Could a provision in the Fiscal Cliff deal help you retire with more money?
I will, for the moment, stay away from the politics of the Fiscal Cliff deal and focus solely on one unexpected upside that arose from the recently negotiated bill – The Roth 401(k) provision.
The new Fiscal Cliff bill allows employees to make a one-time, large transfer from a traditional 401(k) to a Roth 401(k). This could be a huge advantage to certain people during retirement, and it is something that we all should be evaluating whether or not to take advantage of in the wake of the contentious Fiscal Cliff debate.
Warning To All Readers
This article is not meant for your enjoyment, it is hard to write about financial things and make it fun. However, if you invest the next five boring minutes into reading and evaluating this article, you may save yourself hundreds of thousands of dollars during retirement.
Traditional 401(k) vs. Roth 401(k)
For those of you who are not familiar, your 401(k) are pre-tax dollars, which means you don’t pay taxes on them now, but you do pay taxes on them during retirement. A Roth 401(k) allows you to invest after-tax dollars. This means that you don’t get the tax benefits now, but you will get to withdraw the money tax-free during retirement, which can be an enormous advantage in your later years.
Who Should Take Advantage Of This?
The first step is to find out if your company offers a Roth 401(k) option. Almost 50% of companies offer one, though only around 5% of employees take advantage in this phenomenal savings tool. After you confirm that your company does offer a Roth 401(k), you need to determine if you fall into one of these three groups:
1) Younger workers with cash on hand
2) People who are in lower tax brackets and have extra cash on hand
3) People with cash on hand who believe their tax rate will be higher in retirement than it is today
You may have caught on to the “cash on hand” requirement in each group. The reason that is important is that you will be required to pay the taxes on the converted amount this year, which means this option is only right for people who have some savings that can be used to pay for those extra 2013 tax dollars.
Major Upside To Converting To a Roth 401(k)
In almost every scenario, the Roth 401(k) makes more sense in the long-run. The only scenario where it typically will not work out is if you are in a very high tax bracket today, and an extremely low tax bracket during retirement. Take a look at this example:
Jimmy is 35 years old, he is in the 28% tax bracket, and he puts 10K/year into his 401(k) each year.
Scenario 1) Jimmy is in the 15% tax bracket today, and will retire in the 25% tax bracket at 65
Outcome: The Roth 401(k) option will net Jimmy $368,500 more during Retirement
Scenario 2) Jimmy is in the 25% tax bracket today, and will retire in the 25% tax bracket at 65
Outcome: The Roth 401(k) option will net Jimmy $257,740 more during Retirement
Scenario 3) Jimmy is in the 25% tax bracket today, and will retire in the 15% tax bracket at 65
Outcome: The Traditional 401(k) option will net Jimmy$15,560 more during Retirement
As you can see, the only scenario where Jimmy comes out worse-off after choosing the Roth 401(k) is if he is in a high tax bracket today, and he retires in a low tax-bracket. The truth is that most people who are ready for retirement will retire in a similar tax bracket as they are in right now, because they will become used to living off of that same amount of money. In addition, taxes are historically low at this point, and with our National Debt rising with no end in sight, it is almost impossible to foresee a scenario where our tax rates will be lower in 30 years than they are right now (I promise that will be my only political comment in this article).
Major Downside To Converting To a Roth 401(k)
If you convert your Traditional 401(k) dollars into a Roth 401(k), you are responsible for the taxes during that year. For example, if you have $50,000 saved up in your 401(k), here is what it could look like:
Scenario 1: Tim is in the 15% tax bracket and converts $50,000. Tim owes $7,500 in taxes in 2013.
Scenario 2: Sally is in the 25% tax bracket and converts $50,000. Sally owes $12,500 in taxes in 2013.
The math is not nearly as simple as I made it in this article, but it is directionally-correct. For the most part, converting your Traditional 401(k) to a Roth 401(k) will benefit you in the long run. It is always a huge decision to part with cash on hand now in order to avoid paying more taxes later, but these are the types of decisions that financially successful people make every single day. If you are interested in executing one of these conversions, please do your own research, do your own math, and make your own decisions. Financial decisions are never easy, but when an opportunity presents itself that could save you hundreds of thousands of dollars throughout your lifetime, you owe it to yourself to spend some time looking into it. Please feel free to reach out to me with any questions or comments. Good Luck!