Early Career Investing and Taxes
On this week’s episode of the podcast Steven asked about early career investing and his taxes. Quint and Daniel answered him specifically but lets dive more into the concepts behind their answers.
Steven had a very nice starting income that would have put him in the 22% single tax bracket for 2019 and 2020. The majority of Americans will be in similar tax brackets either the second bracket of 12% or the third bracket of 22%. Of course being married usually means you’ll pay lower taxes than someone with the same level of income who is single. What tax bracket you’re in and what kind of job you have can play a big role in choosing your investment strategy. We’ll get into this later in the article but for now if you expect your taxes to go up over time then a Roth 401(k) is probably the best choice for early investing. If you expect it to stay mostly the same or even go down for some reason than a traditional 401(k) would likely serve you better. Early on in your career you’re probably not as worried about navigating your way through taxes as you will be later in life when you may have more things to manage like a house, kids, etc.
For most people one would hope through investing or finding better jobs as they get older that your income will go up and unfortunately your income tax will go up as well. So for most people if they have the option of a Roth 401(k) they should probably look into it. The other thing that you need to consider is that these are retirement plans and your finances can look very different when you’re retired and your taxes are no exception. For example when you’re middle aged and working you’ll probably have more deductions as well. These can include things like your house, your mortgage, your healthcare, your children, and much more. But as you retire you may downsize your house, your kids will move out, and in general you’ll probably have less deductions than you did when you were younger and working. This can cause a significant difference in someone’s taxes and throws a lot of newly retired people for a loop. This can make choosing the traditional 401(k) option even worse as now all that money you made when you had more deductions and were in a lower tax bracket is now being taxed during your retirement with almost no deductions.
The traditional 401(k) has mostly replaced pensions in the US as the main retirement strategy. This puts the choice of where to invest mostly in the hands of the employee. The way they work is you put pre-taxed income into them and your employer will match your contribution up to a certain amount. And you get to pick where your money is investing, albeit within a limited range of options provided by the company. It’s usually a good idea to contribute enough to match your employer if you can afford it, otherwise you’re leaving money on the table. But because this money isn’t being taxed now, it’s being taxed when you withdraw it. Like we previously said, if you’re paying more taxes later in life when you’re retired this generally means you’re losing more money than you would have if it had been taxed first. Of course there’s a limit to how much you contribute, in 2020 it’s set to $19,500 annually or if you’re over 50 you can contribute an additional $6,500 to catch up for a total of $26,000 annually. How much your employer matches can vary but the most common is about 50 cents to your dollar up to 6% of your pay.
An increasingly common and popular alternative to the traditional 401(k) is the Roth 401(k), which uses post tax money instead so that you don’t have to pay taxes when you withdraw it. Now the way it works is that you have 401(k) and the roth is a seperate account inside the 401(k). This is important because it means you can have two separate buckets of money in the same retirement plan. Furthermore, the employer’s match is going to go into the 401(k) side not the Roth even if you’re putting all your money into the Roth. The contribution limits are the same as a traditional 401(k), but Roth’s have an income limit of $124,000 for single filers in 2020 or $196,000 if you’re married. Another important difference is when you can contribute. Roth 401(k) contributions must be made by the end of the year or December 31st while a Roth IRA allows you to contribute up to April 15th or tax day.
Running the Numbers
Alright that was a lot to go through but lets run some numbers to show you the difference between these two plans. Let’s use Steven’s situation as an example to keep it simple. His income is $72,000, putting him in the federal tax bracket of 22%. Of course we don’t know his state tax level but let’s just pick New York, where he would have a rate of about 6.33% for state and 3.5% for the city. He just got out of college so probably around 22 years old and lets say he retires at 65 so he worked for a total of 43 years. In the first example let’s say his income doesn’t change so he contributes the same amount each year and he contributes 10% of his income, so by the time he retires he has contributed 309,600 and his employers has contributed $92,880. Let’s say he has an average rate of return of 7% so this account will be worth $2,406,215 by the time he retires at 65. But it hasn’t been taxed yet. In 2020 his total taxes would be about 31.83%, but if he goes up even one bracket they become about 34.16% (this is for 2020 who knows what it’ll be in 2063). If his tax bracket stayed the same he’d pay $765,898 in taxes but if it goes up in each bracket for federal, state, and city he’d pay $821,963. That’s a huge change and we didn’t even factor in the changes in tax deductibles, changes in salary, outside investments, etc. There’s really too much to calculate everything without knowing someone’s entire financial situation, but I hope this shows you that if you expect your taxes to go up by the time you retire, which if you’re financially successful they probably will, then it’s better to choose a Roth 401(k) than a traditional one. Of course not every company will offer this option so you may need to split your money between a company 401(k) and set up your own Roth IRA outside of work. But if you do go with the Roth 401(K) it’s crucial you make sure you follow it and work with whoever manages it for your company so that he doesn’t mix the pretax money with the post tax money. This is especially important when you switch jobs or retire, the last thing you want is for these two buckets to become mixed because then you may have to fight the IRS for getting your money without it being taxed.