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

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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.

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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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4 Things to Help You Plan for The Worst

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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.

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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.

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5 Lessons From the Bear Market

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One year ago, on March 23, the S&P 500 closed at its bear market low. Today, we are going to talk about 5  lessons we can learn from the bear market of 2020. 

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A year ago, on March 23, the stock market reached its bear market low caused by the COVID pandemic. Stock prices fell about 34%. Over the next 5 months, prices raced higher.

What are some of the lessons we can learn from going through this bear market? For some, it was their first bear market experience. For others, like me, it was not their first. (This was my fifth.) These experiences teach some great lessons. Here are 5 lessons from the bear market.

Bear Markets are a Temporary Interruption.

Bear markets are a temporary interruption to the permanent long-term advance of stocks. About one out of every five years, we see a significant decline in the stock market. It is a reset and a healthy adjustment. Once the stock market hits bottom, prices go on to recover and set new highs.

Since 1946, we have seen 14 bear markets. Every single one has recovered and created new wealth for those who are patient and continue investing in stocks. 

Most People Can't Outsmart the Market

It is virtually impossible for most people to outsmart the stock market. Did you think…

  • February 19, 2020 was going to be the current all-time high?
  • March 23, 2020 was going to be the bottom?
  • The stock market was going to recover as fast as it did?

I did not expect any of the above. I bought stocks two days before the market set the all-time high. We anticipated things to get worse before they got better. We thought that the shutdowns were going to cause even more damage to our investments than they did.

The stock market turned quickly and raced higher. The bear market ended in less than 6 months! We expected the recovery to take at least two years.

Many people try to guess the highs and lows. They look for points to sell and to buy. Doing this often leads to big mistakes, and those can impact your lifetime return.

Buying Stocks "On Sale" is Hard

Buying stocks in the middle of a bear market is very difficult. A year ago, many of these great businesses were trading at 30%, 40%, or 50% discounts. We had the opportunity to buy many of those stocks at prices we may never ever see again.

In the moment, you can say, “Stocks are low, buy now!” At the same time, the news tells you everything is bad and getting worse. How do you see the return potential in those moments? In the middle of a bear market, most people assume stocks are heading lower, and they are going to lose even more.

You Don't Lose Anything Until You Sell

We all looked at our accounts last year and watched the values sink. It was uncomfortable and unpleasant. It created a lot of stress. There is a natural reaction to want to sell when things are going bad. You want to protect what you have.

Until you make that sale, the decline is temporary. If you hold on to your investments, you will most likely recover from the decline.

Selling near market lows makes those temporary decreases in value permanent losses. It also makes erasing those losses very difficult.

A Bear Market is Always in Front of Us

Nobody knows when the next bear market will begin. We do not know how far prices will drop or how long it will last. Bear markets are a common occurrence in the stock market. On average, we see one happen every five years.

We hope it takes several years before we experience the next bear.  When it happens, we can use the lessons learned from our past experiences to make us all better investors.

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5 lessons from the bear market

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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10 Percent Doesn’t Mean 10 Percent

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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.

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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

 


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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