2020 was the year that I really started taking personal finance seriously. I went through a lot of life changes in a short amount of time, and I wanted to make sure that I was making the best decisions possible with my money.
I read Ramit Sethi’s book I Will Teach You To Be Rich and immediately became a personal finance nerd. Once I knew about 401ks and Roth IRAs, I realized that I had $8,461.02 in old employer 401ks that was just sitting there. I researched all of my options thoroughly and decided to roll over the money into my Roth IRA, despite the fact that I would have to pay $1,861.42 in taxes because of it.
What the heck are you talking about?
A 401k is a retirement investment account that you can set up with your employer, if your employer offers one. It’s a great employee perk because normally your employer will contribute money toward your account as long as you contribute as well.
Prior to 2020, I worked at 2 companies that offered 401ks, but I was no longer employed with those companies. This doesn’t matter though because the money in your 401k is yours whether you are employed at the company or not.
Both of my 401ks were traditional retirement accounts, which just means that I had not paid any taxes on the money in the accounts yet.
By the time I was thinking about what I wanted to do with these accounts, I already had a Roth IRA set up with Vanguard. A Roth IRA is also a retirement investment account, but since it’s a Roth it means that you’ve already paid taxes on the money in the account, so you don’t have to pay taxes on it later.
Back to 2020
Alright, so I knew that I had $8,461.02 in old 401ks, and I needed to figure out what to do with this money. After thorough research, I realized that I had 4 options available:
1. Do Nothing
I could just leave the money in my old 401k accounts. If you’ve got at least $1,000 in the account when you leave your job, then most employers give you the option to keep your money in the account. If I did nothing, then my money would still probably grow over time, but I would be at the whim of my old employer’s investment options and my pre-finance nerd decisions, which I didn’t want to do. (Most employer-sponsored plans have limited investment options and higher fees.)
2. Rollover Into My New Employer’s 401k Plan
A rollover is when you move your money from one retirement plan to another. When you leave a job and get a new job, as long as your new employer offers a retirement plan, then you can rollover your old 401k money into your new plan. For some people, this option makes sense if the new employer offers really good investment options and low fees. More often than not though, your new employer won’t have the best investment options either compared to what you can get with an individual account.
3. Rollover into a Traditional IRA
A Traditional IRA is an individual retirement account, similar to a Roth IRA. It offers a wide range of low-fee investment options, and since it’s an individual account, you don’t have to depend on an employer to have one. You can just open one up at any brokerage that you choose, like Vanguard or Fidelity.
One big difference between a Roth IRA and a Traditional IRA is that you don’t pay taxes on the money when it goes into the account, so you will pay taxes on it when it comes out. My 401k money was in a traditional account already, so I could just roll it over into a Traditional IRA and not have to worry about taxes until I retire. Very tempting.
4. Rollover into my Roth IRA
My final option was to rollover my old 401ks into my new Roth IRA. This option is almost exactly the same as option 3, except for one big difference: TAXES. In order for money to be put into a Roth IRA, it needs to be taxed. Since I hadn’t paid taxes yet on the $8,461.02, I would owe taxes on this amount if I decided to roll it over into my Roth IRA.
At this point, I knew that options 3 & 4 made the most sense for me because I wanted my money in an individual account that offered greater investment options, lower fees, and more flexibility. I just needed to figure out which option was better, and it boiled down to pay taxes now, or later?
The Math
In order to figure out which option was better, I used the following:
- My 2020 tax bracket (22%)
- Roth IRA calculator
- Traditional IRA calculator
- Expected account earnings of 8% per year & my age variables (current age = 26, expected retirement age = 65)
I opened the Traditional IRA calculator and starting putting in my variables. I did not put anything into the “annual contribution” field because I just wanted to see what would happen if I put the money in the account now and didn’t touch it again until retirement. One thing to note with the Traditional IRA calculator is that you have to fill out the “Retirement Tax Rate” field. This is the tax bracket that you expect to be in when you retire. I put 22% here to start.
Next, I opened the Roth IRA calculator and I input all of the same variables. The only difference is there was no “Expected Tax Rate” field. That’s because you don’t pay taxes on a Roth IRA when you withdraw the money, which is great. But I would have to pay taxes on that amount now if I went with the Roth IRA rollover:
$8,461.02 x 22% = $1,861.42 (the amount I would pay in 2020 for this rollover).
I’m used to getting a tax return so this would most likely ensure that I either owed taxes for 2020, or didn’t get any tax return. Bummer.
The Results
Both the Traditional IRA and Roth IRA Calculators estimated that my money would grow to be worth $170,196 by age 65. This makes sense because you can choose the same investment options in both accounts and receive the same rates of return. The only difference is the tax treatment.
My Traditional IRA Calculator had an extra column in the graph titled “IRA after taxes” which equaled $132,753. With the Traditional IRA, I would owe taxes on the money when I retire. And the taxes would be for the entire account balance, not just the money that I started with. So I’d end up paying $37,443 in taxes for option 3 ($170,196 – $132,753).
Yikes.
No Brainer
After crunching the numbers, option 4 was the clear winner for me. I could pay $1,861.42 in taxes now and then let my money grow tax free instead of not paying anything now but owing $37,443 on the money later.
That tax amount is based on a 22% expected retirement tax rate, which probably means I’d still be working some in retirement. Even if I didn’t work at all in retirement and my expected tax rate was as low as 10%, my “IRA after taxes” amount is still $153,176.
This means I would still owe $17,020 in taxes. Ouch.
After crunching the numbers, it was clear to me that I should rollover my old 401ks into my Roth IRA, and that’s exactly what I did.
I ended up owing taxes for the first time ever which was a bummer, but knowing that I have about $170,196 tax free dollars waiting for me at age 65 makes it ok.
Disclaimer: I am not a certified financial advisor and this article is intended for educational purposes only.