August 19, 2018
Every week, Simply Money’s Nathan Bachrach, Ed Finke and Amy Wagner are answering your financial questions in The Cincinnati Enquirer. If you, a friend, or someone in your family has a money issue or problem, please feel free to send those questions to email@example.com
Chris in Sayler Park: You guys are always saying how you prefer Roth savings vs. a regular 401(k) that's tax deferred. But I can't see how paying 22% tax now is better than paying 12% once I retire and have a lower income.
Answer: In theory, you make a very valid point. With a Roth IRA (or Roth 401(k)), you contribute with money you’ve already paid taxes on, essentially “locking-in” your tax rate at that time. With a tax-deferred account like a traditional 401(k), you’re getting an up-front tax break and waiting to pay your taxes later.
So, yes, it makes sense to analyze the tax situation you’re in now versus the one you think you’ll be in during retirement. If you believe your taxes will be lower now, a Roth IRA (or Roth 401(k)) is a good option. If you think your taxes will be lower in retirement, a traditional 401(k) is a great way to save.
But we’ve never said to save solely in a Roth-style account. We talk about Roth IRAs and Roth 401(k)s because we think they’re great tools to have as part of your overall financial planning arsenal due to their tax-free growth. Having accounts with different tax structures gives you and your money more flexibility, both now and in retirement.
For example, what happens if you have a major, unexpected expense pop up? Ideally, you have an emergency fund for this exact scenario. But what if you don’t? If your only other option is taking an early withdrawal from your 401(k) to cover these costs, you’re going to most likely pay taxes and penalties. But if you also happen to have a Roth IRA, you could potentially tap the contributions in that account (which come out tax-free and penalty-free) instead.
The Simply Money Point is that this doesn’t have to be a binary decision; you don’t have to put all your money in a Roth-style account or all your money in a tax-deferred account. We like the idea of having a mix of both, but as always, consult a trusted financial planner and/or tax professional to discuss your particular situation.
Shane in Boone County: I hear a lot about the stock market, but not a ton about the bond market. I own some bond funds, so I’m just wondering if there’s anything I should be preparing for the rest of this year.
Answer: Here’s something you probably didn’t know: the global bond market is actually more than double the size of the global stock market. Yet, isn’t it interesting that most news is focused on the stock market?
As a bond holder, the big thing you need to be prepared for this year is for one more (or maybe two more) short-term interest rate hikes from the Federal Reserve, our nation’s central bank. Remember, interest rates and bond prices move in opposite directions. This is because the interest rates on newly issued bonds are higher, which makes older bonds not worth as much.
This doesn’t mean that longer-term interest rates will rise though, as those are more closely related to future economic growth. Since we at Simply Money Advisors currently see little recession risk in the next six to nine months, we wouldn’t be surprised by slightly higher long-term rates.
With interest rates possibly edging higher, investors can now earn higher rates on short-term bonds, which makes these bonds more attractive than they have been in years. Also, these shorter-term bonds are less sensitive to rising rates than longer-term bonds in terms of negative price movement. Don’t forget, the higher rates should offset some or all of this potential negative price movement.
Here’s The Simply Money Point: Any bonds (both short-term and long-term) will provide you some protection from stock market turbulence – we like to think of them ‘shock absorbers.’ This means your total portfolio could be susceptible to less risk. Just make sure your stock and bond mix is diversified properly for your needs and financial goals.
Responses are for informational purposes only and individuals should consider whether any general recommendation in these responses are suitable for their particular circumstances based on investment objectives, financial situation and needs. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing, including a tax advisor and/or attorney. Nathan Bachrach and Ed Finke and their team offer financial planning services through Simply Money Advisors, a SEC Registered Investment Advisor. Call (513) 469-7500 or email firstname.lastname@example.org.