401(k): Roth vs traditional + new 401(k) rules as of 2015

[mark-ER]

First, the silly question. I know, I can look it up/research it myself & should know better but it's a crazy busy day of service work. My residency offers both pre-tax and after-tax 401(k). From some basic reading, I think pre-tax is an equivalent to a traditional IRA: decrease your salary now (ie lower tax burden now), investment grows tax free, but you pay taxes at retirement. Conversely, after-tax 4o1(k) is equivalent to a ROTH IRA: does NOT decrease your salary or tax burden now, but investment grows tax free, and you can withdraw both principal & gains tax-free at retirement. Also if rolled over to a ROTH, no minimal distributions, right? Can someone confirm this interpretation is correct? And please, someone who knows finance & not just Googling or guessing... it's quite important -- my wife just reached an attending-level salary and we are hovering around 2 different tax brackets: how we structure our contributions may mean several 100s now and many 1000s in 30-40 years down the future. Thanks for your kind help.

Second, and this is news to me -- I just read the rules for pre-tax & after-tax combined investing within 401(k) may have changed, such that if you invest in a combination of the two, you may not be limited to 18,500K as was true in the past (as late as 2014):

http://www.bankrate.com/finance/retirement/after-tax-401k-rollover-to-roth-ira-rules.aspx

I generally consider bankrate a good source of information, but this 'article' is uncharacteristically obtuse. Can someone point me to an article that clears this up? Or at least a discussion on the subject (Bogle/Fool.com forums)?

---

Members don't see this ad.

 

[sazerac]

Your analogy for after tax contributions to a traditional 401k are incorrect. It is not like contributing to a Roth.

The correct analogy is that after-tax contributions to a traditional 401k are analogous to non-deductible contributions to a traditional IRA. In either case, you contribute $X which has already been taxed. This money grows tax free into $X + $YYY. As you withdraw this money, $X is not taxed but all that growth $YYY will be taxed as ordinary income. The tax advantage here is that you don't pay taxes every year on growth, and when you retire you generally are in a smaller tax bracket than when you are working.

Whereas with a genuine Roth 401k or Roth IRA, after tax contribution $A grows tax free into $A + $BBB. Later on, all withdrawals are tax free. This results in substantially more tax savings.


Concerning your second point, the tax rules changed so that it is easier to convert a 401k that contains both pre tax and post tax contributions into a traditional IRA (containing your pre tax contributions and all your as-yet-untaxed growth) and a Roth IRA (with your post tax contributions). This was possible before, but now it is easier to do this.

 

[James Martin]

Conversely, people at the beginning of their careers are usually earning less than they will earn in the future, so they are in a lower tax bracket. For these employees, it is most logical to pay taxes at the time they make contributions, while they are in a low tax bracket. So generally advisers recommend that people make some portion of contributions during their early career on an after-tax basis to a Roth 401(k) account. The caveat is that traditional 401(k) contributions lower an employee’s annual taxable income – possibly taking that person into a lower tax bracket. For that reason, accountants might recommend some kind of split between Roth and traditional 401(k) contributions.

 

[mark-ER]

Thanks Sazerac. Lack of tax-free investment growth was lost on me. Somewhat subtle, but important distinction between aftertax 401(k) and Roth 401(k). If I was staying here longer, I would push for our institution to have a Roth 401(k) option added, but I am sure it's a hassle for the administrators. On the other hand serving on the finance/investment committee for the hospital, may be a good (politically-savvy) career move for a senior resident. And James brings up good points too. For a lot of individuals splitting pre-tax versus after-tax makes sense depending on where they are age-/retirement-wise and how far they reside from the next (marginal) tax bracket.

 

[The White Coat Investor]

The employee contribution is $18K. That can be tax-deferred (traditional) or tax-free (Roth). The total of the employee contribution plus the employer contribution can be $53K. When combined with a profit-sharing plan, you can do the "employer" contribution, allowing you to get in up to $53K. That's generally tax-deferred. Some plans allow you to put "after-tax" (not tax-deferred or tax-free but more like a non-deductible IRA contribution) money into a 401(k) and also to be able to pull that money out periodically and convert it to a Roth IRA. This is often called the Mega Backdoor Roth.

Hope that helps.

 

[styphon]

How does a profit sharing plan work when used with a 401k? If you are in a profit sharing plan are they required to show you how they came up with the number?

Is it the 18k employee+whatever percent the company matches+profit sharing = can not be over 53?

What if the above number is below 53k? can you make up the difference?