Traditional Versus Roth 401(k)
Key Points in Traditional Versus Roth 401(k):
- Traditional and Roth 401(k) differences and similarities
- Tax Rates in regard to traditional or Roth
- Distribution effects on other retirement aspects and income sources
- 5 minute read | 39 minutes to listen
People frequently ask us whether they should contribute to a Roth 401(k) or a traditional 401(k). The answer to this question depends on your personal situation. There are several factors you should consider.
401(k) and Roth 401(k) Similarities
A Roth 401(k) and a traditional 401(k) are both qualified retirement accounts offered by employers. Your contributions to both types of accounts come out of your paycheck. Both types of 401(k)s may be eligible for a company match if offered by your company. The company plan specifies the rules for the company match. However, the company match is made to the traditional 401(k) even if you contribute to a Roth 401(k).
The employee contribution limit is the same for both types of 401(k)s. For 2021, the contribution limit is $19,500. Individuals who are age 50 or older can contribute an additional $6,500.
The required minimum distribution rules are the same for both types of 401(k) accounts. This is a big difference between Roth 401(k) accounts and Roth IRA accounts as Roth 401(k) requires participants to take a required minimum distribution. In contrast, there is no required minimum distribution for a Roth IRA. Roth 401(k) participants may want to roll the funds over to a Roth IRA upon retirement to avoid having to take a distribution.
Traditional Versus Roth 401(k)
on America’s Wealth Management Show
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Traditional Versus Roth 401(k)
Links Mentioned in this Episode
Dean Barber: Thanks so much for joining us here on America’s Wealth Management Show. I’m your host Dean Barber, along with Bud Kasper, and we’ve got a great show planned for you.
Bud Kasper: We do.
A Quick Story About Traditional Versus Roth 401(k)s
Dean Barber: We’re going to talk about Roth versus traditional 401(k), and we’ll get into some Roth versus traditional IRA as well because those two things really kind of go hand in hand. And I’ll start you off with a quick story.
Dean Barber: So I walked into the gym Tuesday morning of this last week, and a guy comes up to me. He goes, “First thing I get when I wake up this morning is “Traditional Versus Roth 401(k)” coming out from Dean Barber, Barber Financial Group.”
And he goes, “What should I do?” I work out with this guy all the time, so I know him pretty well. I said, “You’re a young guy, and you’re making good money, but your earnings are likely to go higher. And you’re maxing out your 401(k). You’ve told me that. Your company contributions are going to go into the traditional portion of the 401(k).”
Bud Kasper: Always.
Dean Barber: “But because we think that taxes are probably going to go up in the future. And because we think your income’s going to go up in the future, you should be putting everything into the Roth.” And he said, “Well, right now, I’m doing 50/50.”
And I’m like, “It doesn’t really make that much sense to do 50/50.” In his case, I’d say go all to Roth 401(k). But you can’t just say everybody should be contributing to a Roth 401(k) because that’s not necessarily the case.
Very Rarely Does Splitting Make Sense
It’s very rarely the case that you should be splitting between Roth and traditional 401(k). People that are doing that are typically just guessing. They’re saying, “I don’t know what to do, but let me just do some of both.”
Bud Kasper: Absolutely right. It is a guess and what you’re guessing, let’s say in the case of this young man you’re talking about, how’s he supposed to know what tax brackets will be when he reaches 65 or whatever age he’s going to retire at? There’s no way of knowing that. So if that’s a question and if it’s something that could harm you when those distributions start.
Dean Barber: Yeah.
Taxes on the Seed or the Harvest
Bud Kasper: You’ve got an opportunity here to do something that we talk about all the time. I’ll repeat it. You can either pay the tax on the seed or the tax on the harvest. That simply means that you will pay taxes on your Roth 401(k) contribution instead of your traditional 401(k). However, when the distributions come, and you have a traditional, that will be added to your income that year. However, for the Roth, you don’t have it. So it’s wonderful.
Dean Barber: Right. And so there’s a lot of moving components there, Bud. And I think that if you sat down and looked at it dollar for dollar, right? If you are making a pre-tax contribution, and let’s say you’re in the 22% bracket from a federal level, you put $100 in; it will reduce your income by $100, gross income.
Bud Kasper: Right.
Dean Barber: But it’s going to go in pre-tax. So it’s only going to reduce your paycheck by $78 because you’re in a 22% bracket. Right?
Bud Kasper: Right.
Dean Barber: So a lot of people look at that and go, “I get $100 in, and it only reduces my paycheck by 78. That’s a no-brainer. I’m doing that.” Well, if you go to a Roth 401(k), you put $100 in, it’s going to reduce your paycheck by $100.
Bud Kasper: $100. Right.
There is a Significant Difference
Dean Barber: Okay. So there’s a big difference there. And a lot of people get shortsighted on that, and they say, “Well, gosh, I’d rather have the tax savings today.”
But what you were saying, Bud, about paying taxes on the seed versus the harvest, all of the growth inside of that Roth portion of your 401(k) is growing, not just tax-deferred, but it’s going to grow tax-free.
So when you pull that money out in retirement, you pay zero tax on it. And there are some other ancillary benefits because the way you take money out of your IRAs during retirement can affect all kinds of other taxes. It can affect your Social Security, and how much of that is going to be taxed?
Bud Kasper: Medicare.
Dean Barber: Medicare premiums. It’ll affect your qualified dividends and capital gains. And, of course, that’s under today’s tax law. And if there’s one thing we know for sure, tax codes are always changing, and they’ve changed a lot here over the last couple of years.
Bud Kasper: Yeah. And so I think you gave that young man great advice.
Many Miss the Opportunity
Now for the number of people we have the opportunity to meet with and talk about their situation, it’s sometimes game over. They’ve already contributed all this money, and they’ll come in and say, “Well, Bud, I’ve saved hard. And I’ve got a million dollars in my 401(k),” and my response is, “You want to bet?”
Dean Barber: Yeah.
Bud Kasper: Because when you start taking out, you’re going to find out, you got a partner in that account with you, and it’s Uncle Sam, and he’s taking part of your income that you could have avoided if you had chosen the Roth.
There Will Always Be Some Money in Traditional
Dean Barber: So now that we’ve discussed the key differences between the Roth and traditional, there is one other point that we want to make before we start getting into the detail of how you determine which one you should use. You’re always going to have some money inside your 401(k) that will be on the traditional side.
Bud Kasper: Right.
Dean Barber: Because when your company makes a match, I mentioned this a little bit earlier, but I wanted to explain in a little bit more detail.
Bud Kasper: Yeah, please.
The Company Match
Dean Barber: When the company makes a match, it’s going into the traditional side of your 401(k). So you’re going to get a statement on your 401(k) if you’re contributing to Roth, and it’s going to say, here’s your Roth value. Here are your Roth contributions.
Here’s your traditional value, and here’s your company match, right? So if all you’re doing is Roth, you’re still going to get that piece in there that’s going to say that you have a traditional 401(k). That becomes even trickier now when you go to retire if you leave a job. To do a rollover now, you’ve got to establish two separate IRAs or a traditional IRA and a Roth IRA.
Learn More About Tax Planning, IRAs, and 401(k)s
Look, there is a lot of detail here. No way we get into everything that we want to get into right here on America’s Wealth Management Show. So I want to invite you to do a couple of things. Number one, I want you to get out to our website and pick up our Tax Reduction Strategies Guide or watch our Tax Reduction Strategies Webinar.
Dean Barber: While you’re here, you can schedule a complimentary consultation by clicking here. We’re happy to visit with you by phone, virtual meeting, or in-person, whatever’s comfortable for you. And then I want to turn your attention to our podcast, which is The Guided Retirement Show.
You can find The Guided Retirement Show on any of your favorite podcast apps or YouTube. Episodes one and two are JoAnn Huber, our lead CPA, and I discuss, in detail, Roth versus traditional. And we don’t have to worry about commercial breaks and all that stuff. So you can listen to those at your will. You can stop it, pause, rewind, and do it again.
Bud Kasper: The subject matter today is so important. So many of our listeners, Dean, are preparing for retirement. They’re making decisions as to where they want to park that money. And we might even start by saying what is the contribution limits right now?
It’s $19,500 for the year, but there’s some catch-up if you’re over the age of 50 of $6,500. That brings your total to $26,000. And that’s a lot of savings for people. You do that at a young age, and your wife or husband does it as well, and you can compound into a pretty secure future.
Dean Barber: Right. Now, you’re going to have to have a pretty decent income to max that out. But look at what your contribution limits are from a percentage standpoint, look at what you can save. But there’s a really good way to figure out, should you be doing a traditional 401(k), or should you be doing a Roth 401(k)?
Online Retirement Calculators
Now, I’m going to pick on some of these online retirement calculators for just a little bit because in the case of money in a 401(k) versus a Roth 401(k), a dollar is not a dollar, right? They are two different pieces of money.
Bud Kasper: Right.
Dean Barber: Even though when you look at your statement, it’s going to tell you, I got $100,000 in my Roth 401(k), and I got $100,000 in my traditional 401(k), but they’re not the same.
The reason I say that is, when you take the money out of the traditional, you’ll have to forfeit a portion of that, depending on your tax rate, over to Uncle Sam.
When you take the Roth portion out, Bud, there is no tax due. And when you take the traditional portion out, it can also cause qualified dividends that may have been tax-free, qualified capital gains that may have been tax-free to then, all of a sudden, become taxable.
It can also cause more of your Social Security to become taxable. It can cause your Medicare premiums to increase.
Back to the Online Retirement Calculators
So, how you do this? I’m getting around to the online retirement calculator. They just ask how much money are you saving and how much money do you want to spend?
Bud Kasper: Right.
Dean Barber: Okay? They don’t go into, well, how much is going into Roth? Now, there are some out there that are better than others. But the ones that are better than others, yeah, you have to pay something for those.
But if you know how much is going into traditional, how much is going into Roth, you know what the Social Security is going to be when you’re into the future, you can estimate the tax rates in the future; you can look at all these different pieces, then you can run a side-by-side comparison. But the online calculators aren’t going to be able to do that for you.
Bud Kasper: They won’t.
They Don’t Stack Up
Dean Barber: Our financial planning software does that. All part of our Guided Retirement System™ that we do the, “Here’s the current scenario. Here’s what we’re doing today.”
And then, Bud, as financial planners, our role is to say, “All right, what are all the different ways that we could do this? With the same amount of money, same income, et cetera, what are the different ways to shift things around a little bit? And then what’s the outcome in the future?”
We’re looking for the most favorable future outcome to give you the best financial life that you can have, not necessarily just today but in the future.
Bud Kasper: That’s absolutely right. And I have yet to find an online calculator that can provide that type of detail. But as the CFP®, that’s the most important thing that we can do, is bring an accurate conclusion as to what the money’s going to look like when you’re retired and how much of it’s going to be taxable, et cetera, et cetera.
So if you do this early enough, you’re going to avoid a lot of tax pain, folks. And that’s what Dean and I are wanting to talk about today.
Let’s Review an Example
Dean Barber: So, Bud, let’s go through a specific example here. I’m going to say we’ve got a couple that is in their mid-fifties. They’re earning more money than they’ve ever made before in their lives, they’re able to max out their 401(k), they’re also able to save some money outside their 401(k), and they’re getting their debt paid down aggressively and planning to retire in the next ten years.
Bud Kasper: Sounds excellent.
Dean Barber: Okay? And we see that person all the time. That’s our typical; that’s when somebody says, “I’m ready to come to talk to you guys because now I’m getting serious about getting myself set up for retirement.”
If this person does it right and saves some money outside the 401(k), this person in their peak earning years, I might suggest that they use the traditional portion of the 401(k) in those later high earning years. And here’s why.
Dean Barber: So if we can put in that $26,000, Bud, and we get a tax deduction for doing that, and we get the match on top of that, and let’s say that we’re up in that, 28, 31% bracket, now all of a sudden I’m reducing my tax liability, getting a bunch of money saved.
What I’m going to hope for is that I can save enough outside that 401(k) that for the first five years of my retirement, I can live off of that, and it’s already been taxed, so there’s no tax liability.
While there’s no tax liability, I can then begin to do what’s called a Roth conversion. So I roll that 401(k) out to a traditional IRA. And then I start moving from a traditional IRA year by year, systematically, to stay in as low a tax bracket as possible.
I move money from the traditional IRA over to the Roth IRA. And then, all of a sudden, what I’ve done is I’ve created a big Roth IRA, but I got to deduct the contributions at a higher rate than what I was able to convert at.
Bud Kasper: I understand.
Dean Barber: Right? So that’s one example of when I think a traditional 401(k) makes sense.
Using Conversions to Get into a Lower Tax Bracket
Bud Kasper: Yes. And when you’re doing the conversion, of course, what you’re trying to do is to do it at the lowest possible tax bracket, right?
Dean Barber: Right.
Bud Kasper: So, if you have that deferral capability that you’re talking about, Roth versus traditional, there’s a calculation there that will tell you which direction is going to serve your purposes the most.
Planning for Future Tax Rates
I think one of the things that people have to consider is what’s going on here in the United States at this time. We know that this past week, the $1.9 trillion bill was again presented.
As we look at this and we look at the amount of debt that this nation has, and you’re going to ask yourself, “Are tax brackets going to be lower when I retire?” And my reply to that would be, “I don’t see how that’s going to be possible.” So there’s a lot in our future that will take a lot of planning, Dean.
Dean Barber: Yeah. First of all, the Tax Cuts and Jobs Act that the Trump administration passed sunsets in 2026. so the Democrats don’t have to raise taxes. But taxes are going to get raised automatically starting in 2026.
Bud Kasper: That’s right, January 1st.
Potential New Taxes
Dean Barber: And so, yes, tax rates are going to go up again. Now, some of the things that are being discussed in the Biden administration are very alarming. There is something like a transaction tax on stock trades.
There’s the wealth tax where you’ll pay a percentage of your net worth each year, above a specific limit. And then, there’s the one that I think is probably most devastating to most people, and that is the elimination of the step-up in basis when you pass money to the next generation.
Bud Kasper: Yeah, I would hate to see that happen only because you really shouldn’t have Uncle Sam in your pocket after you pass away. It shouldn’t be something that could be so contrived from the perspective of, “I need more money. You’ve paid me a lot of taxes during your lifetime. Give me a little bit more.”
Dean Barber: Yeah, but dead people are the easiest ones to target. And in most states, they don’t even vote.
Know the Tax Consequences
So we’ve talked about this many, many times. Don’t put your money into anything without knowing the consequences of taking it out.
Bud Kasper: Right?
Dean Barber: Right. That, to me, is the essence of financial planning Bud. We have a reason for saving money, and for some of you, it might be, “I just want to see a big number on my statement.”
But for others, it might be, “This is my chance at financial independence. This is my chance at freedom, where I can go from a state where I’m working for my money to getting my money to work for me so that I can do the things that I want to do in life.”
That’s what we call financial independence, and that’s what our Guided Retirement System™ is designed to do. It’s designed to take you from where you are today, paint that vision of what you want the future to be like, and then guide you to that reality.
Bud Kasper: Right.
The Most Rewarding Part for Dean & Bud
Dean Barber: When that thing comes together, Bud, it’s so beautiful. We talked about that last week, and it’s just to me that’s the biggest reward in the 34 years that I’ve been doing this. My biggest reward is watching those visions and those vivid pictures that we’ve helped our client’s plan become a reality.
Bud Kasper: Absolutely. It’s so rewarding from that perspective to know that we’ve provided an opportunity for people to do before they’re retired the necessary things to mitigate taxes and to maximize their results.
Balancing Short-Term and Long-Term Goals
Dean Barber: Right. The deal is it’s not necessarily saying you have to sacrifice everything now to get to where you want to be in the future. We think there needs to be a good balance between what are your short-term goals, what are your intermediate-term goals, and then what are your long-term goals? You have to balance those things out.
Bud Kasper: Paying taxes is a painful thing, obviously, no doubt about that. But one of the things that people don’t understand is the implications you have when you’re taking taxable distributions out of your rollover IRA, formerly your 401(k). So one of those is Social Security.
Taxes and Social Security
Dean Barber: Huge, huge.
Bud Kasper: If you want to see people go crazy, you mean I’m paying taxes to get my money out of what I saved, and now you’re telling me it’s going to reduce my Social Security benefit as well? The answer is it very well could.
Dean Barber: Well, what we know is this, is that if Social Security was the only source of income that people had, they would pay zero tax on Social Security.
Bud Kasper: Right.
Dean Barber: Now, a formula was created in the Tax Reform Act of 1986 under the Reagan administration.
Bud Kasper: Right, it was.
The Provisional Income Formula
Dean Barber: Under the Tax Reform Act of 1986, there was a formula that was created called the provisional income formula, and that provisional income formula that was created in 1986 has not changed for 35 years Bud, 35 years.
So get this, it’s not been indexed for inflation, and it’s the formula used to determine how much, if any, of your Social Security is taxable.
So it’s pretty simple. You take 50% of your Social Security benefits, and if you’re married, you take 50% of the combined Social Security benefits. Then you add to that any taxable sources of income and any tax-free income from municipal bonds.
If it’s over $32,000, then up to 50% of your Social Security can be taxable. If it’s over $44,000, I believe it is $44,000, then up to 85% of your Social Security can become taxable.
Roth IRA Income is Not Included in Provisional Income Formula
Now here’s the key, though. Roth income, income from your Roth IRA, is not included in that provisional income formula.
Bud Kasper: Isn’t that convenient?
Dean Barber: So it’s super convenient. So when you’re making your forward-looking projections, if you know that the Roth 401(k) comes out tax-free and it’s not included in that provisional income formula, it could also keep more of your Social Security from being taxed.
Bud Kasper: Absolutely.
Dean Barber: So you get a win-win.
Comprehensive Financial Planning
Bud Kasper: Yeah. So now what are we looking at? We refer to this as part of the comprehensive financial planning process because these are all calculations that you should already understand before you ever say goodbye to your employer.
This is what planning is for. This is one reason we love doing this every weekend to share our insight into how we can mitigate things that could take away from your income.
Dean Barber: Right, and that’s one of the big reasons we want and encourage people to build up money in Roth IRAs and Roth 401(k)s or do some conversions early on.
A Quick Story About a Planning Opportunity
So I’ll tell a quick story about a client who last week we were reviewing and going through everything. He had some restricted stock that was sold for the first few years of his retirement that was causing tax liabilities to be through the roof, but it was what it was, and it’s money he’s going to be able to live on in the future.
But the key point here is he also has a very sizable IRA, okay, that rolled over from the 401(k). Well, now we have after-tax money, we got money that’s in the IRA, he’s 65 years old, could start claiming Social Security next year or later this year actually, and I’m saying you know what, let’s hold off on that. Let’s hold off on that. Let’s just live on the cash that you’ve already paid taxes on over the last few years.
Bud Kasper: Right, so no tax consequences.
Dean Barber: Let’s live on that, and then let’s start moving money from that traditional IRA over to the Roth 401(k). What’s that going to do? It’s going to reduce the required minimum distributions in the future because, by the way, there is no requirement of distributions on a Roth IRA. That’s a big difference between the Roth IRA and the Roth 401(k).
Bud Kasper: It sure is.
Dean Barber: Because if you leave your money in the 401(k) and you have a Roth 401(k), you still have to have a requirement of distribution on that.
Bud Kasper: Right.
Dean Barber: But the point here is if we do that right, and now we delay Social Security, we’re not only going to get 8% per year more, so we’re going to get 32% more Social Security into the future. It will increase the survivor benefit if he happens to go before his wife, and less of his Social Security will be taxable because of what we’re doing.
Bud Kasper: Exactly right.
Dean Barber: So this is a significant long-term tax play.
Bud Kasper: Yeah. And again, it comes from a comprehensive plan. When you think about that, that’s incredible because most people know that their Social Security benefit is growing at 6% per year. Still, then when you get to full retirement age, it goes to 8% for a few years, but that’s more money than you can put into your pocket from that perspective.
Social Security Solvency
If you remember, one of the reasons that that taxation came up during the Reagan era was because people were concerned about Social Security going bankrupt.
Dean Barber: That same concern’s been going ever since you and I started in this business.
Bud Kasper: Yeah, exactly right. So is it a legitimate concern? My reply to that is, “Of course, it is.” How we address that issue is doing what? Going more into debt, and that’s going to be a problem at some particular point in time.
Dean Barber: Well, there will be changes coming, but there have to be some changes to the Social Security system. They’ve already made a few changes. Of course, Reagan was the one that did taxing on up to 50% of your Social Security, and then the Clinton administration trumped him saying, no pun intended. He said we’re going to tax up to 85% of your Social Security. So yeah, could they go to a hundred percent?
Sure. Could they remove the earnings limit on the withholding for Social Security? Probably will, or they’ll at least raise it quite a bit so that you’re going to have a more significant chunk withheld for Social Security taxes. Right now, I think we cap it at just under $140,000 or something like that, I don’t know the exact number, but by the way, I’m not a CPA.
Bud Kasper: You’re darn close.
Dean Barber: I know the Tax Code very well, and I think it’s essential to pay as little tax as possible and stay within the confines of the law.
The Art to Financial Planning
There’s an art to this. You could go by some rules of thumb and say, “Yeah, tax rates will be the same in the future as they are today, and I expect to have the same kind of income. It doesn’t matter.”
You could go by that rule of thumb, I guess. But you also have to consider, Bud, that when you start taking money out of the traditional 401(k) in retirement, as we talked about earlier, it can cause some of your Social Security to become taxable.
Bud Kasper: Yeah. It’s a compounding tax problem, Dean. And that’s why, and I’m probably a little, what do I want to say, single-minded in this, I just don’t know what taxation will look like for people, let’s say, in 10 years, 20 years, whatever the case may be.
This worries the dickens out of me that it could be much greater than what it is now. And I’m going to be mighty happy if I’m making my Roth contributions into my 401(k) because I don’t have to pay any federal tax on that and most likely not any state either.
What Are Dean and Bud Doing?
Dean Barber: In your 401(k), Bud, are you doing all Roth?
Bud Kasper: All Roth, yes.
Dean Barber: So am I.
Bud Kasper: Oh, and by the way, all other accounts I had I converted, and I converted not because I was necessarily in a lower tax bracket. I wanted Uncle Sam out of my life. So I just gradually did that over the years to not have any tax-deferred money that I’ll be taxed on in retirement.
Dean Barber: Well, you’re matching contributions in the 401(k). But that’s going to be a relatively small piece compared to everything.
Bud Kasper: You know what? We really should be running these calculations on examples to help people listening to the show. Well, I’m going to do traditional to start with because I’m in a lower tax bracket.
When to Go Roth
Dean Barber: That’s backward. You want to do Roth when you start. Right? So all of my kids that have graduated college, gotten their jobs, are working, and they say, “Dad, what should I do? I got my 401(k) enrollment form here.” And I said, “Put in as much as you possibly can, and use the Roth contribution because you’re in the lowest bracket you’re ever going to be.”
So the tax savings today in the early years aren’t going to be there, but you got years and years and years of compound growth that can take place in that tax-free portion. And then the example that I gave in segment two of the program, where I said if I’m in the peak earning years and I know I’m going to be in a lower tax bracket in retirement, that’s when I want to do the tax-deferred, the traditional portion of that.
Bud Kasper: Right.
Dean Barber: Look, if you’re young and you know that you’ve got a promising career ahead of you and your income is going to do nothing but rise, use the Roth. I can tell you that—no question about it.
Bud Kasper: Yes, I agree.
Dean Barber: Don’t worry about the little bit of tax savings you’re going to get today by doing the traditional.
When to Go Traditional
If you’re in your peak earning years and you know you’re going to retire soon, you have plenty of money saved in an after-tax account to allow yourself to do some conversions after retirement and at a very low tax bracket, then do the pre-tax, right? Do the traditional portion of the 401(k).
Bud Kasper: Yes. And I think in our company, Barber Financial Group, I’ve never done more Roth conversions than I did last year. The reason is obvious. It wasn’t to the advantage of our client to go ahead and pay some tax on some distributions now so that we can keep them tax-free in the future.
Converting Over Years
Dean Barber: Well, it’s interesting. I’ve got one client who we’ve been methodically converting now for, I think, eight or nine years. He reaches 72 and his required minimum distribution date here in a couple of years.
We’re going to be down to maybe $100,000 in his traditional IRA by then. So his required minimum distributions are going to be minimal, and he gets all this tax-free income. And by the way, guess what happens when he passes on? The kids get it tax-free too.
Bud Kasper: Exactly right. Now, there are some distribution rules associated with that, but that’s neither here nor there.
The SECURE Act
Dean Barber: Well, let’s talk about that, though, because that’s why we see more and more conversions, is because of the SECURE Act that was enacted on January 1st of 2020.
Dean Barber: And what that SECURE Act did was it said that when you inherit an IRA, a 401(k) or a Roth IRA or a Roth 401(k) that 100% of the money has to come out of that account within ten years. Now, they don’t have a required minimum distribution every year anymore like they used to, but all of it has to be out within ten years.
Bud Kasper: And guess what that does? You need more planning.
Who is Really Inheriting Money?
Dean Barber: Yeah. Well, but think about that. Okay. So I’ve had clients inherit money, Bud. Most of the clients that I have who have inherited money in their 50s or 60s because the parents are in their 70s, 80s, 90s when they’re passing on.
When you’re in your 50s or 60s, chances are you’re in your peak earning years. And let’s say somebody has got $1 million in an IRA, they pass away, you’re the beneficiary of that. Now all of a sudden, you’ve got to get all that money out in 10 years.
Bud Kasper: Right. So what are you going to do? Well, why don’t you quit working for one year?
Dean Barber: Well, you’re going to forfeit a lot of it to the government.
Bud Kasper: Too much. I’ve never gone through and done an absolute calculation on different brackets versus Roth distributions to see where the line of demarcation is. I know it’s going to favor the Roth. I just would be interested to know how the calculations would work out.
Dean Barber: Well, in your scenario, Bud, you don’t expect that your income’s going to decline even after you retire.
Bud Kasper: That’s right.
Dean Barber: Right? And so I’m in the same boat. But if you think that your income will decline, some people have big pensions and things like that.
It All Boils Down to Your Goals
Everybody listening is in a different situation, and this is not a one-size-fits-all. It’s not something that you read a book, and you go, “Oh, that’s how you do this.”
There’s no instruction manual. There is a science to financial planning, but there’s also a big art to financial planning. And to get the art part of it, you need all the subject matter experts in one room.
You have to have a CPA, CFP®, an estate planning expert, risk management expert, and investment expert working together on your behalf.
Dean Barber: That’s what we do here at Barber Financial Group. That’s what makes us unique in the space that we’re in. And I encourage you to get a copy of our Tax Reduction Strategies Guide or watch the Tax Reduction Strategies Webinar.
Let’s start talking about where you are on your path to financial independence. We discuss and opportunities and what is in front of you that you should be doing to give yourself a better financial life.
What are You Doing?
Bud Kasper: As we start to close out this show for this particular week, I want to go back to what we wanted to accomplish today, Dean. And that is, what are you doing? Are you doing a traditional 401(k)? Are you doing a Roth 401(k)? And if you’re not sure if you’re doing the right thing for yourself in the future, then that means that you should be sitting down with us and letting us have an opportunity to demonstrate a few things to you.
Dean Barber: Yeah, and that’s right. And there is a right answer for every one of you.
Bud Kasper: Yes.
Dean Barber: But, again, there’s no instruction manual. It depends on your personal situation and what your future is going to look like. Right?
Bud Kasper: Yes
Dean Barber: That takes financial planning.
Bud Kasper: Absolutely.
Dean Barber: That’s what it’s all about.
Bud Kasper: Right.
Dean Barber: Without that, you’re just guessing.
Taxes are a Matter of Fact
Bud Kasper: Yes. Taxes are a matter of fact, but how much of that tax you have to pay is certainly subjective to planning. And that’s why we suggest you give us a call.
Dean Barber: Well, and tax planning is an integral part of financial planning.
Bud Kasper: Right.
Dean Barber: Right? And that’s why I say you got to have a CPA in the same room as the estate planning attorney, as the CFP®, and the risk management expert.
Thanks for joining us on America’s Wealth Management Show. I’m Dean Barber, along with Bud Kasper. Everybody stay healthy, stay safe. We’ll be back with you next week same time, same place.
401(k) and Roth 401(k) Differences
The most significant difference between the two types of 401(k) plans is the timing of taxes. When you contribute money to a traditional 401(k), you receive a tax deduction. The amount in the 401(k) grows tax-deferred. This means that tax on the original contribution and growth in the 401(k) is paid when you take a distribution from the account.
On the other hand, you do not receive a tax deduction when you contribute money to a Roth 401(k). No tax is due on the original contribution or the growth in the Roth 401(k) when you take a distribution from the account if you meet the qualified distribution rules. To be a qualified distribution, the Roth 401(k) account must be open for at least five years, and you need to be age 59 ½ or older.
The decision between which type of account to contribute to comes down to when it is best to pay the taxes. You should consider your age at contribution and how long until you will need to use the funds. Careful 401(k) contribution planning can minimize your tax liability over your lifetime.
It may allow for additional tax planning opportunities in retirement.
Three major issues that need consideration regarding 401(k) contribution planning are:
- The tax rates now versus the tax rates in the future
- The IRA distribution’s effect on other types of retirement income
- The IRA distribution’s effect on other aspects of retirement
There are three rules of thumb regarding the decision to contribute to a traditional 401(k) or a Roth 401(k):
- If your tax bracket is the same when you are making contributions and taking distributions, then it does not matter which type of 401(k) you use.
- If you are in a lower tax bracket now than you expect to be in the future, you should contribute to a Roth 401(k).
- And if you are in a higher tax bracket now than you expect to be when taking distributions in the future, then you should contribute to a traditional 401(k).
The one certainty with tax law is that it is always changing. The decision of whether to contribute to a traditional 401(k) or Roth 401(k) would be easier if we knew what the future holds for tax rates. Many people believe that the tax rates will increase in the future. Based on current tax law, the rates are scheduled to increase on January 1, 2026. Some people believe the tax rates will rise before then, with the Democrats controlling both the White House and Congress.
Even with the uncertainty of future tax rates, there is a common misconception that most people are in a lower tax bracket when they retire. Due to IRA distribution’s effect on other types of income, our experience is that many people are in higher tax brackets when they retire versus working full-time.
IRA Distribution’s Effect on Other Types of Retirement Income
Taxation of Social Security
Originally, Social Security was intended to be a tax-free source of income. However, during the Reagan Administration, the laws were changed, so Social Security became taxable for higher-income individuals.
Provisional income is the IRS measurement to calculate if you need to pay taxes on your Social Security benefits. To compute this number, add your adjusted gross income, tax-exempt interest, and 50% of your Social Security benefits. Depending upon your tax filing status and your other income, 50% to 85% of your Social Security benefits could be taxable.
When you take a 401(k) distribution, this increases your provisional income and thus may cause your Social Security benefits to be taxed. In contrast, distributions from a Roth 401(k) are not included in provisional income.
This is one factor that needs consideration when deciding whether to contribute to a traditional 401(k) or a Roth 401(k).
Taxation of Qualified Dividends and Long-Term Capital Gains
Another factor to consider is what impact 401(k) distributions will have on the taxation of qualified dividends and long-term capital gains. Three tax brackets currently apply to this type of income – 0%, 15%, and 20%. The income from a traditional 401(k) distribution may cause qualified dividends or long-term capital gains to move from a 0% tax bracket to a 15% or 20% tax bracket. When deciding where to save, it is important to consider what other types of income you will have in retirement and what effect the 401(k) distributions will have on the taxation of that income.
IRA Distribution’s Effect on Other Aspects of Retirement
State Taxation of Retirement Distributions
State taxation should be another consideration when deciding between a traditional 401(k) and a Roth 401(k). If you are currently in a high tax state and plan to move to a lower tax state upon retirement, the tax deduction for contributing to a traditional 401(k) now may be more beneficial.
Some states also provide adjustments for certain types of retirement income. This may mean that a portion of your traditional 401(k) will not be subject to state taxation. On the other hand, having a Roth 401(k) distribution may make it, so your income is low enough that your Social Security income is not subject to state taxation. It really just depends upon the state tax laws in the state you live in when you retire.
The amount you pay for your Medicare premiums is based on your modified adjusted gross income. Income from a traditional 401(k) is included in modified adjusted gross income, whereas income from a Roth 401(k) is not. When deciding where to save, the 401(k) distributions effect on how much you will pay for Medicare is another aspect to consider. These additional premiums can be significant in retirement.
Putting It All Together
Many factors need consideration in determining whether to contribute to a traditional 401(k) or Roth 401(k). The best way to make this decision is by looking at this decision as part of a holistic financial plan. This plan will include a multi-year tax projection. You should work with your CPA and financial advisor to develop a forward-looking tax plan to help you determine the optimal place for you to save today.
JoAnn Huber, CPA, CFP®, PFS Tax Specialist + Managing Partner
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Investment advisory services offered through Barber Financial Group, Inc., an SEC Registered Investment Adviser.
The views expressed represent the opinion of Barber Financial Group an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Barber Financial Group does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.