Thread by @Ezfinances4u, So in classic fashion, I’m up late and going to start another [...]

So in classic fashion, I’m up late and going to start another finance thread. Today I will talk about Roth 401k and why you should consider getting one over a traditional 401k if you’re:
-Young

-In a stable career

-Project being in a higher tax bracket come retirement

Let me start off by saying this is predominantly for those in the USA, so for my non-USA followers I apologize, I usually try to make most of my posts globally relatable but this one isn’t one of them.

If you work a 9-5 and you have standard benefits you’re probably familiar with a 401k, so in this thread I am going with this assumption. But more importantly what I’ll like to highlight is a Roth 401k which is less common than the Traditional 401k.

A Roth 401k really is a nice hybrid of the Roth IRA & Traditional 401k. The primary difference is, unlike a traditional 401k, the contributions to a Roth 401k are After-tax dollars. So essentially if person A is working their 9-5 with a Traditional 401k this person is

... making their fundings to the retirement account with pre-tax money and as a result come retirement, there will be tax on withdrawals. However with a Roth 401k, because the contributions are after-Tax, there are no additional taxes in future withdrawals or other qualified

...expenses. Now When should you pick a traditional 401k vs a Roth 401k? This really depends on you and this is where the introspection comes in.

For the Brunch with Jay Z Twitter that speaks vehemently about entrepreneurship and generating multiple sources of income (myself...

...included) chances are most people who fall into this category are willing to bet that come retirement the goal is to have multiple sources of income with significant enough revenue/profits (which of course will play into your taxable income or AGI) and more than likely will

...end up in a higher tax bracket (assuming governmental & policy changes stay constant over the years). In essence for these kinds of people you’ll more than likely end up in a higher tax bracket at retirement and should seriously consider a Roth 401k and I will go into more....

..details later. On the other hand if you’re planning on depending solely on your retirement income like 401k, IRA, Social Security (if it exists) you can determine a rough estimate of your total income by retirement and see for yourself if you will likely end up in a higher...

..tax bracket by retirement. Keep in come Traditional 401k withdrawals are taxed just like every other income at retirement. Find out more details here

https://finance.zacks.com/determine-tax-bracket-retirement-9462.html

How to Determine Your Tax Bracket at Retirement

When you're planning for retirement, a major factor affecting your savings decisions involves predicting the tax rate you're going to pay on your retirement income. There's no magic formula to figure...

https://finance.zacks.com/determine-tax-bracket-retirement-9462.html

..However if you’re Young, in a Stable career like Tech or anything STEM related, you’re more than likely going to end up in a higher tax bracket and given the rate of inflation, your withdrawals will definitely push you there even if you’re relying on retirement income alone.

This is where the Roth 401k comes in, by contributing your after tax dollars now you’re essentially being taxed at a lower effective rate and you’re allowing your money to capture the benefits of compounding (WITH TIME- refer to my thread on compounding) without having to worry

... about taxes eating into your cash pot in the future. So going to the fundamentals let’s imagine a Person A. 22 years old fresh out of college starting salary $85K. In my model I’ll show below I assumed over the course or their career they earn on average 5% raise yearly

This is to account for promotions, salary jumps everything... conservative.
For the Traditional 401k and Roth 401k I’m assuming they contribute 5% of their salaries and company matches 4% of their salaries (dollar to dollar for the first 3% and 50 cent to the dollar for the next

... 2 percent). I also assumed an average annualised returns of 7% yearly till retirement... also conservative. I’ll highlight the balance at the end of the person’s career which will be taxed for a traditional 401k based on how much the person withdraws yearly.

And will also try to estimate the tax rate over the years of the person under the Roth 401k model and compare the two.

And for simplicity sake I’ll just stick to the 2020 tax brackets for this analogy. (I’m working on the model as we speak so excuse my delay)

Here’s the Model part 1

Part 2

Part 3.

Okay perfect so we got our big numbers

- this person will have $4,531,210.12 in 401k at the end of their career

I’m also disregarding the 401k contribution limits here just to iterate a point to show the difference between Traditional and Roth 401k, for those not aware

... for 2020, the 401k contribution limit is $19,500 per the IRS and if you’re above 50 an additional $6500. But just imagine this doesn’t exist for my simulation and it’s intentional because I want to show you the implication of difference in effective tax rates over the years

Besides, with a contribution limit of $19,500 and contributing at 5%, we don’t cross that limit until the person begins to earn above $390,000 which isn’t until age 54, so our model isn’t affected that much by this assumption, I’m just stating this for the nit pickers.

Anyways back to the thread/ illustration... financial advisors have a 4% rule so basically this rule determines that during retirement your withdrawals should be 4% of your Retiremnet account and then adjusting for inflation as you go but for this we will even ignore inflation

..for simplicity sake. With 4% of $4,531,210.12 that’s ~ $181,250 which in today’s tax bracket puts us at an effective tax rate of 32% yearly

0.32 x $4,531,210.12 = $1,449,987.24

So Person A essentially pays close to $1.45 million dollars in taxes (remember Uncle Sam always...

.. gets his money back some how) under the Traditional 401k model versus $333,053.90 paid over the course of the career using the Roth 401k option. That’s a difference if almost $1.12 million dollars. Anyways don’t take my word for it, always welcome to do your own research

.. talk to your financial advisor if you have one (if you don’t I always recommend getting one, especially when you’re young) and figure out if Roth 401k makes sense for you, because it probably does.

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