Pre-Tax 401k or Roth 401k: A Deep Dive

Pre-Tax 401k or Roth 401k: A Deep Dive

Pre-tax 401k or Roth 401k, which is better? This is a question we received from a listener. We dig into what goes behind your decision and nerd out the math. 

Pre-Tax 401k or Roth 401k: A Deep Dive

Can Spouses Start Social Secuirty Benefits at Different Times

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The Question: Pre-Tax 401k or Roth 401k: Which is Better?

We received a question from Alicia. She writes, “I’m a 30-year-old single filer starting a new job. I will be making approximately $140,000 per year, including a $20,000 per year variable bonus. This puts me in the 24% marginal tax bracket. I need to complete 401k options. Which account type do you think will be most beneficial for me in the long run?”

What Goes Into Your Decision?

Here are the big factors that impact your decision:

Retirement Income

Most people use their 401k to create retirement income. Distributions from pre-tax contributions are 100% taxable. This means any of the growth and the contributions that you made, are taxed as ordinary income. Roth contributions are not taxed, and the growth on those Roth contributions is not taxed.

Required Minimum Distributions

At age 72, you must take a minimum amount from your pre-tax 401k contributions each year. (This also includes your employer match.) Even if you do not need the income, you still must take them or face severe penalties.

The Roth 401k does not have required minimum distributions. Nothing forces you to take a certain amount each year. You simply take the amount you need for living expenses.

Hidden Tax Costs

Social Security

If you are using a pre-tax 401k, it will impact the taxation of your Social Security benefits. Once you reach a certain income level, 85% of your Social Security benefits get taxed. When you use the Roth 401k, those distributions do not count towards those income limits. The income from your Roth 401(k) will not increase the taxes on your Social Security benefits.

Medicare

Medicare Part B premiums are subject to Income Related Monthly Adjustment Amounts (IRMAA). Distributions from your pre-tax 401k can make your out-of-pocket Part B premiums higher. Income from a Roth account will not raise the cost of your Medicare Part B premiums.

Estate Planning

Alicia’s heirs will have to withdraw funds from her pre-tax 401k over 10 years. They will pay income taxes on the full amount they inherit. If she leaves behind a Roth 401k, they will also have to withdraw funds from the account over 10 years. But, they will not have to pay taxes on those distributions.

Pre-Tax 401k or Roth 401k: Math

Pre-Tax 401k or Roth 401k

Current Tax Benefits

Here are the income tax effects of the pre-tax and Roth 401k contributions.

Pre-Tax 401k or Roth 401k

She will save $208,974 in income taxes by using the pre-tax 401k over 35 years of working. This is a significant savings.

Projecting The Accumulation Amount

Over a 35-year working career, a 10% salary deferral projects to total contributions of $696,000. The growth of those deferrals over the same timeframe is significant. Using a 7% average annual return, we estimate her account will grow to $2.4 million.

If she uses the Roth 401k, every penny is tax free. If she uses the pre-tax option, it is all taxable.

Generating Income

What happens when she starts taking income from retirement? We assume she will take $100,000 gross income with an effective tax rate of 20%. In the initial stages of her retirement, she has $80,000 of net income. If she uses a pre-tax 401k, she pays $20,000 per year in total taxes.

At age 72 required minimum distributions begin. She must withdraw money from the account whether she needs it for living expenses or not. The percentage you take out increases each year, too.

If she lives to be age 90, she will pay over $760,000 of total income tax. This is a lot more than what she would have saved over the course of her working years.

Here is how the Roth 401k changes things. She takes $80,000 per year for the first few years. This is the net same net income. We projected the same net distributions from the Roth account. There are zero taxes paid over that timeframe.

Impact on Accumulation Values

This also can impact the accumulation value. To get the same net income, you must withdraw less from the Roth 401k. The balance has a better ability to grow. The difference at age 90 between the Roth 401k and Pre-Tax 401k in our example is $1.5 million.

Changing the Math—Investing the Tax Savings

What is Alicia going to do with the tax savings? Will she be disciplined and save it in something like a backdoor Roth IRA? Or will she spend it on her living expenses. Investing her tax savings can change the math.

If Alicia was to invest her tax savings, she’s going to have nearly $600,000 more for retirement. Using the “backdoor Roth” means the future income will be tax free. Because she is using the pre-tax 401k, she will have to pay taxes on the income from this portion of her assets.

Retirement Income

If she takes the same net income as the other example, this is what happens. She uses the Roth account to generate income in the first six years. This means she has no tax liability for the income.

At age 72, required minimum distributions from the pre-tax account enter the picture. This means that she must start taking a large sum of money from the pre-tax 401k. Over the course of her retirement, we project she will pay over $788,000 in total income taxes.

This uses current tax rates. If tax rates increase, her tax bill will be much higher.

Accumulation Values

How does it impact the long-term accumulation values? We projected the Roth 401k to grow to about $4.5 Million. Using the pre-tax 401k and backdoor Roth IRA, we estimate an additional $500,000 more at age 90.

Accumulation Values

If she’s disciplined enough to save the tax savings, you can argue for using the pre-tax 401k and backdoor Roth IRA. Otherwise, the Roth 401k works better over the long run.

The effect of compounding over decades is huge. And the tax-free amount that compounds in those accounts is a significant benefit.

 

If you have questions about how this could affect you, talk to a Certified Financial Planner Pro.

Talk to a Certified Financial Planner™ Professional

 


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About the Author

Neal Watson is a Certified Financial Planner™ Professional and a Financial Advisor with Fleming Watson Financial Advisors.    He specializes in helping hard working, middle class families plan for retirement.

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How Does Inheriting Money Impact Your Income Taxes?

How Does Inheriting Money Impact Your Income Taxes?

How does inheriting money impact your income taxes? It is a common question.  We will look at retirement accounts, Roth IRAs, and other types of assets.

Watch Now: How Does Inheriting Money Impact Your Income Taxes?

Can Spouses Start Social Secuirty Benefits at Different Times

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How does inheriting money impact your income taxes?

Inheriting money does not create a direct income tax liability. But the assets that you receive could. There are two primary types of assets, retirement accounts and everything else.

Retirement Accounts

Retirement accounts include IRAs, 401ks, and a TSA from a non-profit employer. There are different rules for spouse and non-spouse beneficiaries.

If you are a spouse and inherit the account, you get to treat that account as if it was your own. You must take required minimum distributions at age 72. (there is pending legislation to increase that to age 75.) If the account is a traditional IRA, the income from that account is taxed as ordinary income. Roth IRAs have different rules. Distributions might be tax-free. (More on this below)

If you are a non-spouse beneficiary, different guidelines apply. The new rules state you must liquidate that account within ten years. We are waiting for guidance from the IRS to know if annual distributions are required. Some believe the annual distributions are not required.

Distributions from a traditional IRA or 401k get taxed as ordinary income. Here is a simple example. You inherit an IRA account worth $250,000. To spread the distributions evenly over the next 10 years, you must take $25,000 per year from that account. This $25,000 gets added to your other income. If you are still working, this could create a tax headache. Remember, tax rates for ordinary income are higher than capital gains.

Non-Retirement Accounts

There are non-retirement assets. This includes a primary residence, an individual, or a joint account. This can create some taxable income in a couple different ways.

Sometimes those investments pay income distributions. It could be rent from a rental property. Some investments, like stocks, pay dividends. Other items like savings accounts or bonds pay interest. Those income streams are taxable to you as the new owner.

The other way income taxes factor into this is when you sell those assets. This is where cost basis comes into play.

In most cases, cost basis is what you pay for an asset. There can be adjustments to the cost basis over a person’s lifetime. For example, you may make improvements to your home. This increases your basis. You may reinvest dividends on a stock, which also increases your cost basis.

Cost basis changes when a person dies owning an asset. Under current law, the cost basis of those assets gets stepped up or down to the value on the date of death.

Your parents paid $50,000 for their home. But when they die, it is worth $250,000. Your basis when you inherit it is $250,000.

Your parents bought stock in the XYZ company for $25, but at their death, it was worth $10. Your cost basis is $10. But you do not have any tax impact until you sell the asset.

An Example:

Take the example of shares of fictional company XYZ. Your mom paid $4 per share for that position several years ago. Over time it increased in value and when she passed away it was worth $10 a share. Your new cost basis is $10. If you sell that for $12 per share, you have a capital gain of $2 a share. However, if you sell that asset for $8 a share because it decreased in value after she passed away, you have a capital loss of $2 per share.

Inheriting Impact Income Taxes
Inheriting Impact Income Taxes

Roth IRA Tax Rules

Distributions from Roth IRA’s might be tax-free, but certain rules apply. The Roth IRA account has to have been open for at least five years. If the account was opened two years ago, your distributions will not be completely tax-free until the five-year period is over.

The second rule applies to Roth conversions. Each conversion has its own 5-year time frame. Even if the account has been open more than five years, you could still owe some income taxes on distributions. If there was a conversion done in 2019, the amount that converted is not tax free until 2024. Any amounts converted in 2020 would not be tax free until 2025 when that five-year window has passed.

You need to be careful if you inherit a Roth IRA. Make sure you understand what is taxable and what is not.

Less Common Situations

There are less common situations, such as inheriting assets from an irrevocable trust. If you inherit assets from an irrevocable trust, you might not benefit from the step-up in cost basis. If this applies to you, check with the attorney and the advisor who helped set up those documents.

Potential Tax Changes

There are some potential tax changes on the horizon. There is the possibility of legislation that would eliminate the step-up in cost basis. There is also a proposed bill which creates what is called a “deemed sale at death.” This means the tax code would treat those assets as being sold on the date of the owner’s death. This creates a capital gain tax liability. Neither of those bills has passed, yet, and they may not pass. It is something we continue to watch.

Talk to a Certified Financial Planner™ Professional

This can be a complicated topic when you get into specifics. If you have a question about your situation, contact a financial planner to help you with the details.  If you would like to talk to us, pick a date and time on the calendar below.

 


Inheriting Impact Income Taxes

About the Author

Neal Watson is a Certified Financial Planner™ Professional and a Financial Advisor with Fleming Watson Financial Advisors.    He specializes in helping hard working, middle class families plan for retirement.

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Looking Forward to The Future

The Watsons

Looking Forward To The Future

The Watsons

This year, Dad and I will celebrate milestones in our careers as your advisors. My father joined Don Fleming 35 years ago in 1986. I joined Dad ten years later. Our office manager, Susan (who is also my wife), has been working with us for 26 years.

Like everyone, we are not getting any younger. Clients often ask Dad when he plans to retire. He has no plans to stop working any time soon. He has been blessed with excellent physical health, and remains sharp and focused. But, eventually he will step away from the daily operations.

Susan will retire at the end of this year. Her contributions to our success often go unnoticed on the outside. She is the one who makes sure everything gets done. She handles the paperwork, deals with TD Ameritrade, processes your distribution requests, and so much more. We would not be where we are without her. The person who steps into her role will have big shoes to fill.

This year, I will reach the big “Five-0”. I still have many good years in front of me to help guide you through your journey. The next several years will look much different than the last 25.

In 1996, Dad was only a few years older than I am right now. Don had retired two years earlier. Clients began asking what our plan was if something happened to him. That is how I got here. Fast-forwarding to 2021, we face the same challenge. Clients now ask what plans we have if something happens to me.

The next generation of our family has pursued different career paths.  My daughter is a teacher and married to an airman. Currently they are living in the Florida Panhandle.   My son graduates from college in a few weeks, and he will pursue a career as an electrical engineer.  My two step-daughters have careers in other industries.  One lives in Durham, North Carolina and the other in Orlando, Florida.  Keeping this a family business does not appear to be realistic.

We view our relationship as a long-term commitment to you. Helping you achieve your most cherished, life-long goals is our highest priority. This makes addressing the continuity of our firm extremely important.

Over the past two years, we have been taking steps to address this issue. It comes with many challenges. Values and principles need to align. Personalities must mix well. Philosophies and beliefs about how to help our clients must match.

Despite those challenges, we are making progress. Later this year we expect to have a plan in place to  resolve this concern.  In addition, we also believe our plan will allow us to deepen our relationships with you, broaden our capabilities, and improve how we run our business.  Rest assured, one thing will not change.  Our commitment to putting our clients first remains the highest priority.

 

 


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About the Author

Neal Watson is a Certified Financial Planner™ Professional and a Financial Advisor with Fleming Watson Financial Advisors.    He specializes in helping hard working, middle class families plan for retirement.

Our Most Recent Videos And Posts