRA you’re not required to begin taking Roth distributions after age 70 1/2. Obviously you’d need to make it with other forms of income but this is a good thing for your potential heirs.

    • Absolutely true Ben.
      I often wonder why they legislators have picked the age of 70 1/2 for the IRAs, and 67 as the maximum for SS benefits. Personally, I believe I’d start drawing on SS before the IRA anyway, but why pick age 67 for those born in 1960 and later?

      • Ben says:

        Good luck figuring out the legislator’s reasons for this stuff. I’m sure there’s no rhyme or reason. You wonder if eventually the SS age will go up and the IRA age will go down (so they can get their tax payments sooner). Another positive for the Roth I guess. Don’t have to worry about it.

  8. Pingback: Choosing a Roth IRA or 401k for investment purposes | Rich In The Heart

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