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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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.

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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Save More or Pay Off Your Mortgage?

Save More or Pay Off Your Mortgage?

As you get closer to retirement, should you save more or pay off your mortgage?  This was a question we received from a listener.  Let’s look at the key factors of your decision.

Watch Now: Save More or Pay Off Your Mortgage?

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Today we have a question from Laura. She writes, “My husband and I will be 52 years old this year. Should we focus on saving more for retirement or paying off our mortgage?”

Why Pay Off Your Mortgage Before You Retire?

Your mortgage payments are typically one of your biggest expenses. Not having that expense frees up money for other things or reduces the stress on your savings. We like to see people not have a mortgage when they go into retirement.

An Example:

Laura and her husband need $2,000 per month from savings to cover their expenses—including their mortgage. Using the 4% rule as a basic guideline, they would need about $600,000 in savings.

save more or pay off mortgage

Their mortgage payment is $800 per month. If they pay off the note before retirement, they would only need about $1,200 per month from savings. Using the 4% rule, this means they only need about $360,000 in savings. It is a significant difference.

Save More Pay Off Mortgage

What Factors In Your Decision?

If you are trying to determine whether you should pay more on your mortgage or save more, ask these questions:

If you keep your mortgage payment the same, will your mortgage be paid off by the time you retire?

If the answer is yes, consider adding extra funds to your retirement savings. You may want to think about using a Roth IRA, Roth 401k, or other types of after-tax savings? If the answer is no, you may want to dig a little deeper.

Will paying more on your loan eliminate your mortgage by the time you retire?

If the answer is yes, consider paying extra on your note.

How much have you already saved and how much are you saving towards retirement?

If you have been a good saver and have a good foundation, it’s easier to favor paying extra on your loan. But if you have not been a good saver, you may want to place a higher priority on your savings.

Talk to a Certified Financial Planner™ Professional

There are a lot of moving parts to this and it is a great thing to discuss with a financial planner. They can help you build a strategy that makes sense for you and helps you achieve the best possible outcome.

 


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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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Can I Max My Roth and My 401k?

Can I Max My Roth IRA and My 401k?

Sandy wants to know if she can max her Roth IRA and her 401k contributions.  Let’s dig into the rules.

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can i max my roth ira and my 401k

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Do you want to hear the full show?

The full episode is over 25 minutes long.  And we’ve found that not everyone wants to spend that much time listening to things.  But if you want to listen to the entire episode, it is below.

We answer:

Transcript: Can I Max My Roth IRA and My 401k?

This question is from Sandy. She asks, “Can you contribute the maximum amount to a Roth IRA and the Roth account in the government’s Thrift Savings Plan?”

The answer is yes—if you qualify to make a Roth IRA contribution.

Here are the contribution limits for 2020. For retirement plans whether it’s the Thrift Savings Plan, a 403b plan at the hospital or a school, or a 401k plan, you can contribute $19,500. If you’re over 50, there’s a catch-up contribution. That amount is $6,500. You can contribute $6,000 to a Roth IRA. If you’re 50 or older, you can contribute an additional $1,000.

If you wanted to maximize both, and you’re under age 50, that’s $25,500. If you’re 50 or older, that’s $33,000 total per person. If you’re married, you can do both, and your spouse can do both. If you have that much extra income, that’s phenomenal!

There are income limits for Roth IRA contributions. You can make the maximium Roth IRA contribution if your modified adjusted gross income (MAGI) is below these limits. For married couples filing a joint return, the limit is $196,000. If you’re single, that limit is $124,000. If you’re married and you file separate returns, the income limit is $10,000.

If your MAGI is over those limits, your eligibility to make those Roth IRA contributions changes. You may be able to do a partial contribution or none at all.

The Married Filing Separately Tax Trap

The married filing separately thing is an interesting little trap. A lot of people will file separate returns to try to save on state income taxes. But it has a hidden impact on things like your IRA contributions. It impacts deductions for traditional IRAs, Roth IRA contributions and Roth conversions.

If you’re married filing a separate return and your income is over $10,000, a lot of those things disappear. You want to be very careful with that. You don’t want to get a surprise later on.

Can I max my roth IRA and my 401k
Can I max my Roth IRA and my IRA
max roth ira and 401k

 

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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