When I say my finger hovered over the “Confirm changes” button and I broke a cold sweat, I’m not exaggerating – this decision wasn’t easy for me, as we all know I love Roth (and for good reason!).

When I first set up my 401(k), I chose Roth (mostly because my dad told me to) – but also because it made sense to me. My income wasn’t that high, and early retirement wasn’t yet a twinkle in my eye. I figured the chances that my “income” (and by extension, tax bracket) would be lower in retirement were slim.

Fast-forward three years, and both my income and retirement goals have changed dramatically.

If you’re unfamiliar with the basics of Roth and Traditional retirement accounts, I recommend checking out this article first. It’ll give you a solid foundation for the riveting narrative below.

It’s important to constantly revisit the plan

This is a hotly contested conversation in the early retirement community, mostly because a lot of the arguments are based on assumptions we’re all making about the future of tax law.

Ever since I started actively working toward financial independence, I’ve been finding as many new sources of income as possible and shoveling money into investment accounts. My current annual spend for 2020 so far (still have December to go) has been $28,752.73.

I don’t know off the top of my head what my total take-home pay was for 2020, but I know it was probably closer to $70,000 after all sources of income (permanent full-time roles, temporary work, freelance, etc.) were taken into account. [Sidebar: This is why I encourage side hustling to the best of your ability – my take-home pay was increased by around 42% by all my other work outside of traditional 9-5 employment.]

Unfortunately, we aren’t just taxed on our total take-home pay – we’re taxed on the original, gross paycheck amount.

This means I was paying taxes on my Roth 401(k) contributions (because remember, Roth means you pay the taxes before you put the money in, so you can take it out tax-free) based on a total income that was probably (pre-tax) closer to $90,000.

Even with the standard deduction of $12,550 (which makes my taxable income about $77,450), the $30,000 that I need to live comfortably is a far cry from my current income.

After all, early retirement goals are predicated on the idea that you spend as little as comfortably possible and try to maximize your earnings so you can save rapidly.

How the tax situation changes when you plan to retire early

If you think the government lets you get off tax-free in retirement when you’re no longer working, think again. Uncle Sam is like the roommate who won’t stop eating your Honey Nut Cheerios after you’ve asked him to Please stop, these are $4.99/box.

In a “Traditional 401(k)” scenario, the government taxes your “income” in retirement, even though it’s coming from your own investment account. (If it comes from the Roth account, you wouldn’t pay taxes on it – because you paid the taxes when you put the money in!)

This means the decision about whether to pay the taxes before you put the money into the account or when you take it out in retirement depends on whether you think you’ll be in a lower or higher tax bracket at the time of retirement.

For most young people starting out (with starting salaries to show for it), the conventional wisdom is that it’s better to pay the taxes in your current tax bracket (because you’ll probably be cashing out more in retirement, and we know tax brackets will change and likely go up based on the way our government has spent money this year).

HOWEVER:

If you plan to retire early (late 30s, early 40s), you’re most likely planning to stick to a rather conservative “annual income.” Remember my annual spend above? About $28,000, as of November? Let’s say I decide to ball out a little more and use $36,000 per year in early retirement, or $3,000/mo., instead of my current $2,600/mo. (See?! Moving up in the world!)

$36,000 is still a whole hell of a lot less than the $77,450 (a rough estimate of $90,000, minus the $12,550 standard deduction for singletons like myself) or so taxable income I’ve got right now.

So in my Roth 401(k), I was paying taxes in the 22% tax bracket on my contributions, and edging closer to the 24% bracket.

My ballsy $36,000 withdrawal rate in early retirement puts most of my taxable income in the 12% tax bracket, and would be taxed as such (when you consider what a $12,550 deduction would do to a $36,000 income, you realize it’s even dramatically lower: $23,450 of taxable income).

It’s either pay 22% on my contributions now, or between 10% and 12% when I take them out.

The big fat caveat? Tax rates will probably change

This is where the uncertainty comes in, and the reason for my cold sweats. It was an emotional decision, because nobody knows what the future will hold for our federal income taxes (and how tax law might change over the next 15 or so years before I retire).

I essentially had to make the following call:

I feel reasonably confident that, even if tax law changes, it’ll be cheaper for me to pay taxes on the money I actually withdraw in retirement than the 22-24% I’d be paying right now in the income bracket from which my Roth contributions would be coming, which I’m constantly trying to maximize and will likely increase over the next few years.

Plus, a big benefit of the Traditional 401(k) for early retirees is that you can complete a Roth IRA conversion ladder, which enables you to use your 401(k) penalty-free (this is a fancy logistics waltz that I break down here – don’t worry too much about the ins and outs of this just yet; all you need to know is that the Traditional 401(k) enables you to skirt some penalties).

Another consideration for singles

I’m legally single (and pay taxes accordingly) right now. Chances are, by the time I’m 40, I’ll be married – and the “married filing jointly” tax brackets are even more forgiving than the tax brackets that unmarried people are in, which makes me feel like the Traditional route is even more attractive. Can’t wait to break it to Thomas that we have to get hitched in order for my early retirement plot to pan out smoothly!

One last thing: Embrace the confusion and math

Trying to educate myself on the logistics of early retirement (and then challenging myself to share it with you in a way that makes sense) has been one of the most humbling things I’ve encountered yet writing Money with Katie. Just when I think I have it all down, I find another nugget of information that throws my strategy into a baby tailspin.

If you’re feeling confused, remember: You’re not alone. Luckily, the O.G.s of the early retirement game have already reached retirement and spend their ample free time combing through 1,000-page PDFs of tax law on sites that end in .gov, so we’ve got some strong advocates on our side.

I realize all the back and forth, assumptions, and options can make analysis paralysis overwhelming. I encourage you to just keep increasing the contribution. Keep investing. Don’t worry about whether or not it’s perfect, or if you’re going to wish you’d done it differently someday. The important thing is that you do SOMETHING – and through that something, I guarantee you’ll learn.