The following is a staff writer post from MikeS and it was supported by Genworth. MikeS is a married father of 2. So, with the cat, he ranks number 5 in the house. He loves numbers and helping people. Please leave any questions or comments below for either Mike or Crystal.
I am happy to say that I am increasing my retirement contributions starting in January. As I outlined previously, I was changing my company benefits for next year. With those changes, I also analyzed how my take-home pay was going to be impacted and whether I needed to adjust my federal income-tax withholdings. Since, I was setting aside a larger amount of money pre-tax via the HSA; I was able to increase my deduction number.
This has enabled me to increase my retirement plan contributions so I can afford to retire quicker or use my accounts for something like annuities in the future. My first thought was simply to increase my 401k contribution by 1%. But then I realized that I had another option, I could contribute to my Roth 401k. So which one to choose? This presented a problem, a nice problem to have for sure.
The Difference Between a Roth 401k and Traditional 401k
The main difference between the Roth and traditional is the tax treatment. A Roth 401k contribution is subject to taxation before you invest it. From there, the contribution and any growth you will be able to receive tax-free in retirement. The traditional 401k contribution is pre-tax; however the contribution and any growth are treated as taxable income upon withdrawal during retirement.
The other notable difference is the ability to access the money contributed to a Roth 401k without penalty. With the Roth 401k, 5 years after making a contribution, you can withdraw that contribution amount without penalty. You can only withdraw the amount you put in, not any of the gains. In contrast, if you withdraw anything from the traditional 401k prior to retirement, you are subject to a 10% penalty, along with ordinary income taxes.
At first, I will be honest; I didn’t put much thought into it. When January rolled around I was just going to up my traditional 401k contribution percentage by 1 and be done with it. However, I began to rethink that thought.
For starters, I have already maxed out my employer’s contribution. The match is 100% up to 6%. They also contribute a flat 2% on top of that, regardless of whether you contribute to the plan or not. The extra 2% contribution essentially takes the place of a traditional pension. So, I gain nothing, in terms of matching, by contributing to the traditional 401k.
The second thought I had was in regards to my current tax bracket. I currently am in the 15% marginal tax bracket, with a ways to go before I cross into the 25% bucket. So, I began thinking, what bracket am I likely to be in upon retirement. I envision my deductions will be much lower if not the straight standard deduction. Other than my wife and I, there probably will be no other dependents. I also will probably have more taxable income. Thinking through all of this, I began to think the probability of being in a higher tax bracket at retirement was high.
Being a numbers guy, I decided to see what the impact would be over the course of 30 years. I did a basic analysis on how the 1% contribution will grow over time and how much the taxes would be in 30 years. In the end, I can save more on taxes in the long-term, by paying some now on the contributions. Why is that you might ask? Since I expect to pay more than 15% in taxes during retirement, it makes sense to pay the lower rate on the contributions now, rather than pay the higher rate on the contributions and gains in the future.
As always, you have to know your situation and evaluate your options. Had I just went ahead an increased my traditional 401k contribution without any additional thought, I likely would have cost myself money in the future. When you make informed decisions, you are much more likely to make the correct one.