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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Required Minimum Distributions

Required Minimum Distributions

Today we discuss required minimum distributions and cover:

  • when you have to start taking them
  • why it’s important to take them
  • the basics of how they’re computed
  • when during the year is the best time to take your distribution
  • and, what you can do with the money if you don’t need the income

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required minimum distributions

Required minimum distributions may not be an interesting topic, but our clients ask a lot of questions about them. If you’re heading towards your retirement, it’s something that should be on your radar.

When do you have to start taking your required minimum distributions?

In 2019, the government passed the SECURE Act. This legislation increased the age at which you have to start your required minimum distributions. It used to be the year you reached age 70½.  Now, you must start the year you reach age 72.

Why do you want to take your required minimum distributions?

If you don’t take your RMD, the penalty is severe. The penalty is 50% of the shortfall. If your required amount is $10,000 and you fail to take that, the IRS penalty is $5,000.

required minimum distributions

How much do you take the first year?

Your first RMD is roughly 4%. The IRS uses the Uniform Lifetime Table. It is a life expectancy table which uses a 10-year difference in age between spouses. If your spouse is more than 10 years younger than you, you can do things differently.

You look up your age on the table find the divisor. The first year the divisor is 25.6. (25 equates to 4%.) The next year, the divisor goes down a little bit, which means the percentage increases.

Required minimum Distributions

Here is an example. The balance of your IRA at year’s end is $256,000. Divide that by 25.6. The amount you have to withdraw is $10,000. Next year, you divide the year-end balance by 24.7. The following year, you divide the year-end balance by 23.8. You always take the balance at the end of each year and divide it by the number for your age.

Eventually, you will take more from the account than you can earn. At age 88, the amount is about 8%. At age 92, the required amount is roughly 10%.

Required minimum Distributions

When is the right time to take your distribution?

Some clients take their RMD early in the year. Others wait until later in the year. Many people worry about what is happening in the investment markets. If the stock market is near all-time highs, a lot of people will want to take it at that point.

We do not know what will happen later in the year. Values could be higher or lower than they are right now. The correct answer to this question is, “take the distribution when you need the money.”

Income Taxes

Most custodians will withhold taxes from your IRA distribution. Most will withhold both state and federal income taxes. If you pay quarterly estimates, you should adjust your estimated tax payment.

What if you don't need the money?

One of the better planning tools you can use is a qualified charitable distribution. You direct a distribution from your IRA directly to a charity of your choice. You do not report the distribution as income. You will save both the state and federal income taxes on the amount that you donate.

The other thing you can do is reinvest your distribution in a taxable account. Many custodians allow you to transfer shares of an investment to another account. This is an “in kind” transfer. You can also transfer cash.

You cannot convert your required minimum distribution to a Roth IRA.

Benefits of Using a Roth IRA

There are no required minimum distributions from Roth IRAs. It’s another great reason to use the Roth IRA to help you save for your retirement.

These specific rules only apply to the original account owner or their spouse. If you have an inherited IRA, different rules apply to you.

Talk to a Certified Financial Planner™ Professional

If you have specific questions about your situation, a financial planner can help. Talk to one today.  Click below to schedule a call

 


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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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Why Not Use Dividend Stocks For Retirement Income?

Why Not Use Dividend Stocks for Retirement Income?

Today we answer a viewer question about using dividend stocks to create retirement income.

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Our question from Ronald. He writes:

I am looking to retire soon and trying to determine the best way to generate retirement income with interest rates so low. Traditionally, you could have done this with treasuries or CDs. Why wouldn’t buying dividend stocks paying 4% to 5% makes sense? In addition to the dividends, you have the opportunity for appreciation.

The Challenge of Low Interest Rates

Ron makes a couple of good points. Interest rates are ridiculously low right now. Traditional methods of using bonds or CD’s to generate income are a challenge. Ten-year Treasuries are yielding about 1%. Thirty-year Treasuries yield about 1.8%. CDs, unless you lock those up for a few years, are going to be well below 1%. Using these interest-bearing investments to create retirement income is very difficult.

Using Dividend Stocks For Retirement Income

Why can’t you use a portfolio of dividend-paying stocks to create that income? You can, and there are some benefits. The dividend income is more than you would earn on a lot of fixed-income investments. You also have the opportunity for capital appreciation. Many of these companies will increase their dividends over time. And there are some tax advantages.

The Challenges

1. Volatility

But there are significant challenges to doing this. The first one is volatility. Companies who pay good dividends will decrease in value. You are going to see periods where your account drops 20%-30%. You must be able to withstand those periods, and not sell something at an inopportune time.

2. Portfolio Construction

The next challenge you have is how you build your portfolio. You want to make sure you have diversification across different industries. You want to make sure you are picking good companies.

Oil companies provide a great example of why you should diversify. When oil prices went down last year, many oil companies saw their share prices decrease. Many of them also decreased their dividend. Investing too much in one industry could impact your ability to maintain your income.

Stock selection is also important. Look for companies that have good earnings as well as a decent payout ratio. (The payout ratio is how much of the earnings are being paid out as dividends.) If a company is paying more in dividends than they earn, it could be a problem down the road.

You also want to look at their dividend history. Has the company been able to maintain their dividend over time? Have they been able to increase their dividend over time? Or have they had periods where they cut the dividend? When you depend on that income, the last thing you want to see is your income cut.

You want to be cautious of owning too few companies. When you own too many shares of one company, bad news could hurt your account.

3. What if You Need Extra Income?

You may find you need extra income. This can also be a challenge. You can sell positions that have appreciated in value. But when you sell those shares, your future dividend income is going to decrease. It can create a problem if you do need extra income. One of the ways to address that challenge is to have a bigger emergency fund on hand. When you need extra income, use your emergency fund and not disrupt your regular income flow.

Tax Advantages for Using Dividend Stocks to Create Retirement Income

This can be a tax-advantaged way to generate income in a non-IRA account. Qualified dividends receive preferential tax treatment. For most people, qualified dividends get taxed at 15%. It could be lower, depending on your total income. Other types of income are taxed at higher rates.

Qualified dividends come from common stocks of US companies and some international companies. When you build a portfolio of common stocks, you are going to be in a more tax-advantaged position.

Some higher-yielding investments pay dividends that are not qualified. Real Estate Investment Trusts (REIT’s), Master Limited Partnerships, and Business Development Companies pay good dividends. But those payments are not qualified. You can hold those, but you will not see the same tax benefits.

If you can handle all the challenges, using dividend stocks to create retirement income can be a good strategy. But it may not be easy.

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 Retirement Income is Taxed

How Retirement Income is Taxed

How Retirement Income is Taxed

Today we look at how the most common types of retirement income are taxed.  We look at:

  • The common types of accounts retirees use
  • The types of income taxed at the highest rates
  • Types of income which receive favorable tax treatment

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how Retirment Income is Taxed

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When you retire, you go from earning a paycheck to using your savings to create a paycheck. You will still have to pay income taxes. Today, we look at the common types of accounts retirees use to create income, and how they are taxed.

Retirement Plans and IRA's

This might be a 401k, a 403b or even a 457 deferred compensation plan. Many people roll those over into an IRA.

The taxation of the income generated from those accounts depends on the contributions. If you made pre-tax contributions—meaning you took a tax deduction—the income is taxable. Your contributions, your employer’s contributions, and the earnings are taxed as ordinary income. Tax rates for ordinary income start at 10%. The maximum tax rate is 37%.

If you used the Roth type accounts, the contributions happened on an after tax basis. This means withdrawals from these accounts are not taxed.

Individual and Joint Accounts

The second type of account that retirees use is an individual or a joint account. If you have this type of account, you pay taxes “as you go”. The investments in those accounts often pay dividends or interest. Interest is usually taxed as ordinary income. Dividends paid by a common stock get favorable tax treatment. In most cases, the highest tax rate for qualified dividends is 15%.

You may also have capital gains. A capital gain happens when you or one of the investments you own sells an investment. If you own a mutual fund, that mutual fund may buy and sell stocks and bonds inside the mutual fund. The gains pass to you as a shareholder.

If you own an individual investment, and you sell those shares, you can generate a capital gain as well. If you owned the position for at least a year, the gain is a long-term capital gain. Long-term gains get favorable tax treatment. The highest capital gains rate is 20%. Most people will pay 15%. The full amount of the sale is not usually taxed. Taxes are due on the amount above what you originally paid for the investment.

This can be a factor if you are using a systematic withdrawal. This strategy involves selling shares of your investments to generate monthly income. Part of the income is going to be taxable, and part of it is going to be return of your principal. The taxable part may get taxed at lower rates.

Pension Plans

The other type of account used to create income in retirement is a pension plan. If your company offered a pension plan, the income is taxable as ordinary income.

Annuities

Another common type of account is an annuity. If you annuitize a contract, part of the income is taxable. The balance is a return of your principal.

Social Security

The last type of income source that’s taxable in retirement is Social Security. We will cover taxes of Social Security benefits next week.

Talk to a Certified Financial Planner™ Professional

Knowing how taxes impact retirement can help you plan for a better future. If you have questions or concerns, talk to a financial planner.

 


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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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Is Gold a Better Investment than Stocks?

Is Gold A Better Investment Than Stocks?

Is gold a better investment than stocks?  Wendy asks, “I keep hearing ads advising us to sell our stocks and buy gold or silver. For an older investor, is this a valid point?” 

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Gold Better Investment Than Stocks

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Gold Better iNvestment than stocks

Is gold a better investment than stocks?  

Gold is one of the ultimate fear assets. When things go haywire in the markets, people tend to turn to gold because it’s a tangible asset, and it has value everywhere.

We’re dealing with the possibility of hyperinflation. If that happens, gold could do very well. Another shutdown could increase the fear level of investors. Gold could also do well in that case. There are periods of time, like early 2020, where gold really shined.

Fact or Myth? Gold is safer than stocks

You have a gold bar locked in the safe. You paid $1,500 dollars for it. Unless you pay attention to gold prices, you know you have a gold bar and it has value. You may not know how much it’s worth, but it’s going to be worth something to somebody.

If you pulled it out earlier this year and thought to yourself, “I wonder how much this is worth?”, you discovered it was worth $2,000. Then, you put it back in the safe until next year. The next time you think about the bar, it could be worth $1,500. It could be worth $1,200.

Gold has extreme fluctuations in value, just like stocks. Let’s look at the last 13 years.

  • 2013 -28%
  • 2014 -2%
  • 2015 -10%
  • 2018 -2%.

Over the same timeframe, stocks were down

  • 2008 -37%
  • 2018 -4%.

Over 13 years, gold lost money four times, and stocks were down twice.

If you look at the last 48 calendar years, gold experienced declines 18 times. Stocks fell 11 times.

Gold is not a “safer asset” than stocks.

Is gold better than stocks?

Here is a link to a good article called, Gold’s Romantic Delusion. There’s a graph in that article which shows $10,000 invested in gold in 1980 versus $10,000 invested in stocks. On July 31 2020, the gold would have been worth about $36,000. Stocks would have been worth $761,000.

Is Gold Better Than Stocks

Source: Gold’s Romantic Delusion by Andrew Hallam.  Click here for the full article

Is it a better asset than stocks for older clients, or any client for that matter? In our opinion, no. The numbers say the opposite. Gold isn’t a bad investment, but I wouldn’t own gold instead of stocks.

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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