Transcription
So, I have a question for you: if you had $10,000 growing at 8% for 30 years, it would be worth slightly over $100,000. So, would you rather pay income taxes on the $10,000 or on the full $100,000? Wait, don't answer that because it's kind of a trick question. But that's the incorrect logic many people fall for when they're trying to decide between a Roth and a traditional retirement account. It's simply bad math and a complete misunderstanding of what's happening.
Others may recommend that if you are in a high tax bracket now, you should opt for a traditional 401K rather than a Roth because your taxes will probably be less in retirement. But that's an oversimplification too and leaves out so many other important factors. This video will provide you with the detailed information you need to make a better decision when choosing between a Roth and a traditional 401K; some surprising tax strategies down the road to be aware of; and the unique recent changes that you're probably not familiar with.
First, let's get the basics out of the way. There's no income limit for these types of accounts, so regardless of how much you make, you can still contribute to a 401K. Contributions to a traditional 401K are made with pre-tax dollars, meaning you don't have to pay income tax on the money you invest each year. However, when you eventually retire and begin withdrawing the funds from the account, the amount you take out annually is taxable income. Money invested into a Roth 401K is made with after-tax dollars, meaning you pay the income tax upfront before investing. However, as the investment grows over time and you decide to withdraw the money in retirement, none of it is subject to taxation, regardless of how much you withdraw each year. The entire balance is income tax-free.
Here's an example that might really surprise many of you. Let's say there's a contribution of $6,000 to a traditional 401K, so no income taxes due on that amount. If it grows at 8% at a compound or annual growth rate for 30 years, that one deposit would have grown into $66,350. In contrast, if someone uses $6,000 of their gross earnings for a Roth 401K, they first have to pay income tax on that amount. Let's say they fall into the 24% tax bracket; in that case, they would have to deduct 24% from that $6,000, and that leaves $4,560 to contribute. Over that same 30-year period, growing at the same 8% rate, this contribution would have grown into $45,881. Now, if we assume that the person pulls $66,350 out of the traditional 401K account, all of it is subject to the same 24% tax rate. What remains is exactly the same amount: that $45,881 that's in the tax-free Roth account. Using the same rate when you're working and in retirement, it will always work out like this. And that's exactly why you hear people say, if you anticipate a lower tax rate in retirement than you are currently in, opting for a traditional 401K makes sense; and if you find yourself in a low tax bracket while working, a Roth 401K may be best.
However, there's far more to this decision than just that analysis. First, regardless of which type of 401K people choose, most just decide how much they want to contribute each month. If you compare two people contributing $6,000 per year into a traditional 401K and the other doing the same in the Roth 401K, both accounts would grow into the same total, but the Roth account would be income tax-free. So the person doing the Roth is way better off at the end because they were contributing more of their earned income. Think about it: to contribute $6,000 to a Roth, it would have required $7,850 of gross earnings to have $6,000 left after taxes.
What makes either 401K such an appealing retirement account is that most employers match up to a certain point what you contribute. According to Fidelity, they were the largest service provider in the country in 2023 with almost 25,000 plans, and of those plans, 85% offer some kind of employer contributions to the plan. They state that the most common plan is a dollar-for-dollar match up to the first 3%, and then a 50% match on the next 2%. Using this example, if an employee contributes 5% of their salary, the company will put in 4% since they would match the first 3% dollar-for-dollar and then match half of the next 2%. Regardless of the plan, participating in a 401K plan just enough to get the full matching dollars is a very good idea, and you should absolutely do it; otherwise, you're turning away free money. But for starters, only do what you need to to get the full match from your company. That's because 401K plans generally have higher administrative fees than other comparable retirement options that might be available to you, and 401Ks may have a limited menu of investment options to choose from that are not quite as good as you can find elsewhere. However, since you are doubling your money on day one, it's a very good deal. Plus, the fact that it's set up to be an automatic deduction from your paycheck makes it much more likely that you'll stay on track investing for your future. But once you have done enough to get the full match, you're probably better off switching to a self-directed Roth IRA at a discount broker, as long as you qualify, or use an HSA as a retirement account, which is a great idea. If you want detailed information about the best way to use an HSA as a retirement account or detailed information on a self-directed IRA, I'll provide links to videos in the description below. In these types of accounts, you'll have better options for low-cost ETFs and be able to make investments without a bunch of administrative and other hidden fees. Then, once they are maxed out, and if you can still invest more, then go back to the 401K and contribute.
Okay, now let's do a rundown of the other items we need to be aware of, and then I'll go over some surprising tax implications most people never think about. If you do have a Roth 401K, you're going to find that the entire balance at the end is probably not income tax-free. If you elect to have a Roth 401K, your employer is probably making their contributions to it in a pre-tax fashion. With the recently passed SECURE 2.0 Act, there is a choice, but most employers are still contributing on a pre-tax basis. Many still don't have the proper payroll systems needed in place, or they don't want to deal with the added accounting it requires. Thus, check with your payroll department, but it's very likely that you have a blended account of Roth contributions you made and all of their related earnings, and the traditional contributions from your employer and all of their related earnings. Once you reach retirement age, the IRS will look at the ratio of these two different balances, and your withdrawals will be treated according to that ratio. It's sometimes referred to as the "cream and the coffee rule"—you can't pull one out without the other. Let's say the Roth contributions and their earnings account for 75% of your balance, and the employer pre-tax contributions and their earnings account for 25% of your balance. If you pull out $40,000 during a calendar year, 25%, or $10,000, will be treated as earned income on your tax return, and $30,000 will be tax-free. Also, if you leave your place of employment and want to roll the Roth 401K into an IRA, part of it will roll into a Roth IRA, and part of it will roll into a traditional IRA.
Roth 401Ks don't have any required minimum distributions (RMDs), either. So if you don't need the money, you can allow it to continue to grow. Thus, they can allow you more flexibility with estate planning. However, you're in partnership with the government on a traditional account—some of that money is theirs, and they force you to start withdrawing it so they can start collecting taxes whether you need the money or not. You must start taking distributions at the age of 73 for people born between 1951 and 1959 and at the age of 75 for those born 1960 or later. If you fail to take the required minimum distributions, that amount is subject to a huge 50% tax. There are no income limits on a 401K like there are with IRAs, so regardless of how much money you make, you can contribute. Plus, they allow you to save and invest way more money. The total contribution limits for a 401K in 2024 is $23,000, and if you're over 50, you can put in an additional $7,500. Those limits do not include your employer contribution. Thus, if you put in $23,000 and let's say your employer puts in $5,000, you're still under the limit. However, if you're lucky enough to have an employer that puts way more than you do in, the total contributions of you and your employer cannot exceed $66,000 in 2024.
Now, if you leave your place of employment, transferring a Roth 401K to a Roth IRA at a discount broker is a most desired option because it allows a wider range of investments and much lower expenses. But beware of the 5-year rule applied to Roth IRAs: you must be 59 1/2, and the Roth IRA must be open for 5 years to avoid the 10% penalty on withdrawals. The amount of time the Roth 401K has been in existence is irrelevant; once it rolls over, it takes on the age of the Roth IRA. If you don't already have a Roth IRA that you could use for something like this and you're planning to maybe do this in the future, it's a good idea to open one right now and get that five-year clock ticking. You can also do both a Roth 401K and a traditional 401K, but the total combined contribution in any single year cannot be more than $23,000 and an additional $7,500 if you're over 50. Those are 2024 limits. Having a combination of the two types of retirement accounts can provide flexibility to maximize tax bracket management in retirement. No one knows for sure what tax brackets will look like in the future, but with the snowballing government debt, I believe it's very likely everyone will be in a higher tax bracket in the future, and that's for all income levels. How much? Who knows? But a Roth type of retirement account adds a level of protection and insurance from higher taxes. For example, we could take the required minimum distributions from any traditional retirement account and then withdraw the rest of what we need from a Roth tax-free account. This could allow us to stand in a lower tax bracket, which has other related benefits: it could lower the Medicare premiums you pay, and it could help avoid or lessen the potential taxes on Social Security benefits. Plus, if you have other investments that are not in a retirement account, like maybe stocks in a personal brokerage account, the lower tax bracket can allow you to avoid capital gains tax altogether on those profits. For example, a married couple won't pay any capital gains tax if their total taxable income is below $94,500. If their total taxable income is over that amount but less than $583,500, their rate is lower. So, by using a Roth account to manage your income tax brackets in retirement, it can help you avoid or greatly lessen the taxes on other categories of income that might have otherwise been taxed at higher rates. So, even if you are in a slightly lower tax bracket in retirement, only having traditional accounts in retirement can push your Social Security benefits and profits from capital gains into higher taxable ranges. As you can see, there are numerous factors to consider, and there's not a perfect answer that fits everyone. But I hope this video covered some essential factors to allow you to make a more informed decision for yourself. If you need help, it might be a good idea to talk to a CPA about your personal situation. As always, thank you for watching. If you haven't already, please subscribe; leave some comments below.