But just because you can reduce your current tax bill doesn't mean it's always the right move. For many workers a smarter option -- and one made possible by more and more employers -- is a retirement plan that completely eliminates your tax bill down the road.
Make Way for the Roth 401(k)
401(k) plans have been staple benefits from employers for decades. Your retirement plan at work lets you have money taken straight out of your paycheck, and in some cases, your employer matches those funds with extra money of its own.
In a regular 401(k), the money you set aside reduces your taxable income for the year, potentially saving you hundreds or even thousands of dollars in current-year taxes. But a relatively new type of retirement plan -- called the Roth 401(k) -- can be an even better idea for some workers.
Based on the Roth IRA, these retirement plans don't give you the same up-front tax break. But unlike regular retirement plans, you don't have to pay a cent in tax when you pull money out of a Roth 401(k) to spend after you retire.
Is the Tax Trade-Off Worth It to You?
Currently only a very small number of workers who have access to Roth 401(k)s at work have taken advantage of them. In part, that's because you lose your current-year tax savings when you contribute to a Roth 401(k). (Apparently, the idea of paying taxes today on money that will be locked up for decades in a retirement account doesn't sit well with many workers.)
Take a simple example: Many taxpayers currently pay taxes in the 15% bracket. For them, putting aside $2,000 in a traditional 401(k) gives them a $300 boost to their tax refund. But by the time they retire, they could well be in the 25% or higher tax bracket. When they withdraw that money in the future, they'll pay far more in taxes -- not just on the original $2,000
they invested, but on any gains they earned between now and then.
With a Roth 401(k), you give up that $300 refund now. But in exchange, you never have to worry about whether higher tax rates will end up costing you more later -- because you'll never have to pay any taxes on that money ever again. All the growth on that money is tax-free even when you use it in retirement. In the long run, that can add up to big tax savings.
If that's a trade-off you're willing to consider, it can make a big difference in how much after-tax money you have when you really need it.
Get in touch with your HR department to find out whether your employer offers a Roth 401(k) plan. Depending on your personal financial situation, switching from a regular 401(k) to a Roth could make you a lot richer in your golden years.
More on smart money management:
- The Money-Saving Refi Move You've Never Considered
- Why Inflation's Much Worse
- How to Live on Less Social Security