Should I Switch From Pre-tax to Roth 401k?

Our topic on this episode of the Ready for Retirement podcast is about 401(k)s and specifically whether or not you should switch from pre-tax to after-tax (Roth).

Questions answered: What’s the most tax-efficient strategy to contribute to my 401(k) / Roth 401(k)? What are the pros and cons to each? What strategies can I implement today to improve my financial future? What is the best approach for my individual situation? 

Are you ready to start focusing on the things that truly matter when it comes to your financial future?

Key Points

• Tax brackets
  • Whether you choose to invest in a 401(k) or Roth 401(k) comes down to understanding what your tax bracket is today vs. what tax bracket you will be in, in the future.
    • If we knew taxes wouldn’t change over time, we could make an educated guess of what that may look like.
    • However, since we don’t know what tax brackets will be, we must monitor and determine what’s likely going to happen to understand potential tax implications.
• Taxes in retirement
  • What we know today is that if you’re in the same exact tax bracket today as you will be in retirement, it doesn’t matter which 401(k) option you elect.
    • This is in terms of your marginal tax bracket (if you make $1 more, what’s the rate of taxes you will owe on that next $1?).
  • Example: Let’s assume you’re in a 20% tax bracket today and you will be in a 20% tax bracket in retirement.
    • Let’s assume you have $1,000 of pre-tax salary you would like to save.
  • 401(k)
    • Let’s assume you put $1,000 into a 401(k) and it grows by 10x what you invested initially and it’s now worth $10,000.
      • This $1,000 goes directly to your 401(k) and you receive a tax deduction.
      • In retirement, you are still in a 20% tax bracket and you end up with 20% of $10,000, which is $8,000 after-taxes.
  • Roth 401(k)
    • Let’s assume you put $1,000 into a Roth 401(k) and it grows by 10x what you invested initially and it’s now worth $10,000.
      • This $1,000 goes directly to your 401(k) and you receive no tax deduction. 
        • This means 20% will be paid to the IRS which is $200.00 and the remainder will be invested in your Roth 401(k).
      • In retirement, $800 grows to $8,000 and you choose to take all of the funds out. 
        • $8,000 comes out in retirement and you don’t owe taxes.
    • If you were in the same tax bracket today as you anticipate being in, in the future, you would not receive a benefit by electing a Roth 401(k) over a 401(k) and vice versa.
• 401(k) or Roth 401(k)
  • Will you be in a higher tax bracket today or in retirement?
  • Do you anticipate you’ll be in a higher tax bracket today then you will be in, in the future? If so, a traditional 401(k) allows you to save taxes today when you’re in a higher tax-bracket and you can take out the funds in retirement in a lower tax bracket.
  • Do you anticipate you’ll be in a lower tax bracket today then you will be in, in the future? If so, a Roth 401(k) allows you to take funds out in retirement without paying any additional taxes.
• Marginal tax brackets
  • Example: Let’s assume you’re married and you file your taxes MFJ (Married Filing Jointly) and you take your Taxable income (Adjusted Gross Income – Deductions) and it increases by $81,050. 
    • This would mean your tax bracket jumps from 12% to 22%.
    • Another large tax bracket comes when you are at $329,850. Income below is taxed at 24%, whereas income above is taxed at 32%.
  • Let’s assume you make $91,050.
    • Once you cross $81,050, you are $10,000 in the 22% marginal federal tax bracket.
      • When viewing your income, consider putting $10,000 into the pre-tax 401(k) to avoid going into the 22% tax bracket and put the remaining amount in the Roth 401(k).
      • This reduces your taxable income to $81,050.
        • Any Roth 401(k) contributions would be at the 12% federal tax bracket as composed to the 22% tax bracket.
• Tax Planning
  • When evaluating whether a Roth 401(k) or 401(k) is best for your individual situation, understand your tax situation to ensure you’re being intentional when it comes to realizing taxes.
    • It may make sense to do a portion of pre-tax (401k) contributions and a portion of after-tax (Roth 401(k)) contributions. 
  • Understand the marginal tax rate brackets to manipulate your income and take advantage of tax brackets that are most advantageous to your overall strategy.
• What tax bracket is best in retirement?
  • If you’re currently choosing a percentage to contribute for retirement, the Roth 401(k) is going to always be the best option as withdrawals in retirement are completely tax-free.
• Cash flow
  • Example: A 10% contribution to a 401(k) is the same as a 7% contribution to a Roth 401(k) from a cash flow perspective.
    • Do I put more money into a pre-tax 401(k) where I receive a deduction or do I do 7% to my Roth 401(k) which costs 7% of my net income?
  • What I often recommend is finding out what number you want to contribute to retirement, whether it be 15%, 10% or 5% and electing the best option for your goals. 
    • When it comes to paying for the things you want to do, a Roth essentially forces yourself to save more.
• Roth 401(k) example
  • Let’s assume you’re maxing out your traditional 401(k) and you want to find ways to maximize the amount you’re saving with great tax benefits.
    • You are foregoing a tax benefit when you are electing a Roth 401(k).
• Comprehensive planning
  • Understand your complete financial situation before electing a 401(k) v. a Roth 401(k).
    • If you do elect a Roth 401(k), can you still take the trips you want to do? Can you still do all of the things you want to do whether it be graduate school or start a new business?
  • Financial planning shouldn’t be done in a vacuum. 
    • It’s about understanding your goals and when/how to save for them (or save less & understand how to avoid over saving for retirement). 
  • View your retirement holistically in conjunction with your overall financial picture.
    • Does it make more sense to prioritize an HSA?
    • Is there a purchase in the short-term you wish to make and not subject these funds to the stock market?

Timestamps

1:44 – Listener Question

2:15 – Understanding Tax Brackets

4:53 – Roth 401(K) vs. 401(k) Example

7:31 – Marginal Tax Bracket Jumps (Big Ones!)

12:11 – How To View Roth 401(k)s

14:25 – Comprehensive Financial Planning

16:36 – Tax Planning

17:58 – Aligning Your Investments With Your Financial Goals

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