This week’s blog in our Financial Planter series is written by Chris Vasquez, Guest Blogger,
who is a Personal Finance Expert*
If your employer offers a sponsored retirement savings plan or 401(k), it’s important to know what your contribution options are and what their long-term impact may be on your tax situation. Not all employers offer a Roth option inside a 401(k), so you’ll need to check with your HR department before deciding which one is best for you.
Let’s make sure we all understand how these two retirement vehicles work, starting with the older of the two: the Traditional 401(k). The Traditional 401(k) allows employees to contribute into a qualified retirement plan through their employer on a pre-tax basis. What does pre-tax mean? Pre-tax allows an employee to have money deducted from their paycheck and then contributed into a 401(k) plan before taxes are withheld. By doing this, you receive an immediate break from federal income taxes on the portion you contribute. For example, let’s assume you earn $100,000 this year and you decide to contribute $15,000 into your Traditional 401(k). Instead of paying income tax on $100,000, you’ll only pay it on $85,000 of your income. The rest is contributed directly to your retirement account.
Another important point is the huge power of tax-deferral, which applies to both Traditional and Roth 401(k)s. Here’s a quick example: Let’s say you have $100,000 in your 401(k) and $100,000 in a taxable account. Assume you are in the 25% tax bracket and both accounts generate an 8% return every year for 30 years. At the end of 30 years, assuming you pay taxes owed out of the account, your taxable account will be worth $574,349. Not bad! However, your tax-deferred 401(k) account will have accumulated $1,006,266. Whoa! This is also assuming you never contribute anything else during the entire 30-year time frame. Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t, pays it.”
Now, what about a Roth 401(k)? A Roth 401(k) allows an employee instead to make contributions to the plan on a post-tax basis. What does that mean? The money is contributed to your account after taxes have been collected, so you won’t receive an up-front tax savings on your income. However, there is another critical difference – once you reach age 59 ½, hopefully after decades of contributions and decades of tax deferral compounding, it will come out…wait for it…tax-free! This is assuming current tax laws stay the same. Imagine having $1,000,000 in your Roth 401(k) for retirement and you have full access to the entire balance during retirement without tax implications. This compares to having to pay income taxes on any distributions from a comparable $1,000,000 in your Traditional 401(k) (at 25%, as an example). Ouch!
That being said, it does not mean that a Roth 401(k) is better than a Traditional 401(k). It all depends on your specific situation. If you just started your career, you’re probably not in your highest earning years, right? If this is the case, you might be in a lower tax bracket right now, so it may make sense to put more of your paycheck toward a Roth 401(k). Then as your income and the relative tax benefit increase, you might consider setting money aside in the Traditional 401(k) to lower your tax burden.
On the other hand, let’s say you’re in a high tax bracket now and are looking for ways to lower your taxes. One way might be to make contributions into your Traditional 401(k). The IRS allows an individual to defer up to $18,000 for the year 2016, so by making contributions into the Traditional 401(k), you’ll reduce your taxable income immediately. If you are over the age of 50, it gets even better. The IRS allows for an additional $6,000 catch-up contribution after the age of 50, so you have the potential to defer taxes on up to $24,000.
One simple takeaway here is to start contributing, continue contributing, and eventually max out your contributions. Capitalize on the power of compound interest tax-deferred growth and how it can work in your favor with these retirement vehicles. You will pay taxes either way, but the real key is to start the habit of saving for your future. This is one area in your life you have complete control over, and no one else can do this for you!
*All content provided in this blog is supplied by Chris Vasquez and is for informational purposes only. Barclaycard makes no representations as to the accuracy or completeness of any information contained in the blog or found by following any link within this blog.
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