Many of us are just completing our 2018 tax returns. It is becoming more common for employers to offer both a traditional 401K and a Roth 401K. For those of you that have chosen a traditional 401K, you will have noticed that the amount you contributed reduced your taxable income this year, providing an immediate tax benefit. I work with many young clients trying to balance competing goals such as repayment of student loan debt, saving for a wedding, saving for a house and also trying to put some money away for retirement or college funding. Many times, they have immediate short term goals that they would like to achieve, and need the cash flow to accomplish these goals. For some clients whose main goal is to improve their cash flow in the short term, a traditional 401K makes sense because they will have higher take home pay since this contribution is excluded from their taxable income. But does this always make sense?
A Roth 401K differs in that you do not receive the tax benefit at the time of contribution, but when you retire, the money you withdraw will be tax free. You always have to pay the income tax on either type of 401K, so it makes sense to develop a strategy to see what makes sense. For those who expect to have a higher income in retirement than they currently have, a Roth 401K may make sense since they will be taxed on the contribution now at their lower income, and will not be taxed on it when they withdraw the money when they are in a higher income bracket during retirement. Some people earn high incomes now, and their retirement income may actually be less than what they are earning now since they are not saving enough to generate their current income in retirement.
It is a good time to revisit this while you are finishing up your taxes this year. How much could you have saved on your taxes if you had contributed to a traditional 401K this year? Do you need the cash flow now, or does it make sense to pay the taxes on your Roth 401K now since your retirement income will be higher and the withdrawals from the Roth 401K would not be taxable at that time? I would love to help you with this and your other financial planning needs.