When you contribute to retirement accounts, you typically have two options:
- Contribute pre-tax dollars today, pay taxes in retirement when you withdraw (Traditional 401k/IRA)
- Contribute after-tax dollars today, withdraw tax-free in retirement (Roth 401k/IRA)
Ask 100 people and 99 of them will likely choose option one every time.
A tax deduction certainly sounds better than no tax deduction.
I get it. I love tax deductions.
But I think the Roth 401(k) is actually the right decision for most retirement investors.
Tune in to today’s episode to learn why.
How to Listen to Today’s Episode
Episode Links & Resources:
- 👉 Get Your One-Time Retirement Plan
- Stop Abbreviating the Year 2020 [USA Today]
- Traditional 401(k) vs Roth 401(k) [Define Financial Blog]
- 401(k) Contribution Limit Increases in 2020 [IRS]
Episode Transcription
Financial Myth #4: A Traditional 401k is Better Than a Roth 401k
Taylor Schulte: Hey everyone, Happy New Year and welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and before we get into today's topic, I just wanted to share a quick tip with you just in case you haven't caught wind of it yet.
So the tip is not to abbreviate the year 2020 when you're signing documents or writing checks. This year's abbreviation is interchangeable and it could possibly be used against you. For example, a scammer could manipulate a document or a check dated 1/15/20 into 1/15/2019, or even 1/15/2021.
So let's say you agreed to make a payment and you wrote 1/15/20 on a check. If the wrong person got ahold of this check, they could theoretically change your payment obligation to let's say 1/15/2019, and they could try to collect some additional money by cashing a backdated check. They could also change it from 1/15/20 to 1/15/2021, making an uncashed or a lost check active again.
Now, perhaps you don't write checks these days, and I don't really either, but you're still likely going to be signing important documents and writing out the full date could possibly better protect you and prevent legal issues on paperwork. If there's ever something in question according to a USA today article that I'll link to for you in the show notes. So when possible, spell out the month and just write the full date just to be safe.
Okay, onto today's topic, we are busting myth number four, the final myth in this myth busting series. Myth number four says that contributing to a traditional 401K and getting that nice big tax deduction is better than contributing to a Roth where you don't get a tax deduction and money is deposited after taxes have been paid. Even if you don't have access to a 401K, you likely have the ability to contribute to a Roth IRA or even a non-deductible IRA.
So stick with me to learn why a current year tax deduction shouldn't necessarily influence your decision here. For all the links and resources mentioned in this episode, visit youstaywealthy.com/60.
When you contribute to retirement accounts, you typically have two options. Now, there are some nuances and caveats, but in general you have two options.
Number one, you can contribute earnings before they're taxed, receive a tax deduction for that contribution, and then pay taxes when you withdraw that money in retirement. This is the case for traditional 401Ks, traditional IRAs, SEP IRAs, and simple.
The second option is you pay taxes on your earnings. You contribute these after-tax dollars. You don't receive a tax deduction, but you get to take the money out tax-free in retirement. That was a bit of a mouthful, so let me try to summarize and simplify a little further.
Option one, you get a tax deduction today and you pay taxes when you withdraw. Option two, no tax deduction today and no taxes when you withdraw in retirement. If you ask a hundred people, I bet that 99 of them will likely choose option number one every single time.
And even if you don't choose a traditional 401K intentionally, it's often the default option in most retirement plans. I get it. A tax deduction certainly sounds better than no tax deduction. I love tax deductions, but here's the biggest reason why. It's a myth that a traditional 401K or traditional IRA is always the better option.
The biggest reason is that most people lose track of their tax deduction. Lemme try to put some numbers to this to help explain what I mean. Let's say you want to contribute $26,000 to your 401K this year. Remember, the limits were increased in 2020. So if you're 50 or older, you can now contribute $26,000.
You're a stay wealthy listener, so in addition to being a good saver, you're also a rockstar earner. So let's assume that you're in the 35% tax bracket if you choose the Roth 401K. In order to contribute the full $26,000, you'll have to pay about $9,100 in taxes this year.
Remember that with a Roth, you earn money from your job, you pay taxes on those earnings, and then you contribute after-tax dollars. So you're paying $9,100 in ordinary income taxes this year in order to get that $26,000 into your Roth 401K. If I say this another way, you would've had to make $35,000 in order to save $26,000 for retirement.
However, that money does grow tax deferred, which is magical, and you can withdraw that money in retirement completely tax-free. So you truly just saved $26,000 for retirement net of taxes. On the other hand, if you choose the traditional 401K, you'll contribute the full $26,000 before your earnings have been taxed. So you've essentially escaped $9,100 in taxes. If we assume the same tax rate, you've essentially escaped $9,100 in taxes this year.
You simply had to make $26,000 to save $26,000, and in essence, you have an extra $9,100 in your pocket because you escaped the tax bill. Here's the problem. What do you think most people do with this extra $9,100? My guess is that most of the time that money gets spent without even knowing it, it's kind of this phantom savings.
And unless you're super intentional with your money, it just kind of becomes part of your day-to-day living and day-to-day spending. The problem is that in 10, 20, 30 years, when you go to retire and take that $26,000 out, you'll need to pay the tax bill not only on the $26,000 but also on the growth of the investment.
So that tax liability could double. Instead of $9,100, it could be $20,000 to get that money back out. And obviously that depends on your future tax bracket and the investment growth, but that tax liability could certainly increase over that period of time.
So when you put $26,000 into a traditional 401K, you aren't really saving $26,000. You're really only saving $16,900. But when you put $26,000 into a Roth 401K, you are truly saving $26,000. You're saving more money.
This example illustrates in my mind the psychology of savings. In each of these two situations, you believe that you're saving $26,000, but you have to look at net savings or savings, less your expenses. And expenses in this example would be taxes.
Now, if you just can't wrap your head around using a Roth and you really want to use a traditional option, the smart move would be to calculate your tax savings and this example would be $9,100, and then invest that tax savings in a low-cost diversified portfolio. This is the kicker earmarked for retirement.
I would literally put this money in its own special account. Don't co-mingle it, put it in its own special account, create a custom label for it, which you can do with pretty much every custodian, I would call it retirement.
Invest that money and don't touch it. You would want to do this every single year until you're done contributing to retirement accounts. So you contribute to that traditional 401k, calculate the tax savings, whatever that tax savings is, deposit that into this new retirement account that you've set up.
If you're in a high tax bracket today and you are absolutely certain that you're going to be in a low tax bracket in retirement, this would be a good strategy. But remember, we don't have a crystal ball and tax laws like we just witnessed last month can change really quickly.
In my mind, using the Roth just adds a bit of certainty to our financial planning and our financial life. The other reason why I like the Roth option for most people is you don't have to take required minimum distributions or RMDs in retirement.
Remember, with a traditional IRA or traditional 401K, you have to take required minimum distributions, but with a Roth, you can roll your Roth 401K to a Roth IRA, or maybe you already have that Roth IRA, and you're never forced by the IRSs to take a distribution ever.
And there are really three main reasons why not having RMDs and not being forced to take money out by the IRS is really valuable. Number one, not having to take RMDs in retirement allows your money to remain in this magical tax-deferred retirement account longer, and the longer it stays in there, the more money you're going to have.
Number two, not having to take RMDs simply gives you more flexibility in retirement to manage your tax bill and your income. You aren't being forced to realize income at an inopportune time. And then number three, human behavior.
Look, as a human being, you're probably going to be tempted to spend your required minimum distributions. After all, if you have to take money out of an account, why not just spend it and look, if you have other savings and non-retirement accounts, that might just be okay.
But most people in America have a shortage of savings, not a surplus, and with retirement accounts as the foundation of their future income, it likely just doesn't make sense to spend money just because the tax law requires you to move it out of an account. In summary, I typically favor the Roth option for most people at all ages, and I think it's a myth that just because you get a tax deduction or just because you're in a high tax bracket today that you should automatically just contribute to a traditional 401K.
Of course, there are always exceptions and look, saving some money is better than saving no money at all. So if you take anything away from this, just don't let this debate between traditional and Roth become avoidance behavior. Again, saving some money today is better than saving no money at all.
Once again, happy New Year and thank you all for tuning in. This is a final myth busting episode. Let me know what you think. I just try to do something a little bit different to change it up.
If you have any topics that you would like to hear discussed on the podcast this year, just shoot me an email at podcast@youstaywealthy.com. I read and respond to every single email. If you've ever emailed me, you know that to be true. I love hearing from you guys. It's what keeps me motivated to continue this podcast.
So please don't be shy once again for all the links and resources mentioned in today's episode, visit youstaywealthy.com/60.
Hey, it's me again. I just wanted to say thank you one more time for listening and remind you to please, please leave a quick review. If you're on an iPhone, leave a quick review on iTunes. If you're enjoying the show.
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Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.