I’ve got retirement on my mind for this edition of Investing With Charles. Today, I want to help you figure out which account is the best fit for you: a traditional 401(k) or a Roth 401(k).
Right now, I’m enjoying the quiet Pacific breeze on my family’s ranch in Middle-of-Nowhere, Peru, and it has me thinking about the future. Maybe it’s the birds chirping, or the lull of passing farm vehicles … who knows.
When it comes to retirement accounts, you have plenty of options. It’s tricky to figure out the best fit for you. I want to demystify that today. It all boils down to one factor: taxes.
In the latest episode of Investing With Charles, research analyst Matt Clark and I walk you through the best ways to protect your hard-earned gains using various retirement accounts.
Watch the video above for the whole discussion, or you can check out some of the highlights below.
Investing With Charles: Traditional or Roth Retirement Accounts?
Why Your Employer’s 401(k) Plan Is a No-Brainer
I know it sounds boring, but you should almost always go for your employer plan. It’s a menu of mutual funds that you choose from, and that’s the end of it, for the most part. But that’s OK, because you get the employer matching.
Whether you’re putting $1,000 or the maximum — which, for folks over 50, is over $25,000 — you’re getting a percentage match from your employer.
If you aren’t participating in that, you’re just leaving money on the table. So for every dollar you put in that gets matched, one for one, that’s a 100% return before you ever put a nickel into an investment.
So for that reason alone, I’ve always said do your 401(k) first.
Traditional 401(k) or IRA vs. Roth
If you have the ability to choose between a Roth 401(k) or Roth IRA and a traditional option, which one should you go for?
With a traditional 401(k) or IRA, you get a tax break today. Whatever amount you put into that plan, you get back your marginal tax rate; if you’re in the 20% bracket, you put that dollar in there, you’re making 20 cents on that tax break. That’s with the 401(k) or the IRA.
When you take the money out to live in retirement, you are required to take distributions, and you pay taxes on it then. So it grows tax-free for years. You pay taxes later on a much higher amount, and everyone’s happy.
Well, the Roth is sort of the opposite. You don’t get a tax break now. You put in after-tax dollars. But it’s also like the traditional in that it’s able to grow tax-free dividends, interest and capital gains. It grows tax-free for as long as you want it to, and you are not required to take required, minimum distributions on a Roth account — and then, when you do, if you take it out in retirement, you’re not paying taxes on it then.
Both are smart tax-avoidance vehicles.
Which One Is Better for You?
For me, it comes down to one thing: your current tax bracket.
If you’re at a stage of your life where you’re not making that much money, or you’re in a lower bracket, go for the Roth.
If you’re in a high bracket, if you’re in your prime earning years and you’re either taxed off here, then you don’t really care about the future — well, you care about the future, but the future is a problem for another day.
You care about saving money on your taxes now. So for me, and this is somewhat arbitrary, that cutoff is about 20%. If you’re paying about 20% in taxes, that’s the breakeven point.
If you’re paying more than that, go traditional 401(k). Get the tax break now, and take advantage of that.
If you’re paying less than that … if you’re paying 10% or 15%, then there’s not much value in taking the tax break today. You might as well get it in the future when you could be in a higher bracket. Go for the Roth in that case.
These are just some of the highlights from our conversation about traditional and Roth retirement accounts. If you’d like to hear more, click here to continue the Investing With Charles video now.
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Where to Find Us
Coming up this week, Matt will have more on The Bull & The Bear podcast, so stay tuned.
Don’t forget to check out our Ask Adam Anything video series, where chief investment strategist Adam O’Dell answers your questions.
You can also catch Matt every week on his Marijuana Market Update. If you are into cannabis investing, you don’t want to miss Matt’s weekly insights.
Remember, you can email my team and me at feedback@moneyandmarkets.com — or leave a comment on YouTube. We love to hear from you! We may even feature your question or comment in a future edition of Investing With Charles.
To safe profits,
Charles Sizemore
Co-Editor, Green Zone Fortunes
Charles Sizemore is the co-editor of Green Zone Fortunes and specializes in income and retirement topics. He is also a frequent guest on CNBC, Bloomberg and Fox Business.