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The Roth IRA Income Limit and the Roth 401k

If your employer offers a Roth 401(k) option — as mine will, starting in 2008 — it's worth exploring the tradeoffs between the Roth and Traditional 401(k) plans.

Many advice columns are happy to demonstrate that the results are equivalent unless taxes change. If your tax rate is lower now than when you'll retire, you should go for the Roth… and if your tax rate is higher now than when you'll retire, you should pick Traditional. As I explained a couple years ago, there's a lot more to consider.

Most importantly, the fact that the contribution limit ($15,500 in 2008, unchanged from 2007) is the same whether you're making Roth (post-tax) or Traditional (pre-tax) contributions is an advantage for Roth contributions if you're able to contribute up to the full limit: $15,500 in post-tax dollars is more money than $15,500 in pre-tax dollars.

If you're in a position to save a lot of money, your inclination should be toward the Roth. But there's an interesting interaction between the Roth 401(k) and the Roth IRA. Eligibility to contribute to a Roth IRA is phased out at higher incomes. By making Roth instead of Traditional 401(k) contributions, you lose that tax deduction, which may reduce your eligibility to contribute to a Roth IRA. When does it make sense to make Traditional instead of Roth contributions to your 401(k) merely to remain eligible to contribute to a Roth IRA?

Let's do some math. First, here's some reference material on Roth IRAs and their contribution and income limits.

The figure we need are:

  • Income estimate, after all deductions except for Traditional 401(k) contributions.
  • 401(k) contribution limit
  • Roth IRA contribution limit
  • Roth IRA income limits (start and end of phase-out)
  • Marginal income tax rate

I created a spreadsheet to calculate the post-tax-equivalent contribution to retirement accounts. I tried a few scenarios and then realized that I did a lot more work than I needed to.

The phase-out range for Roth IRA eligibility is $15,000 wide. Each $1 reduction in income increases your Roth IRA contribution limit by one-fifteen-thousandth of the normal contribution limit ($5,000 in 2008), or $0.33. But to get that $1 reduction in income by making a Traditional instead of Roth contribution to your 401(k), that contribution becomes taxable upon withdrawal.

Compare your marginal tax rate to the $0.33 per dollar Roth IRA contribution increase. My marginal tax rate is 37% (28% federal + 9% Oregon), so I lose more in taxes on my eventual 401(k) withdrawal — $0.37 — than I gain on my ability to contribute more to my Roth IRA — $0.33. So for me, in Oregon, it doesn't ever* make sense to use Traditional 401(k) contributions for the purpose of retaining eligibility to contribute to a Roth IRA.

In a state with low or no income tax, the reverse could be true. But it's difficult to take advantage of that fact because you need to very accurately know your income before the end of the year — before you get tax statements! (If your Traditional 401(k) contributions are too large and bring your income (after deductions) to less than the lower bound of the Roth IRA phase-out, you're missing out on the opportunity of making more of those contributions Roth.) You'll likely need to fine-tune your contributions in December, which implies you're contributing throughout the year instead of front-loading your contributions. I prefer to front-load because that gets the funds invested as early as possible.

Summary: If your marginal tax rate is greater than 33%, maximize your Roth 401(k) contributions and don't worry about losing your Roth IRA eligibility. If your marginal tax rate is less than 33%, try to plan your Traditional 401(k) contributions so that your income (after deductions) exactly hits the lower bound of the Roth IRA phase-out.

(*Actually, it can. If you're eligible for a Roth IRA at all, the contribution limit has a $200 floor. So there is a point where a $1 reduction in income is worth a $200 increase in Roth contribution limit. But I'm not going to worry about a mere $200.)

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