Could a provision in the Fiscal Cliff deal help you retire with more money?

Money (Photo credit: 401(K) 2013)

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.

Opportunity

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.

Conclusion

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!

Related articles

• Roth 401k options after ‘cliff’ deal (kypost.com)
• IRA, Roth IRA, Roth 401K Guide (infolific.com)

What Is A Roth IRA?

What Is A Roth IRA?

This type of account has contribution limits (under the 2010 rules, you could invest $5K/year if you are 49 or younger, and $6K/year if you are 50 or over). This type of account also has income limits, so you should check to see if you make too much money to qualify (2010 limits ranged between $105K – $120K for single filers, and between $167K – 177K for joint filers, meaning that if you made less money than the low-end of the range you could invest fully in the account, and if you fall somewhere in the range you may be able to invest a portion of the limits into the account).

There are two main differences between the Roth IRA and the Traditional IRA: The Roth IRA grows Tax-Free, and the contributions are not Tax-Deductible. Tax-Free means is that if your $3,000 contribution grew at 10% for 20 years, you would then have just over $20,000 without ever paying a dime of taxes. You will then not be taxed at all on the income when you withdraw the money during retirement. By not paying taxes throughout your working years, the money accumulates much quicker, and your retirement pot grows more rapidly. By not paying taxes when you withdraw the money, you save an enormous amount of money during retirement. Since the contributions are not Tax Deductible, this means that if you put in $3,000 dollars, you will not be able to write off any tax dollars for the current tax year.

Retirement Junkie is a website that the Hagopian Institute put together as a source for free information to help people prepare for retirement.  Please visit retirementjunkie.com, and follow MrEmergingMedia on Twitter for more retirement tips, along with other fun offerings from Todd Hagopian and the Hagopian Institute.