Ah, the traditional pleasures of September. Summer's heat starts to fade. Pumpkin-spice-flavored everything begins to appear on menus. People get in their first complaints of the year at seeing retailers roll out the Christmas marketing before they've even picked out their Halloween costumes. And, of course, the month would not be complete without a mailbag show from Motley Fool Answers hosts Alison Southwick and Robert Brokamp. To help them address all your autumnal financial conundrums, Sean Gates, a financial planner with Motley Fool Wealth Management, returns to the studio.
In this segment, they talk taxes and time as they discuss whether one email writer is better off using an account that cuts what he owes to Uncle Sam this year -- i.e., a traditional 401(k) -- or does it after he retires -- i.e., a Roth 401(k).
A full transcript follows the video.
This video was recorded on Sept 25, 2018.
Alison Southwick: The next question comes from Daniel. "My wife and I make a combined $140,000 per year. When we did our taxes for 2017, we had about a $6,000 tax bill. We could not figure out why.
"When we entered our W2s into the nifty tax software, it was mine that skyrocketed our tax bill into Sadland. The only thing we could think of is that I contributed to a Roth 401(k) whereas she contributes to a traditional 401(k) plan. Would this affect our tax bill? We're desperately trying to avoid another hard-hitting tax bill. In fact, I've even reduced my exemptions from one on my W-4 to zero, since we had to pay up. Please, for the love of all things Foolish, help us!"
Sean Gates: Well, as the president of Sadland, I think I might qualify to answer this question. Yes, I think you've identified the primary reason why your tax bill went up and the reason for that is that when you save to a 401(k) pre-tax, you are essentially deferring taxes on the amount that you contribute to that 401(k) and your paycheck is higher, because they're not clipping those taxes out of your paycheck per contribution.
If you have a $2,500 a month salary and you save $700 a month into your 401(k), that turns your salary from $2,500 a month to $1,800 a month and you don't owe the taxes on that extra $700. Come the end of the year, your tax bill is lower because your income is lower and taxes on lower income are lower. So by saving to the Roth, you are paying that tax in real time. It doesn't act as a deduction on your salary, and so that's pretty much the primary reason why you're facing it.
Then the question you have to ask yourself is whether that higher tax bill is worth saving into the Roth because in the future you won't owe taxes on those Roth contributions; whereas if it's pre-tax you will. You just have to decide whether your tax bracket is currently low in totality of your future and in totality of the different tax brackets.
Robert Brokamp: It's an interesting question. Thanks to the new tax law, most people are in a lower tax bracket. And many people will say they're at the lowest tax bracket they possibly could be given that Social Security is underfunded. Medicare is underfunded. Growing deficits. At some point taxes have to go up.
But we've been saying that for years. And the decision of the Roth is am I going to be in a higher tax bracket in the future when I want that tax break or am I in a higher tax bracket today? They make a decent income, so it's a tough question. I think part of what they're doing is actually smart where they're saving in a traditional account with the wife's income and the Roth with his income, so they're getting that tax diversification. But when you work with clients, do you make any sort of projection about what tax rates will be in the future?
Gates: We do. As you've been pointing out, everyone has been saying that tax rates will go up in the future and we'll keep saying it because we just are in a historically low tax environment.
Now other planners and researchers will say that you can raise taxes without raising income taxes, so you could increase sales taxes. You could create a VAT tax system or all sorts of policy mechanisms that would increase the overall tax collection process to account for those debts without raising taxes on income. And so it's possible that we never see higher income tax rates.
And really, when I work with clients, we will look at their specific income projections and we'll say, "Right now you're at $140,000 a year. Do you see that getting to $300,000 in the future and at what time do you think you'll retire?" And we'll just map out the next 40 years of their life and just make sure that we're tending to the tax brackets each year to maximize their overall total lifetime tax liability.
Personally, I save pre-tax. I don't make a huge amount of money. I prefer tax deferral so that I don't have to pay that tax liability up front and can get my growth engine on the investments going as fast as possible. It is a hard question to answer.