As tax reform talks were happening in Washington, D.C., one of the rumors that managed to draw enormous criticism revolved around changing your 401(k).
And then, when it was revealed in the House’s latest version of its tax reform bill that 401(k)s wouldn’t be touched, you would have thought the world’s greatest crisis was just averted. Headlines popped up saying things like, “Don’t worry, your 401(k) plan is safe” and “Near miss on 401(k)s.”
But contrary to what you may have seen, heard, or read, this 401(k) change wouldn’t have necessarily been a bad thing. It’s just that the media didn’t take the time to explain the alternative, one that we think is actually pretty great.
The main argument against changing the 401(k) rules was that it would ‘disincentivize’ saving since you wouldn’t be getting as big of an immediate tax break. Generally speaking, the idea was this: instead of allowing you to defer the taxes you pay on $18,000 worth of contributions (and having those contributions be tax-deductible), you would only be able to do that with a few thousand ($2,400).
Ok, fair. Some people probably see the up-front tax break as the incentive to save.
But how’s this for ‘incentivizing’ you to save: tax-free growth.
Let’s repeat that.
Tax. Free. Growth.
Because that’s what you would have been getting as the alternative. Yes, only $2,400 of your contributions would have been tax-deferred and tax-deductible. But anything on top of that would have been ‘Rothified,’ meaning you would pay the taxes on your contributions up-front and the earnings would be tax free.
Doesn’t sound too terrible now, right?
And yes, a change like this would have probably meant your paycheck would be a little less since you would have to pay more taxes up-front. But we at Simply Money Advisors want you to see the bigger picture. Because having tax-free growth in retirement can give you more flexibility.
Just consider this: if you have $100,000 in your 401(k), how much do you have? (It’s not a trick question.) Depending on your tax bracket, you actually have less than $100,000. That’s the ‘deal’ you made with the government: tax break up-front, pay the taxes later.
So, for example, if you’re in the 25% tax bracket in retirement, you would really only have $75,000 in that 401(k) because the government still needs to get its share.
But, if you have $100,000 sitting in a Roth 401(k) or Roth IRA, all of that is yours in retirement. In this case, the deal you made allowed you to pay your taxes up-front to get tax-free growth.
The Simply Money Point
At Simply Money Advisors, we believe you probably already have way too much tax-deferred money thanks to the popularity of traditional 401(k)s and the relative newness of Roth-style accounts.
However, it’s not a bad idea to consider ‘Rothifying’ some of your retirement money on your own, even without the government doing it for you. You can do this through a Roth 401(k) at work or through a Roth IRA on your own (just note that a Roth IRA comes with income eligibility requirements).
And if you see headlines that say your 401(k) dodged a bullet with tax reform, just take it with a grain of salt. Because, in the long run, you might have been pleasantly surprised with change.