August 2020

EDIT FROM MARCH 2021: When I wrote this post, I had not yet figured out a way to get money out of a pre-tax (traditional) 401(k) without paying taxes on it. Now that I’ve figured it out, I no longer believe the Roth 401(k) is the best option, but I’ve left this article intact as it was originally published so you can see my original thought process. Here’s the more recent follow-up about why I switched my 401(k) from Roth to Traditional.

I almost included this breakdown within a larger post about investing, but decided the sexy and salacious world of investment taxes deserved its own standalone post – mostly because I don’t trust the attention spans of people my age and I became increasingly wary as the length of the article grew longer.

Without further ado, let’s address the IRS-sized elephant in the room.

One fundamental distinction that’s crucial to understand when you’re investing is the difference between Traditional and Roth retirement plans. I’ve found it to be one of those things that people ask in hushed tones, eyes darting around the room to ensure secrecy, “So… what’s Roth mean anyway?” Much like references to classic movies we’ve never seen and words we should’ve learned studying for the SAT, “Roth” is one of those financial terms that elicits nods and smiles while Googling under the table.

Why do I care about taxes on my retirement plan? Isn’t everything I do taxed anyway?

Yes, despite the fact that the government taxes you coming, going, and getting the T-shirt, this is still worth the 5 minutes to learn. (For some reason it feels appropriate right now to mention that I almost flew to Portland once to make an expensive purchase because Oregon has no sales tax. I will stop at nothing to save, even while splurging.)

But the taxes that will impact your retirement accounts either happen right now or when you’re old and decrepit (I apologize in advance to my retired parents for the #old jokes to follow).

For our purposes today, the accounts that this decision will apply to (for most) are probably the 401(k) and IRA, but you may have a 403(b), 457, or any number of other more obscure accounts as well, depending on your employer.

Let’s use 401(k) as our primary example

If you have a Traditional 401(k), you’re contributing pre-tax income to the account.

This means if you make $2,500 per paycheck and you contribute 10% to a Traditional plan, the IRS has not yet taken its cut of your $250 contribution. Instead, they’re biding their time on the promise that, at 59.5 when you’re able to withdraw, you’ll pay taxes on your withdrawals in your 59.5-year-old self’s income tax bracket.

That’s really all there is to it.

Why I doodle Roth + KG 4ever in my notebooks

Which brings me to the Roth. Man, I love Roth plans. I have a crush on Roth plans. If I were a senior in high school, I’d ask my Roth 401(k) to prom and shyly stand in the corner all night, feeling self-conscious.

Here’s why:

Remember our 10% paycheck contribution? Well, in a Roth plan, you’d be contributing 10% of already-taxed paycheck dollars. Which means you bite the bullet and pay Uncle Sam now, in your current income tax bracket, and invest the money. It grows and grows and grows over the next 35 years, facing no taxes on the growth, and then, at 59.5 when you start withdrawing, it’s just… yours. No taxes to speak of.

I know. But I’ve already asked Roth to prom, so get your own date.

You might be wondering why anyone would use a Traditional given the absolute tax-free #payday that a Roth retirement account provides later in life, but the main advantage to a Traditional account is that it lowers your tax burden now. In other words, if you contribute the limit of $19,500 to a Traditional plan now, the government basically subtracts $19,500 from your salary and you only owe income tax on what’s left.

For example:

Say you make $80,000.

Subtract the standard deduction of $12,400 for a taxable income of $67,600.

Now pretend you’ve somehow finessed a scenario in which you can afford to contribute all $19,500.

Subtract another $19,500 and – bada bing, bada boom – your taxable income is $48,100.

That’s a pretty substantial amount lower than your base salary of $80,000!

So that’s why some people choose Traditional. Honestly, my theory is that most people who opt for Traditional just didn’t know the difference and picked the one that was set as the default, but hey – I remember feverishly texting my roommate-at-the-time Rob and going, “Shit, should I pick Traditional or Roth?” and he told me Roth, so… thanks, Rob. I owe you one.

Limitations

I feel like anyone who makes too much to qualify for a Roth retirement account probably doesn’t read my blog, but maybe I’m selling myself short. If your modified adjusted gross income is more than $139,000 for the 2020 tax year, you can’t contribute to a Roth. Boo-hoo. We’re sad for you and your monstrous income. Something tells me you’ll be all right, though.

At that point, though, you probably wouldn’t want to anyway – since you’re paying the taxes upfront in a Roth scenario, you’d be paying them in accordance to that Mack Daddy income. At $140,000+ per year, it’s probably a safe-ish bet that your tax rate in retirement will be lower (unless you have grand Wolf of Wall Street plans for your 70-year-old self, in which case, rage on).

Retirement accounts in general

So I guess now you know that I make under $139,000/year. Surprise! The girl who’s obsessed with budgeting and almost flew across the country to evade sales tax doesn’t make six figures. I understand – it’s shocking.

But alas, we’re all on different paths to wealth, and my PR degree and I unintentionally chose the “slow and steady” path. Until I become a full-stack developer or invent something that “disrupts” an industry that didn’t need to be disrupted, I’ll be here. Join me!

To my knowledge, you can opt Traditional or Roth for almost all retirement plans (of course, some odd-ball employer plans may not allow it; I’m not clairvoyant so I can’t say for sure but 99% of the people I’ve worked with have no trouble).

More broadly, “401(k)” and “IRA” are both alphanumeric soup names you should know. They’re both able to be Traditional or Roth, and in my upcoming “How to Prioritize Your Investments” post, I’ll explain more.

But in the meantime, you can think about it like this:

The account (401k, IRA, 403b, etc.) is the car. Your 401(k) is a minivan – dependable and ready for the long haul. Your IRA is the hybrid SUV. A 403(b) is… honestly, I can’t even think of an analogy. A Camry?

Traditional and Roth are just the colors of the car. You can imagine Traditional as blue and Roth as red. Your minivan and SUV can both be blue or red – you could have both blue, both red, or a mix.

Does this make it more or less confusing?

Regardless of Traditional or Roth, retirement accounts are baller

And here’s why: You aren’t paying taxes year-over-year on the growth in a retirement account.

That might not seem like that big of a deal, but taxes really eat into the compound interest of your returns over time. This is to say that regardless of whether you opt to pay the taxes on your income now or on the withdrawals later, you don’t have to pay taxes on the growth every tax season like you do with “regular” investment accounts that aren’t for retirement.

This is why there are limits – the IRS doesn’t want someone who’s bringing home $250,000 per year to stick $200,000 of it in an investment account for retirement that they can’t take their cut of every year.

Next time

Now that we’ve covered our tax basics, we can dig into the priority order of accounts. See you same time next week.