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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Taxing Social Security

Taxing Social Security

Today we talk about taxing Social Security. We will discuss:

  • the factors that go into determining whether your Social Security income is taxable or not
  • give you some examples, and
  • tell you about a few potential surprises that you may encounter.

Watch Now: Taxing Social Security

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Taxing Other Types Of Retirement Income

Last week we discussed how other types of common retirement income are taxed. Click Here to watch that episode.

Today, we focus on taxing Social Security benefits. For some people, your Social Security may be taxable. Here is how we can determine if your benefits will be taxed.

Provisional Income

It starts with your provisional income. To determine if your Social Security is taxable, you’ll need to compute this. It includes:

  • half of your Social Security
  • dividends
  • interest, both taxable and non taxable
  • earnings
  • pension income
  • IRA distributions, and
  • other income

If your provisional income is less than

  • $32,000, for a couple
  • $25,000 for a single person,

your Social Security benefits are not taxed.

But if your provisional income is between

  • $32,000- $44,000 for a couple
  • $25,000- $34,000, for a single filer,

50% of your Social Security income is taxed.

And if your provisional income is over

  • $44,000 for a couple
  • $32,000 for a single person

85% of your Social Security benefits is taxed.

Examples

John and Carol

John receives about $27,600 in Social Security benefits and Carol receives $21,600. That totals $49,200. Half of their benefit is $24,600. They receive $2,000 a month from John’s IRA, for a total of $24,000. Total, they earn $5,000 per year in dividends and another $1,500 in interest.

Their provisional income is $55,100. This means 85% of their Social Security benefits are taxable.

taxing Social Security

Mary

Mary was recently widowed. She receives $21,600 in Social Security, half of which is $10,800. She takes a required minimum distribution from her IRA which was $8,300. Her provisional income in this case is $19,100. This is below the $25,000 threshold, so her Social Security benefits are not taxed.

taxing Social Security

Carl

Carl is single. He receives $2,000 per month from Social Security, $24,000 total. Half of that is $12,000. He also gets about $2,000 in dividends and $1,000 in interest. The rest of Karl’s income comes from a Roth IRA. He takes $50,000 from his Roth account. His provisional income is $15,000.  His Social Security benefits will not be taxed.

The Roth IRA distributions do not add to his provisional income.This is an additional benefit of using a Roth IRA in your retirement planning. Distributions from the Roth are not taxed. They also won’t make your Social Security benefits taxable.

taxing Social Security

Potential Surprises

Change in Marital Status

The first surprise is a sudden change in your marital status. If you find yourself suddenly single, you may owe more in taxes. The income limits for single people are lower than those for married couples. A sudden change in marital status may lead to more of your social security benefits being taxed.

Change in Income

A sudden increase in your income can also have a hidden surprise. This normally happens when you reach the age for required minimum distributions. At age 72, you have to start taking money from your IRA account. This will add to your provisional income. The distribution may cause your Social Security income to be taxed

Talk to a Certified Financial Planner™ Professional

There are a lot of factors that affect your taxes in your retirement, and you can manage some of them. Talk to a financial planner to learn more.

 


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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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What is Tax-Loss Harvesting?

What Is Tax-Loss Harvesting?

A listener asks a question about year end tax planning.  Can tax-loss harvesting help your tax situation?  Today we look at this strategy and how it works.

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What is Tax Loss harvesting

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What is tax-Loss harvesting

Today we answer a question from Joanne. She writes, “Last week I heard about something called tax-loss harvesting. What is it, and how can we benefit from it?” This is a strategy you can use to reduce your tax liability.

Understanding Capital Losses

From time to time, investments will decrease in value. And they may decrease to a level that is below your cost basis. Your cost basis is what you paid for the investment, plus any dividends reinvested into that position.

If the market value drops below your cost basis, you have an unrealized capital loss. You realize that loss when you sell it, and that can help reduce your income tax liability.

How Capital Losses Affect Your Taxes

First, losses offset any capital gains. Capital gains happen in two ways. They happen when you sell something for a profit. If you own a mutual fund, the fund may pay a capital gain distribution. The fund creates gains when the fund buys and sells securities.

An investor sells shares of Amazon for a $10,000 profit. They also sell shares of Ford for an $8,000 loss. They would only pay capital gains taxes on $2,000.

Loss-Harvesting

If your losses exceed your gains, you can use those losses to reduce other income, up to certain limits. You can use $3,000 of capital losses to reduce your other income each year. Any excess gets carried forward to future years.

Our investor sold shares of Amazon for a $10,000 gain. They also sold shares of General Electric for a $15,000 loss. You would not incur any capital gains taxes this year. They can use $3,000 of the remaining loss against their other income. The investor would have to carry $2,000 forward to use against their taxes next year.

What is Tax-Loss harvesting

Planning Tip

This does not apply to any investments in an IRA, 401k, or other types of qualified plans. You are not paying capital gains taxes on anything you buy and sell in those accounts.

Wash Sales

If you are harvesting a capital loss, you can’t buy the same investment you sold for a loss within 30 days. Doing so creates a wash sale. The IRA will not allow the loss on your taxes. If the stock you sold has a sudden increase in price, you can miss out on the gains.

Keep Good Records

If you have a large capital loss, it could take a long time to carry it forward. You will need to keep very good records.

There is Still Time for 2020

You still have time to harvest capital losses for this year. Any sales made between now and December 31 count on this year’s taxes. But you should speak to your tax professional to see what kind of impact those will have on your situation.

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.

Our Most Recent Videos And Posts