The 401k Traditional Plan is Pre-Tax
The Traditional 401k plan is pre-tax. That means, all the contributed money over all the years, will be taxed when you are going to retire.
If you are going to put money into the Traditional 401k Plan, you need to understand that this money and all its capital gains will be taxed in the future – so to speak when you are going to retire.
That means, at the time you are paying into the 401k TRADITIONAL PLAN, you are not paying any taxes. Because of that nature, it’s also known as a so called pre-tax contribution. What basically means, your payments have been made before taxes have been paid.
Yes, that’s right. At the time you put that money into your account, you don’t pay any single Dollar on taxes! Instead, you will be paying taxes on all your funds when you withdraw them during retirement!
Hurray.. this seems to be fantastic, and it looks like the best and smartest option to go. You don’t pay any taxes when you contribute, and therefore you can use it as a deduction on your annual tax return. That just sounds amazing, right? Well.. is it really amazing or are there any smarter and better options? Where’s the catch?
Now, let me explain why this might NOT be the best option for your investment. And why you might want to consider choosing the other plan, the so called 401k Roth plan. Well.. to explain this a bit better, we need to understand the nature of taxes. So let’s dive into that topic for a bit.
The nature of Taxes
Looking back in history, taxes have always been going up. That means, what ever taxes you are going to pay today, it will be less than the taxes you’ll have to pay in future.
Considering this fact and knowing that we always had a progressive tax system – we’ll learn that taxes have been always going up. Every year the government was raising the taxes. And at this time, we can’t see any major changes.
Important: A major change would be a so-called FLAT-TAX. That would influence dramatically the output of the two offered 401k plans. However, at this point, we can’t see the congress changing the progressive system to a FLAT-TAX System. Unfortunately.
Knowing those facts, we also have to consider that we’ll hopefully earn more money year after year. Looking 20-30 years into the future, you’ll most likely have also a higher income than today!
But a higher income in future also means, that you’ll have to pay more taxes ! And when you’ll retire, you’ll pay much more taxes for your hard earned Dollars. Much more, as if you would have paid all of your taxes before retirement!
Kaboom.. what a hard punch straight into your face. Feels like a technical knock out, right?
The 401k plan gives you the choice, to pay your taxes now or in the future. Now let’s think about this twice to make some really smart decisions.
If you think about the fact that you’ll have to pay higher taxes in future, why would you not want to pay your taxes now?
Why would you like to postpone your tax payments and ultimately accept a punishment with higher taxes? Remember, most likely you’ll earn more money in future. And with our current progressive tax system, you’ll pay automatically higher taxes on your higher income.
Knowing that fact, would it be really as smart to use the Traditional 401k Plan and pay all your taxes (most likely higher taxes) when you’ll retire?
If that doesn’t seem to be so smart anymore, what else could we possible do with our money?
Luckily, there is a better option for you & me. An option that helps us saving money while paying less taxes. The solution is the so called 401k ROTH Plan.
The 401k ROTH Plan is After Tax
Now we know, that the Traditional 401k Plan is Pre-Tax. And we also know that it might not be the smartest choice to pay all the taxes when we want to retire. Taxes will go up, and our earnings will be taxed more. Probably not the best choice at all.
Soo.. what’s the other plan offering? What was it called again? Oh yes, the so called 401k Roth. Now let’s have a look at this plan. The big difference about this plan is the fact, that you pay the taxes first, and after your tax payments have been done, your net earnings will go into that plan.
That also means, that you can NOT claim the 401k Roth payments as deductions in your annual tax return.
At first, this doesn’t sound very attractive. Especially when filing your annual tax return, you might get a bitter and sour taste that’s coming up straight from your guts. However, if you do the math and if you just compare the contributions without considering any additional earnings, you’ll already see the difference.
Also don’t forget: Your future income will most likely go up as well. Higher income & and higher taxes. Both would hit you at the same time.
Example 401k Calculation
How was this calculated?
Step 1: First we found the value of a Roth 401(k) if you contributed $18,000 per year for 30 years earning an assumed 7% per year. This equaled $1,764,097. Since qualified withdrawals from a Roth 401(k) are not taxed, the total value remains $1,764,097.
Step 2: We then computed the totals for a traditional 401(k). Again we determined the value of $18,000 per year for 30 years earning an assumed 7% per year. This is the same amount as the Roth 401(k) total, $1,764,097.
However, contributions and all earnings in a traditional 401(k) are taxable when they are withdrawn. After taxes, the value of your traditional 401(k) account would be $1,499,482.
Taxation on the Traditional 401k Plan
We discussed, if you are going to put money into the Traditional 401k Plan, that money and it’s earnings is going to be taxed when you retire.
Let me give you a simplified example with a one time contribution of $10k
Annual Contribution: $10k
At the age of 65, you are going to take out the money. The traditional 401k plan has the following status & funds:
$10k – that was the money that was put down and payed before taxes
$4k – that’s the earnings from the performance
Total value: $14k at the age of 65
Unfortunately, you’ll be taxed on the entire 14k.
Taxation on the Roth 401k Plan
For the Roth, the profits on your contributions will not be taxed when you withdraw them at retirement. The employer’s contribution and profits on the employer’s contribution will be. Let me give you an example.
Bernhard contributes $18,000 and there is $10,000 of gain. None of this will be taxable when you pull it out. There is no deduction for the $18,000 contribution up front. It is not taxable later and the gain is not taxable later either.
Bernhard’s employer matches all $18,000 and there is also $10,000 of gain, all $28,000 (18 +10) will be taxable.
Remember: It makes sense to contribute if the employer contributes as it is basically money given to you that you would not receive otherwise.
Unfortunately, the employer match will be taxed down the road for the Roth or Traditional 401k. Read more about it here.
In my next article I disclose The Myth about the Secret 401k Backdoor!