A few months ago I talked about how my wife and I were considering switching retirement contributions in my 401(k) plan to Roth 401(k) contributions, since my employer just started offering that as an option. We ultimately concluded that we would save hundreds of thousands of dollars net when all is said and done if we switched to the Roth.
While researching this stuff, I was a bit frustrated with some of the opinions that are thrown out there on this subject. One of the blanket statements a lot of personal finance websites make is that the decision to contribute pre-tax to a 401(k) or to contribute after-tax to a Roth 401(k) only depends upon what your tax rate is in the present and what your tax rate will presumably be at 59.5 when you can start making tax-free qualified distributions.
I even saw a spreadsheet that calculates the optimal time to switch from contributing to one and start contributing to the other. I found this rather interesting, and it does make sense at a high level – assuming you get steady raises over time that consistently push you up through the tax brackets as you age, there is an optimal time, technically where you can switch the method of contribution in order to get the maximum tax savings.
Although I believe the basic assumptions are sound, digging deeper there are other variables at work. Number one is that we don’t know what tax rates are in the future and we have no way to predict how the tax brackets will or will not change. Also, we don’t really know the extent of what our income growth will look like over the next few decades.
Personally, I’m going to make the assumption that I’m going to be making a lot more income in the future than I do now. (Side note: This is not meant to sound arrogant. I believe that over time I can exponentially increase my skills and bring such a great amount of value to the world that I will deserve much more claim checks on society in the form of money). So, even if I don’t know what future tax rates look like, I can make a reasonable assumption that the active income I earn will ultimately be taxed at a higher rate in the future.
Number two is the age of retirement. Although I am not necessarily trying to retire early like many other bloggers out there, I DO strongly desire for my family to be financially independent (which would provide the option to retire early if we feel like it at that point). As mentioned in a post by the Mad Fientist, pre-tax contributions are much more advantageous for people who want to retire super-soon. This is because pre-tax conversions can ultimately end up in the hands of the early-retiree without being taxed by using a Roth conversion ladder. Since Mrs. Mase and I view this account as “old man, old woman” money, we don’t have a desire to tap this account any time soon. As such, Roth contributions are best for us.
When sitting down with our accountant to do our taxes this year, I brought up the Roth question to him, and asked for advice given our current situation. He basically told us it was a no brainer and that we should go for it. He likened it to, “making a lot of desserts now that come out burnt and tasteless that you pay a lot for…but having all the free delectable desserts you want in the future if you wait long enough…” Ha, kind of a weird analogy, but we got the point.
After getting home Mrs. Mase and I had to sit down and talk about the reality of the first part of our accountant’s analogy – we were going to take a hit on our paycheck now in order to contribute to the Roth. After doing some simulations of what our paycheck would look like after taxes, we ultimately decided to lower our contributions by a couple percentage points. These lowered after-tax Roth contributions plus the impact of a raise that will kick in soon theoretically will leave us the same amount of net income as the pre-tax contributions currently do with a higher contribution.
I guess we’ll see how well that pans out. The reason we feel it’s OK to lower those contributions slightly is because we want to stay focused on paying off our mortgage, but we also want to immediately start taking advantage of the power of the Roth 401(k), especially now that I have a raise kicking in that will offset some of the taxes. Hopefully, this is another one of those seemingly small decisions that the old version of me will look back in time and be glad we did this.