So it’s Finance Fridays again.

This is going to be a relatively short post I hope. Over the past few months, I’ve dedicated a lot of time to teaching what I consider the basics of finance. I looked over the past 28 Finance Fridays posts and I’ve talked about investing and retirement. I’ve spoken about portfolios and financial advisors. However, I think the best place to start when it comes to finance is these two posts:

Talking the Talk

The Philosophy

It is here where I try to distill down the definitions you need to know and the importance of passive investing.

Let’s talk about Roths.

Why don’t I use a Roth? or My 401k/403b has a Roth option, should I use it?

So let’s take the time to discuss it here. Roth 401k/403b versus traditional 401k/403b? Basically, it boils down to:

When do you pay your taxes on the money you put away?

If you pay taxes later, it’s a regular 401k/403b. If you pay the taxes now, it’s a Roth 401k/403b. That’s it, that’s the difference.

Why does it matter?

The amount of taxes you will pay is dependent on your tax bracket. So (in general), the more money you make, the more taxes you pay. Of course, there are tax brackets, but I am trying to keep it simple here. For the most part, most of us will making less money in retirement than we do during our normal career. For that reason, it is more tax efficient to use a regular 401k/403b rather than Roth because you would most likely pay less taxes.

In what instance would a regular 401k/403b be worse?

Well, let’s say you’re a doctor making 200k a year. A regular 401k/403b would be worse if you were withdrawing > 200k/year in retirement because your taxes would be higher (simplified case).

Wait, how is that even possible?

Well, there are a few ways. Maybe you are a super-saver. Or maybe you have some form of passive or extra income during your retirement such that you make more money in “retirement” than you did during your career. Also, you have to remember inflation still happens. The $200k you make now is not worth the same as in 2046.

This is all too complex, what should I do?

In general, if you believe you will make less money in retirement than you do during your career, then a regular 401k/403b is better. This is especially true because you can always opt to simply take out less money from your retirement in order to pay less taxes. Most likely, if you were ok with your current lifestyle during your career, then there should not be a huge need to lead a more lavish lifestyle in retirement. Unless you have very expensive hobbies like boating, needing to withdraw more money than what you made during your career doesn’t really make sense.

So then why do people use a Roth at all? Why does it even exist?

The most common reason to use a Roth is because you are early in your career with a relatively low salary. A classic example of this would be residency. As a resident, you are making $50k a year with the likelihood that you will make >$200k a year as an attending. Also, the likelihood is that in retirement, after compound interest and inflation, you will need to withdraw > $50k a year. This is the perfect situation to use a 401k/403b because it is the most tax efficient option you have. However, once you are an attending, a regular 401k/403b will be the way to go.

Another situation would be a young intern at a big company, with ambition/plans to move up. As a young intern making $40k/year, using a Roth 401k/403b is a reasonable choice if you plan to move up to middle or upper management and make more money, with plans to withdraw > $40k/year in retirement. Most likely this individual will switch over a regular 401k/403b once they hit upper level management.

Or maybe you plan to leave money to your heirs. Since the tax has already been paid on the Roth 401k/403b contributions, you can stretch out that tax benefit.

Wait, what if I’m not sure whether I’ll have more money in retirement or not?

I would say err on the side of using a regular 401k/403b. I think having more money than you know what to do with in retirement is a good problem to have. I also think it is a very uncommon problem. You can either opt to save it for your heirs or make charitable donations to decrease your tax burden. These are good things.

Is there any other benefit to use a Roth 401k/403b?

Since you’ve already paid the taxes on the contributions, you can withdraw the money from a Roth 401k/403b without a huge tax bill. This may be important when an emergency situation comes up that requires a lot of money, ie. medical emergency, loss of job, etc.

Can I split the difference?

Yes, you can contribute to a regular 401k/403b and a Roth 401k/403b. Just remember, these contributions can not exceed $18k (altogether) for the year. I also think this makes things more complex than they need to be. However, to each their own. In theory, if you planned out your life perfectly, you could figure out the optimal tax benefit. However, you can not predict what taxes will be 30 years from now.

TL;DR

Roth 401k/403b is good for early career when you think your retirement income will be higher than your current income.

Roth 401k/403b as a resident. 401k/403b as an attending.

Don’t forget about inflation.

No one can predict what taxes will be.

-Sensei

Agree? Disagree? Questions, Comments and Suggestions are welcome.

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