1 simple New Year’s resolution that will juice your retirement savings
Lets just be clear upfront: New Years resolutions almost never work.
Their failure rate is so high, Im half embarrassed to suggest one. Ive yet to ever keep one myself; the success of this years attempt to avoid injuries by stretching after exercise can best be summed up by my midyear herniated disc.
One of the many reasons resolutions dont work is that we get this intense urge to be a better person in early January, then a few weeks later we turn back into the person we really are. For me, thats apparently someone too lazy to spend three minutes stretching.
But the resolution Im going to propose doesnt take yearlong willpower. It doesnt even require that you save more, something that Americans surveyed by NerdWallet said they flat-out wont do next year. Its a one-time decision that you can implement during those few short weeks when youre the best version of yourself: Switch to saving for retirement in a Roth IRA or Roth 401(k).
Youll give up the immediate tax savings of the status quo a traditional IRA or 401(k), the version youre probably using but youll gain a pool of tax-free money in retirement.
The math of Roth vs. traditional retirement accounts
Full disclosure: Ive been meaning to get around to making this switch for, oh, 15 months, so this is my resolution, too. Over half of plan sponsors now offer a Roth version of the 401(k). My employer is one of them, but I chose the traditional option for the same reason most people do: Contributions to a traditional 401(k) cost less in the moment, because they come out of your paycheck pretax.
With a traditional 401(k) or IRA, you defer taxes until retirement, when distributions from the account are taxed as income. With the Roth version of these accounts, you pay taxes upfront. You make contributions with after-tax dollars, but distributions of both your contributions and investment growth are tax-free in retirement. (Those coveted tax-free distributions are one reason the IRS puts income limits on Roth IRA eligibility; there are no income limits, however, on participating in a Roth 401(k).)
How those different tax treatments work in practice: Saving 5% of a $50,000 salary comes out to about $96 every two weeks. But if you make that contribution pretax to a traditional 401(k), it might reduce your paycheck by only around $75. The money you save on taxes now will be money you owe in retirement, but to me and probably to you, paying for something in 30 or 40 years or even 10 or 15 years sounds more appealing than paying for it right now.
When you contribute to a Roth 401(k), that 5% will reduce your paycheck by the full $96. So why would you do it? Because as any good Roth IRA calculator will show you, youre banking highly valuable future tax savings.
Why a Roth account is often the better choice
Even as I opted for the traditional 401(k), I knew I shouldve chosen the Roth version. The standard Roth vs. traditional decision makers all point to Roth for me. Im young, or at least youngish. While I cant predict tax rates, its not a stretch to think they could go up by the time I retire. I certainly hope my salary hasnt yet peaked. All of that means paying taxes now via a Roth and avoiding them later makes sense.
But as Tim Maurer, a financial planner and fellow Forbes contributor, told me when I was researching a recent article about Roth 401(k)s, even if all of those factors point to a traditional IRA or 401(k) for you meaningyou want to put off taxes because you expect your tax rate to be lower in retirement the Roth is very often still a better bet.
Thats because unless you contribute to the traditional account and then invest the tax savings you receive from that contribution, money in the Roth will be more valuable in retirement. When the 65-year-old snowbird version of yourself pulls money out of a traditional account to buy a condo in Florida, youll have to pull out the down payment plus enough to cover taxes on the distribution.
If you can instead tap a Roth, you only need to pull out enough for the down payment. Having money you can tap tax-free in retirement also allows you to manipulate your taxable income. You may be able to use Roth money to keep yourself in a lower tax bracket, reduce taxes on your Social Security benefits and lower the cost of Medicare premiums that are tied to income.
None of that matters much when youre young. And the switch may be a painful adjustment at first; youll need to get used to a slightly lower paycheck, a slightly smaller tax refund or a slightly higher tax bill. But like much of retirement planning and, for that matter, resolution-making this decision is a favor to your future self.
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This article originally published at NerdWallet here