It’s tough to be a grown up. Things that didn’t matter at all before now matters a lot and vice versa.
I was going through my finances just to make sure that I have all my ducks lined up in a row when I noticed something. Reviewing my 401K made me feel better. I remember looking at the value of it back in 2009 and I thought I was going to have a heart attack. Thankfully, it has recovered since then.
About 10 years ago, I decided to maximize my contribution to my 401K at work. That’s what I have heard experts say. Suze Orman has repeatedly stated that maximizing your 401K at the time of your “highest earning years” is the way to go. A little extra investment makes a lot of difference in the long run. And so I did. Then, I heard her say a different story recently. She said to only put the maximum amount of contribution to my 401K up to the point where my company matches it. She advocated putting the rest of my investment into a Roth IRA. For whatever reason, I didn’t ask or figured out why. I followed what she had advocated and that was that.
I was contributing 15% of my salary to my 401K. That is the maximum contribution I could make. From the 15% total, my company will only match up to 6%. The 9% remaining or extra that I am contributing is not matched at all. It’s coming straight from my paycheck to the investment. Contributing 15% tax-free to an investment was a benefit to me. It lowers my taxable income at the end of the year, and therefore, I don’t need to pay more taxes but rather I get a refund every year. When I made the change from contributing 15% to my 401K to splitting the 15% between 401K and Roth IRA at 6% and 9% respectively, I noticed something different. I noticed that my take home pay went down as well. This is because Roth IRA contribution is money that is contributed after tax. 401K contribution is pre-tax. It freaked me out so I returned it back to the way that it was – 15% to my 401K.
I have a friend (a financial adviser by profession) who recently gave me an advise on how to set up my 401K and other investments optimally. Apparently, I was not diversifying my investments enough to make the most gains out of them. I have a personal mutual fund set up outside of my 401K, but that is all. I have savings and in case of anything urgent, I do have cash to pull out. But even that wasn’t enough in my friend’s eyes. He recommended the same exact recommendation that Suze Orman suggested. Maximize contribution to my 401K only up to the maximum allowed to be matched by the company. Put the rest of the contribution into Roth IRA. I reasoned with him by telling him that my net pay went down because of that and I don’t want to do it.
This is how he explained it to me.
Roth IRA is an after-tax contribution where you invest money that has already had taxes taken out of it. You deposit $100 dollars today, and you take out $100 dollars tomorrow – no problem. No penalties, no wasted money. For 401K – any monies invested cannot be withdrawn without penalties (except for certain cases – like using the money to buy your first home – you can take out a loan from your 401K for that without penalties) until you are at the retirement age. That’s the big difference. But it still did not convince me. So my friend continued to explain.
Let’s say I want to invest to a Roth IRA today, the 9% amount that I was going to invest will be taxed. Let’s say the 9% of my total salary is 100 dollars. And let us say that I am taxed 35%. $35 dollars of the $100 dollars will go to the government. So, I can now only invest $75.00 into Roth IRA. If the $75.00 that I invested into Roth IRA today, grew to $20,000 dollars in 20 years – when I take the money out at that time, I will not be taxed again. That money is free and clear of taxes. 401K works the other way. you contribute $100 today tax-free, and in 20 years it grew to $20,000 dollars. When you withdraw that $20,000 dollars, you will be taxed on $20,000 dollars. The question my friend asked me was this, “Would you rather be taxed at $100 dollars now or at $20,000 dollars later?” The simple answer is: NOW.
This change may have changed how I am taxed on my income when I file my taxes next year – I don’t know. But if I have to look for a tax preparer to help me sort this type of concern, it’s easy to find one. How? Let’s say you live in Arizona (I live in New Jersey), and you want to look for a tax preparation company, all you have to do is search “tax preparation Phoenix” and you will find one. Just do a quick look up and make sure you read reviews about the company (usually Yelp and other apps out there help you with reviews) and make the choice. So the tax changes this investment change that I did wasn’t worrying me. I can always count on a tax preparer to sort it all out.
Grown up stuff! Ugh.
Have a great weekend! Sorry for blabbing! I hope I made some kind of sense. 🙂