Well; you won’t have to imagine; I will show you. Senator William Roth of Delaware is one of your best friends and you probably have no idea who he is. Senator Roth included a piece of legislation in the 1997 Tax Relief Act that fundamentally altered methods of planning for retirement.
In my last post I spoke extensively about 401(k)s. Now we are going to talk about his lesser known brother, the Roth 401(k). One of largest downsides to the traditional IRA or 401(k) is that you always have to remember to take whatever number you see as your account balance and cut it in half. The reason is that once you withdraw the funds; the IRS will be stepping in for their share in the business they helped you build (sarcasm intended).
But our friend, Senator William Roth, stepped in to alleviate this situation. Under the Roth method; you will receive no tax deduction today. In exchange, the funds are not taxed once they are withdrawn. See the below example, which is a simple illustration.
As you can see in the above illustration; the regular 401(k) will net you a greater paycheck today through tax relief; about $500 more per year through tax breaks assuming $40,000 payroll. The Roth 401(k) provides no tax relief today and you will need to bear the full burden of the taxes. BUT — pay special attention to year 30. The balances at year 30 are the same; assuming the 6% contributions in the two vehicles were invested in the exact same assets. Then look at how much you have available for withdrawl; under the Roth Vehicle; you have access to the full $200k, but under the traditional vehicle; you only have access to about $120k; as the IRS needs to claim their share for giving you tax breaks for thirty years.
Logically, you should consider sacrificing a little bit in tax savings today, for big tax savings in the future. Many people I know and explain this concept to continue to use the regular 401(k) as they do not believe their account balances will ever be large enough to warrant future tax savings. This is a concept I call “Hedging against yourself.” You are making a bet today; that you will fail tomorrow. Well, guess what; if you believe it; then so be it. If you truly believe you will never have a large enough balance to warrant a sacrifice today; then you will probably not.
Money management takes time, commitment, planning, and lots of energy. It’s a willful process that you need to make happen; no one will do it for you. I can only teach you and encourage you, but YOU have to take action to reach out to your employer and switch to the Roth, or enroll in the 401(k) program at all. YOU need to open a brokerage account and start moving money into it; I can not do it for you. YOU need to look at an impulse buy and say, “I do not really need that.” Knowledge is step 1. the Decision to take action is step 2. Commitment is step 3. Continuing education is step 4. So, go and make it happen. I will be here for you every step of the way.
**Please remember that I am not a tax or investment professional. I am someone who lives and breathes taxes and investments. Any piece of information you receive should always be consulted with an investment or tax professional, such as a series 7 broker, Registered Investment Adviser, Enrolled Agent, or Certified Public Accountant .