This week, I started a new job with a tech company. I’m sure you’ve heard the cliché of drinking through a firehose. Well, yea, that’s been real this week. Along with all of the orientations, the trainings, the intros, the rabbit holes of internal links, and giving in to my general curiosity of some of the things my new colleagues were working on, there was the 401(k) election decision.
I had the choice between a traditional 401(k) and a Roth 401(k). If you’re unfamiliar with 401(k)’s, read my full explanation here first and then come back to this post. The TL;DR explanation is that a 401(k) is a tax-advantaged retirement savings account. In my case, I could choose either the traditional 401(k), the Roth 401(k), or a combination of the two. For 2020, the maximum annual contribution is $19,500. That’s the total across both the traditional 401(k) and a Roth 401(k). In other words, whatever combination/distribution I select, the most I can contribute is $19,500 for 2020. However, my company does a dollar for dollar match up to a certain amount. This company match does not count towards your annual contribution limit so the match actually allows me to save more than the annual limit. This is awesome!
So the no-brainer part of the decision was to contribute at least enough to get the full company match. That’s free money! Since I started mid-year and my previous company didn’t offer a 401(k) plan, I hadn’t made any 401(k) contributions so far this year. For that reason, I set my per-paycheck contributions to make sure I contributed enough to hit the maximum company matching contribution by the end of the year. It means a fairly significant hit to my take home pay for the next 6 months, but it’s worth the sacrifice…and then when January rolls around, it’s almost like I’ll be giving myself a raise. Even though I’ll still be contributing the same amount to get the match in 2021, I’ll have 12 months to do it vs. 6 so only half as much will be taken from each paycheck. To be clear, I’m saying “taken”, but it’s really more like “giving” because the money’s not being taken from me, I’m just saving it to pay myself later…with interest!
Which Is Best For Me?
Ok, so what did I decide, traditional or Roth? Well, I chose a combination of the two. I decided to go with a 70% traditional, 30% Roth split. Why? As we’ve discussed, traditional 401(k) contributions are pre-tax and Roth 401(k) contributions are post tax. When you’re eligible to withdraw funds from your 401(k), with a traditional plan, you’ll be required to pay taxes on any gains (any increases in the investment values) at your tax rate at the time of withdrawal. With a Roth 401(k), since the contributions are made with after-tax money, the withdrawals, including the gains, are tax free. The exception to this is any employer matching funds. Those are considered pre-tax so you’ll still have to pay taxes on that part of any withdrawals, even though it’s a Roth 401(k). But, that was free money anyway so…
I chose to do the split for a couple of reasons.
It’s all going to depend on your personal tax bracket and exemptions, but for example, a $500 pre-tax (traditional 401(k)) contribution won’t actually lower my take home pay by $500, it will be less than that because I’m effectively being taxed on my salary minus that $500. On the other hand, if I contribute $500 post-tax (Roth 401(k)), it lowers my take home pay by at least $500 because I’m contributing the $500 and I’m being taxed on the $500. BUT (HUGE “BUT”), I won’t pay taxes on the withdrawal from the Roth 401(k) when I retire. So, one approach is not always better than the other. In short, there’s no avoiding paying taxes, it’s just when you want to pay them. In my case, this is the option that works for me right now.
As I’ll continue to say, personal finance is personal. I’m simply sharing my experience. I encourage you to consult a financial advisor and/or tax professional to make sure you’re doing what works best for you and your specific situation. Care to share? I’d love to hear your stories.
