I’ve spent years (and now started a business which is focused on) getting people interested in investing in their retirement plan. The first option is what we call “traditional” retirement accounts. In my previous blog, I talked about getting one of those all set up. If you hear someone talking generally about their retirement, on TV or at work, they are mostly likely talking about a traditional retirement account.
But what about folks who have an option on their plan to contribute to a “Roth”? Magda, stop making up words…what the eff is that?
A Roth account (in this case we are talking Roth 403(b) or 401(k)), is a retirement account similar to a traditional retirement account, except, you don’t get to skip the tax bill up front. Ok, ok back up… I didn’t know I was skipping a tax bill for any retirement accounts! Now I have to sign up to not skip the tax bill up front? Or do I want to skip the tax bill? Let me explain…
Quick run-down on traditional account benefits
When you are contributing to your “traditional” retirement plan (401(k) or 403(b)), you don’t pay taxes to the government quite yet. Hallelujah, sweet Jesus! I found a way to outsmart the government. Not so fast spunky…a traditional account defers your income taxes until you withdraw at 59 ½ years old or later. When you withdraw your retirement money, you will pay income tax based on your income at that time you withdraw.
The reason this is so valuable is because you lower your taxable income for the year. Magda, English please. Ok here’s an example, you make $100,000 in 2018 and contribute $10,000 to your traditional retirement plan. When you report your income to the government, sometime in and around April of 2019, you will only be reporting $90,000 instead of the full $100,000. Pretty cool huh? #nerdalert
The other major benefit of a traditional account is that is ‘grows tax-free’. We pay taxes on accounts normally? Hopefully. If not, I’ll have to refer you to another blog about tax-fraud… What ‘growing tax-free’ means is that when you have a non-retirement account and you invest money in the stock market or in other such investments, if you make any money on those accounts over the years, you will pay taxes on those gains in the year you sell the funds. Any gain is automatically reported to the government and you’ll end up paying Uncle Sam. Thank god for Turbotax! With tax-free growth you don’t pay taxes on any gains within the retirement accounts.
Ok, back to the Roth accounts. Roth accounts DO NOT defer taxes and therefore you have to pay the government immediately. Well now Magda, why would I do that if I can avoid taxes up front? I’m so glad you asked…
When you contribute to your Roth and invest the money, you still get the benefit of ‘growing tax-free’ as you do with a traditional account.
You can contribute up to $18,500 for 2018 (moving to $19,000 for 2019). It’s important to note that you get a total of $18,500 across both a Roth and Traditional for your retirement plan so you can’t do $18,500 each.
It might be smart to pay taxes now… Ugh Magda, you just explained why it’s good to pay taxes later, why would I want to pay taxes now?
That’s an excellent question...
There are several reasons to pay taxes now:
1. You make very little money right now.
As you make more money, you pay more taxes (#richpeopleproblems). That same rule
does, unfortunately apply to you as well. So, if you are just starting out your
career, or are taking a break to go back to school, you should expect your salary to
increase over time. You pay less taxes when you make less so wouldn’t it make sense to
pay taxes now, while you’re making less than when you are older and are totally
financially crushing it? You will likely pay more taxes than.
2. You live in a low- or no-income tax state AND plan on moving to a higher one.
Back-up, what does that mean? Doesn’t everyone pay an income tax? While everyone pays income tax to the federal government, each state has their own requirements around an additional state income tax. If you’re like me, and you live in California (max of 13.3% of your paycheck goes to the state) you are at the tip-top of the chart when it comes to these rates. Check out where your state ranks in terms of state income rate with the graph provided in this article.
Here’s a good example: my sister was living out in Florida (max of 0% state income tax) for 9 years, finishing up her medical school degree, and I knew she’d be moving back to California when she finished (See ya later gators!). Soooo, you guessed it. If we knew she was paying 0% in state income taxes and eventually would pay up to 13.3%, why not have her pay taxes on her investments while she lived in a state with 0% taxes? That way it will be tax-free when she takes it out in California at retirement, thus avoiding the 13.3%. Pretty smart huh?!
3. You just don’t know what your income will be when you’re ready to withdraw from either of your retirement accounts.
If you don’t fall into one of the categories above where you know that your income situation will be changing, you should still diversify your retirement savings with a Roth account if you can. This is a good way to have two options when you need it later in life: one account where you’ve paid taxes on and one where you haven’t.
Ok, I have all of this information now, so what’s the game plan? Head into work tomorrow and do the following:
1. Find out, by logging into your retirement account or asking your HR, if you have a Roth account to contribute to.
2. If so, consider putting some of your paycheck towards the Roth. (allocate a % or dollar amount)
To help you out, here’s a chart to explain the differences between the two
I know some of you have heard of a Roth “IRA” but we will save that fun conversation for another time. For now, just focus on your employer’s retirement plan.