I’m switching jobs and getting a huge pay bump – should I funnel money into a Traditional and a Roth 401(k)

When people plan for their retirement, they tend to come across two of the most popular retirement accounts: Roth accounts and traditional accounts. Roth retirement accounts allow you to make tax-free withdrawals, but you have to pay taxes when you contribute to your Roth account. Meanwhile, a traditional retirement account defers your taxes now, but you have to pay them when you withdraw funds from your account.

A Redditor is deciding if a traditional or Roth 401(k) is the better choice. The Redditor posted in the Fat FIRE subreddit and is looking for advice. They will receive a significant pay raise in their new job, but some of the Redditor’s earnings will be subject to a 37% tax rate. 

I’ll share my thoughts, but it is good to speak with a financial advisor if you can.

Consider How Long You Will Stay at the Job

A big detail to consider is how long the Redditor plans to work. If the Redditor plans to retire at 60, a traditional retirement account may be more beneficial. They get to defer taxes and then have more years when they can make withdrawals at low rates.

However, if the Redditor plans to work into their mid-70s, they won’t have as many years to make withdrawals. A Roth account may be better in this case, as your heirs won’t have to worry about a high tax bill if you pass a Roth account onto them. 

It’s also good to keep in mind how Social Security and other cash flow sources will elevate your taxable income when you retire. Those income streams can push you into a higher tax bracket, but likely not as high as the 37% tax rate that the Redditor currently has.

Tax Rates Can Change

Tax rates have changed throughout history, and these are relatively some of the lowest tax rates. The United States has periodically raised its tax rates during depressions and wars to collect more money. For instance, the highest tax rate was 77% in 1918 during World War 1. The Great Depression featured a 62% marginal tax rate at the highest level in 1932. 

There are two trends to monitor that can impact tax rates. The first change is that President Trump may eliminate personal income taxes and use tariff revenue to fund the country instead. This development would be a significant victory for people who deferred taxes with traditional retirement accounts.

However, low fertility rates can lead to higher tax rates on personal income, especially if Trump doesn’t remove personal income taxes. Governments may have to raise taxes on the remaining workers to compensate for declining fertility rates. While we will all know how Trump’s policies affect personal income taxes within the next four years, the second scenario is more seismic in nature and may play out within the next 30-40 years. It’s good to consider how tax rates can change when deciding if you want to store money in a traditional or Roth retirement account.

Using the Roth Backdoor Method

The Roth backdoor method is a viable approach for someone who wants to avoid the 37% tax rate while putting money into their Roth account. You can’t move the money to your Roth account while being employed, as it will show up as taxable income.

However, the Redditor can make a mega Roth backdoor contribution if they get laid off or opt to work part-time after saving enough money. This approach results in a lower tax rate and shields those funds from taxation on capital gains and dividends.

The post I’m switching jobs and getting a huge pay bump – should I funnel money into a Traditional and a Roth 401(k) appeared first on 24/7 Wall St..