When it comes to how to invest your money, the decisions you have to make sometime seem endless. And, well, they kind of are endless.
But this doesn’t mean you should not start investing your money or that you won’t be able to make good decisions. A little education will go a long way (I promise!).
One such decision is what type of account to use for your investments. You don’t have to use only one type but at different points during your earning years, it can make sense to put more into one type than another.
This is a question I have struggled with recently.
Two Types of 401k Retirement Accounts
Through my employer, I have access to two different types of 401k accounts: a Roth 401k and a traditional 401k.
These aren’t the only retirement accounts out there offered by employers. And, if you are self-employed or you work for a small business or a non-profit organization, you might have access to different accounts, such as a solo 401k or a 403b.
But they are the accounts I have access to and it is choosing how to allocate my contribution between the two that has been the source of my current struggle.
Traditional 401k
A traditional 401k is similar to a traditional IRA in that the money goes in pre-tax—meaning you haven’t paid taxes on it—and is taxed as regular income when you withdraw it as long as you are at least 59½ years old. If you are younger than 59½, you will also be assessed a 10% penalty (there are a few exceptions but you would need to talk to a tax professional about those).
Roth 401k
Likewise, a Roth 401k is similar to a Roth IRA because you pay taxes on your contributions now but not on the money you withdraw.
There is one difference, however. With a Roth IRA, you can withdraw your contributions for any reason as long as the account has been open for at least five years. With a Roth 401k, the account has to have been open for five years and you have to be at least 59½ years (again, I am simplifying things a bit so talk to your tax preparer if you have additional questions).
What’s the Big Deal About When You Pay Taxes?
If you’ve ever looked at your pay stub—and if you haven’t, I encourage you to do so pronto—you will have noticed that a decent chunk of your earnings goes toward taxes. How much depends on your tax rate which is based on your taxable income. If you want to lower your tax rate, a simple way to do so is to lower your taxable income.
How? U.S. tax laws give you a couple of ways to do so without taking a voluntary pay cut (because most of us would not want to do that!). One of these options is to contribute to a traditional 401k.
As noted above, money contributed to a traditional 401k goes in pre-tax. This means, for example, someone who make $100,000 and contributes $10,000, will only be assessed taxes on the $90,000 remaining.
This is great news today—yeah, pay less in taxes!—but this person isn’t off the hook forever: the tax bill will come due when she withdraws the funds.
I know what you’re thinking. If she has to pay anyway, what’s the benefit in postponing? The benefit is her tax rate may be lower in retirement because her income may be lower or the tax laws will have changed. So, while she will still have to pay taxes, she might be able to pay less in taxes.
Which Brings Me to My Dilemma—and Possibly Yours Too
If you have followed my money story you will know I have been working really hard to get all my financial ducks in a row now so I can have a great retirement later. This includes paying off almost $60,000 in debt in 16 months and maxing out my 401k, Roth IRA, and even an HSA.
This is a great approach to ensuring financial stability in retirement, but it could mean that, after factoring in Social Security and a pension I will receive, my income stays about the same as it is now after I retire even though I will no longer be working a regular job.
Don’t get me wrong, this is not a bad problem to have. I can’t wait to retire from my 9-5 job and have more time to travel and to work on this blog, and the money I am saving now is what will support me later.
But in this situation, when it is unlikely my tax rate will be lower in retirement (and could even be much higher if tax laws change), it may make more sense to pay taxes now. And that is where the Roth 401k comes into the picture.
Choosing to Pay Taxes Now, Even as a Higher Earner
At the time I am writing this—2018—there are seven tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. I fall right in the middle, in the 24% bracket, because I am single and make between $82,501 to $157,500 annually.
This may seem high, but in the history of tax brackets, it’s on the lower end for this income range. It’s also on the lower end of what it will likely be in the future given that at some point, taxes will go up to address the growing national debt.
This alone makes it attractive to pay my taxes today instead of waiting until I retire.
There is, of course, a consequence to doing this. My paycheck goes down because I am now paying the taxes on that income that I was previously investing pre-tax. How much of a difference, I wondered, would it make in my paycheck?
Turns out, it wasn’t that bad. My bi-weekly check went down by $270. It did require me to adjust some of my automatic transfers but because I am out of debt, I have the flexibility to make these adjustment.
How Have You Balanced Paying Taxes Now vs. Later?
I know it may seem nutty to worry about what my tax rate will be in twenty years. But given the many unanswerable questions that crop up when planning for retirement, I find it’s nice to know that, for at least the portion of my retirement savings in my Roth 401(k), the amount in the account is exactly the amount I have to spend.
What’s your approach when it comes to traditional vs. Roth 401k accounts?
