Today, I want to talk about three reasons why you might want to choose contributing to your Roth 401k rather than your traditional 401k, especially if you're within five years of retiring. But first I want to introduce myself. My name is Warren Burger. I'm the owner of luminary financial advisors, and we help people that are getting near retirement or just recently retired a financial plan that really focuses on tax efficiency in retirement. The first reason to think about contributing to that Roth 401k really has to do with the power of compounding. But I think we have to have just a little bit of an understanding of the difference between the traditional and the Roth just before we get started. So with the traditional 401k, you're contributing your money with pre-tax dollars, which means you're not going to pay any taxes on the money that you're contributing this year, but sometime in the future, you're going to pay taxes, not only on the money that you contributed, but also the growth that happens in that account, as opposed to your Roth 401k, where you're going to be contributing after tax dollars, which means you're going to be paying the taxes now.
But sometime in the future, when you're taking money from that account, you don't pay taxes on either the contributions or the growth. So let me just give you a very simple example of why this can be so powerful. So let's just go on the assumption that you're going to contribute $20,000 to your retirement account this year. And let's just make an assumption as well that you are in the 20% tax bracket. And we're just using 20% as really kind of a round number in a placeholder here. So you're going to contribute $20,000 this year. And in option one, you'd be contributing to your traditional 401k. So you wouldn't be paying any taxes on that money now putting $20,000 into your account and you will pay taxes at some time in the future. When you take money out of that account. Now the Roth 401k you're putting that same $20,000 into the account, but you will be paying taxes on that money this year, you're doing it with after tax money, you'd be paying $2,000 on that contribution and taxes that would be taken out of your paycheck throughout the course of the year.
So you would see a little bit less in your take home pay each week or every couple of weeks, whenever you're getting paid to reflect that tax payment throughout the year. So now let's fast forward. We're jumping our time machine you're now retiring and let's just, we have to change some of the assumptions. So we're going to assume that that $20,000 that you originally put into that account has now grown to the sum of $30,000. And let's just also say that you're retiring. So it's likely that you're not going to be having the same income. You, you're not going to be working, taking, taking in that income, which is going to lower your tax bracket. So for this example, let's just say that your tax bracket is now 10%. So you're in the 10% tax bracket. And we're going to take out that $30,000 that account now with the, with the growth that we've seen. So option one, we go back to the traditional 401k. And so we're going to take that $30,000 out, but we're going to have to pay taxes on that
30,000, even though we're paying it at the the lower marginal tax rate of 10%. So that $30,000 will be taken out, you'll pay $3,000 on that $30,000 at the 10% tax rate, the Roth option will now come out completely tax free. So you'll take that $30,000 and you won't pay any taxes on it. So you can see that the difference really is that paying the taxes. Now we pay $2,000 in tax on that money taking it out later with that growth and that power of compounding gives us a lesser tax bill in the future. Now, this is a really simplified example. There are other factors that could enter in and play into this decision for you. But it's just something to think about that that compounding in a tax free account can be really powerful. Now, the second reason that you might want to use your Roth 401k also has to do with taxes, cuz really when you're talking about these accounts, these Roth and Roth versus traditional, it's really a tax play and how you're going to manage your tax burden.
So the second example really has to do with how you're going to manage tax brackets. When you do finally retire, it's likely that you have been already contributing to your traditional 401k. And so you're going to have this tax deferred money. That's, that's there by starting the Roth 401k, you're actually able to create tax diversification to help you. When you finally get the retirement and you start withdraw taxes, this means that you can manage tax brackets in retirement. So for instance, you could use both your traditional 401k and your Roth 401k in combination with each other to manage those brackets. So if you're getting close to a next tax bracket in retirement, because you are going to be taxed on the income that comes from your traditional 401k balances that are being taken out that's going to push you through different tax brackets. And so you can find yourself in a situation where you have a choice between taking money out of your traditional pushing you into the next tax bracket, or you could use a piece of your traditional 401k and then the balance of funds that you need for that given year could be taken from your tax free bucket.
And so it doesn't push you into that next tax bracket, thereby saving you money on taxes, but also keep into consideration that when you turn 65 and Medicare comes into play and that, that could be a while for some of you. But the fact is that Medicare comes into play. If you, your income goes beyond certain thresholds, your actual Medicare premiums will go up. So being able to have that tax free bucket to help manage that that tax rate might allow you to take out the same amount of money that you need, but not push those thresholds or jump into those next tax brackets. It can be really helpful as you get into retirement. And it's not something that you can create once you get there, right? You need time to build up these buckets so that they can be useful for you in retirement. You know, take this information. This is general education information. It might not apply to your specific personal financial situation. So make sure anything that you're seeing on any of these videos, you're running by your financial
Professional, either your accountant or your financial advisor it's just really important that you take any of these concepts and make sure they apply correctly to your situation. So back to this third reason, it has to do with one of the rules that apply to a Roth 401k. And that rule is it's called the five year rule. And so you have to have had this account in existent for five years before you can have access to that money without having to pay penalties or pay taxes on that money. So you want at least five years for this account to grow. And so you, if you are five years from retirement, it's a perfect time. If you haven't been contributing to your Roth 401k to start to do so, this way you've started the clock running on that. And when you do get to retirement, now you have access to those tax free funds that will allow you to use these strategies of maximizing your tax bracket. So I hope this has been helpful. If you have any questions, feel free to reach out. I've included in the comment section below some really helpful flow charts and checklists for people as they approach retirement. And if you ever want to have another set of eyes on your own financial situation, I've also included a link to my personal calendar. You can schedule a complimentary call and we can talk about your personal situation. Thank you, and have a great.