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

Check Out Our YouTube Channel

Our YouTube Channel has over 100 videos on a variety of topics.  Click here to visit.  And while you are there, please subscribe.
Blog Post Alt Tag

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

Subscribe Where You Find Your Podcasts

Blog Post Alt Tag

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

 


insert here

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

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

Check Out Our YouTube Channel

Our YouTube Channel has over 100 videos on a variety of topics.  Click here to visit.  And while you are there, please subscribe.
Blog Post Alt Tag

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

Subscribe Where You Find Your Podcasts

Blog Post Alt Tag

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.

Our Most Recent Videos And Posts

4 Things to Help You Plan for The Worst

4 Things to Help You Plan For the Worst

Today we are going to talk about 4 things everybody should do to help you plan for the worst. These steps will make it easier for the people you care about the most.

Watch Now: 4 Things to Help You Plan For the Worst

Can Spouses Start Social Secuirty Benefits at Different Times

Check Out Our YouTube Channel

Our YouTube Channel has over 100 videos on a variety of topics.  Click here to visit.  And while you are there, please subscribe.
4 Things to Help Plan for the Worst

Listen Now:
4 Things to Help You Plan for the Worst

Subscribe Where You Find Your Podcasts

4 Things to Help Plan for The WOrst

Today, we are talking about 4 things that everybody needs to do to help plan for the worst. “The worst” means your death or becoming incapacitated. These steps will help your loved ones move forward more efficiently.

Some of this involves legal documents, and we are not attorneys. We cannot offer you legal advice. We are sharing some of our experiences to make it easier for people to handle these situations.

1. Name Beneficiaries

The first item is naming beneficiaries. Certain types of accounts do not have to go through the probate process. IRAs, retirement plans, life insurance policies, and annuities all have beneficiary designations. When you die, those assets go directly to your beneficiaries.

It is important to name those beneficiaries and keep those designations up to date. This helps avoid future problems. If you do not name beneficiaries, these assets then go to your estate. This involves the probate process. This mistake can result in extra costs, and potentially some extra income tax costs.

2. Durable Power of Attorney

The second thing everyone needs to have is a durable power of attorney. This is a legal document prepared by a lawyer.

A durable power of attorney allows you to name someone to make decisions on your behalf. This goes into effect when you become incapacitated.

A durable power of attorney allows the person you name to make “business decisions” on your behalf. For example, it will allow them to

  • pay your bills
  • buy or sell investments
  • sign checks
  • sign your tax return

Not having a durable power of attorney can create difficulties. Your loved ones will have to go to court and have a guardian appointed for you. This takes time and money at a stressful and inconvenient time.

3. Will

The third item everyone needs to have is a will. A will is a legal document prepared by an attorney.

Having a will allows for an orderly distribution of what you own to go according to your wishes. If you die without a will, your state’s intestate rules apply to your assets. This can add confusion, hassles, and red tape to the process.

4. Health Care Directives

The fourth item everyone needs is healthcare directives. This is a healthcare power of attorney and a living will. The healthcare power of attorney appoints someone to make healthcare decisions for you. If you need surgery and cannot sign the form, your appointee can sign the medical orders for you.

The living will deals with end-of-life decisions. It allows you to specify what means you want used to keep you alive. It allows someone to make that decision for you.

What About a Trust?

A trust can be a useful tool, but it may not be beneficial for everybody. Even if you have a trust, you still need to take care of these four items.

A trust is something you should discuss with an attorney to see if it makes sense for you. There are extra costs involved, and sometimes the cost does not add value.

If you are not sure who to talk to about these legal documents, please contact us. We can provide referrals to local attorneys who specialize in estate planning.

Talk to a Certified Financial Planner™ Professional

 


4 Things to Help Plan for the Worst

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

10 Percent Doesn’t Mean 10 Percent

10 Percent Doesn't Necessarily Mean 10 Percent

When it comes to stocks, 10 percent doesn’t necessarily mean 10 percent. We will explain this and how setting reasonable expectations can make you a better investor.

Watch Now: 10 Percent Doesn't Necessarily Mean 10 Percent

Can Spouses Start Social Secuirty Benefits at Different Times

Check Out Our YouTube Channel

Our YouTube Channel has over 100 videos on a variety of topics.  Click here to visit.  And while you are there, please subscribe.
Blog Post Alt Tag

Listen Now:
3 Things to Know About Bear Markets

Subscribe Where You Find Your Podcasts

Blog Post Alt Tag

When young financial advisors go to financial advisor school, one of the first things they are taught is the stock market has an average annual return of 10% per year. This leads people to believe the stock part of their investments are going to improve by 10% each year. But, 10% doesn’t mean 10%.

Only two times in the last 96 years have we seen stocks return close to 10% in a calendar year (10.06% in 1993, and 10.88% in 2004). It is more likely the positive years are going to be much better. And, there will also be some negative years, too.

When you’re thinking about what could happen in any given year, you should expect anything. In the short term, almost anything is possible. But over a long period of time—20 or 30 years—expecting stocks to return 10% per year is reasonable.

Setting Reasonable Expectations

It helps to set reasonable expectations when you’re an investor. It helps you to understand volatility is part of the process. And, we also know there will be difficult periods you have to navigate.

For example, you should expect the stock market to be positive three out of every four years. And, you should anticipate one year in four will be negative. Those plus years are likely to be much better than the 10% average annual mark. The average up year is about 21%. The negative years average -13%.

Corrections

You should also expect corrections to happen at least once a year. (We may be in the middle of one right now.) The average correction is about -14%. But even with those interruptions, the market has continued to improve over time.

Bear Markets

You should also expect bear markets. We had one last year, and it was an awful experience. But, the stock market recovered, and the recovery happened a lot faster than any of us anticipated.

When we set reasonable expectations, we can make better decisions about our investments. It keeps us from selling at bad times. It may keep us from buying at bad times as well. Avoiding those key mistakes can help us improve our real-life returns.

Talk to a Certified Financial Planner™ Professional

 


insert here

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

How Can You Invest in Electric Vehicles?

How Can You Invest in Electric Vehicles?

How can you invest in electric vehicles? Today we discuss:

  • the two ways you can do this
  • the difference between the two
  • and a valuable lesson we can learn from one of the best-performing stocks over the last quarter-century, Amazon.

Watch Now: How Can You Invest in Electric Vehicles?

How Can You Invest in Electric Vehicles

Check Out Our YouTube Channel

Our YouTube Channel has over 100 videos on a variety of topics.  Click here to visit.  And while you are there, please subscribe.
Blog Post Alt Tag

Listen Now:
How Can You Invest in Electric Vehicles?

Subscribe Where You Find Your Podcasts

Blog Post Alt Tag

How Can You Invest in Electric Vehicles?

This is a hot topic right now. More people are wanting to know how they can take part in this new and emerging technology.

Individual Stocks

The first way to invest in electric vehicles is to buy individual stocks. The most popular is Tesla. They have been making electric vehicles for a few years. The other major auto manufacturers are also getting involved in this. Both GM and Ford are committing billions of dollars to this technology. GM is also challenging Tesla on the battery front.

There are other companies in this industry. Nikola is developing battery-powered semi-trucks. And there are companies working on charging and battery components. Examples of those include Blink Charging and Plug Power.

There are also companies that manufacture the technology for the cars. Intel and Nvidia will also have a role in this emerging industry.

You can also look for investments in companies who focus on lithium. Batteries are a major component.

Mutual Funds or Exchange Traded Funds

The other way to invest in this industry is to use an exchange-traded fund or a mutual fund. The financial industry has been very innovative over the years. When industries like this emerge, they create a fund to focus on these companies. You can buy the fund instead of trying to pick individual stocks.

The Difference Between Using Stocks and Funds

The big difference between the two is the potential risk and reward.  Both ways of investing offer the opportunity to benefit from the growth of the industry. Both also experience a lot of volatility.

An individual company offers the potential for more reward, if you choose a good one. But when you pick the wrong one, you could lose more.

Using a fund reduces the potential gains. When you buy funds, you make smaller bets on a larger list of companies. Not all of them will be the big winner. You own shares of Tesla, GM, and Ford. You also may own shares of Nvidia and Intel.

The Lesson From Amazon

Amazon went public in May of 1997 in the middle of the dot-com boom. Since its offering, it has been one of the best-performing stocks over the last quarter-century. But early on, there was a lot of volatility.

In its first five years of existence, Amazon suffered significant price drops.

  • It fell more than 20% twice.
  • There were two 40% price drops.
  • One price drop exceeded 60%
  • And one time the price declined 90%!

Withstanding that much volatility takes a strong stomach and nerves of steel. Emerging technologies are not for the faint of heart.

Talk to a Certified Financial Planner™ Professional

If you would like to consider an investment in electric vehicles, talk to a financial planner. They can help you understand how it fits within your plans and your goals.

 


insert here

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