Change Is Coming to Your 401K Contribution Tax Status

After a market update, Lori and Lisa discuss how company 401k plans work, common pitfalls, and changes that are coming to catch-up contributions for high earners, 50 and older.

Find out more and reach out to us on our blog.

Transcript

[00:00:00] Lori: Hi, I'm Lori, and I'm here with my partner, Lisa James. We are 2X Wealth Group, a team at Ingles and Snyder, which is an independent registered investment advisor. 

[00:00:15] Lisa: Today, we're going to talk about 401k plans. But before we do 

[00:00:25] that. We've decided that it would be helpful to give a regular market update for people who follow us monthly. And so it's very interesting to talk now because some things have changed since last month when we did our podcast, trees don't. So Lori, why don't you tell us what's been going on?

[00:00:45] Lori: Well, basically what we talked about, both in writing, which you can get on our website, if you go to the quarterly letter section of 2X Wealth Group, you will see a quarterly for the second quarter that says, Trees Don't Grow to the Sky. And what we talked about is the S& P 500 continuing to rise and the things that had done well were continuing to do well and that 10 stocks were up so much more than the rest of the market that one of the indices, the Nasdaq was 100, was reconfiguring itself because, you know, It had more 

[00:01:17] Lisa: than 50% of the index in seven stocks.

[00:01:21] That is just crazy. And it really says something about how the market is, uh, currently dominated by a very small number of stocks or 

[00:01:29] Lori: was then. Yeah. And the stocks are Microsoft, Apple, Nvidia, Tesla, Alphabet, Meta, and Amazon. Those are the Magnificent Seven. And since we wrote about that, there has been a little bit of weakness in a number of those names, specifically some of the higher priced ones, which were Microsoft and NVIDIA, Tesla.

[00:01:52] Google's done relatively better than the others, but there's definitely been some pressure on the technology sector. And part of the problem is that most mutual fund managers wouldn't be considered diverse if they, uh, look like the indices because they're so dominated by these seven stocks. So we, um, had said then that we think that, uh, other things were likely to catch up and start to perform if the market were to continue to go up.

[00:02:20] And really what's kind of happened is the market has kind of gone down, but other things have acted better. Um, those of you that know us. and followed us for a while, know that we have been worried about inflation. It sounds like people are starting to talk about some of the things that we've been worried about, which has to do with energy prices and food prices and the Federal Reserve cannot control that.

[00:02:43] That's a concern, I mean, Pal knows that, and he's... it just like we are. Lisa and I were having a conversation about the election coming up. Regardless of whether you're a Republican or a Democrat or who you're going to vote for, it looks like Biden's decision. And it probably wasn't him, but his people to drain the strategic petroleum reserve, as he has started at the midterm elections.

[00:03:06] And it helped him. I mean, that's how 

[00:03:08] Lisa: basically what happens is they sell, they don't sell. They take oil out of the strategic. petroleum reserve and release it on the market. And just like a typical economic scenario, the increased, uh, supply actually lowered prices, but that's a very temporary phenomenon.

[00:03:27] And they did it over the course of nine months or so. And it did have an impact on lowering prices, but there's not enough in the strategic. Petroleum reserve to continue to do that. And in fact, at some point they need to refill it. So he's kind of stuck now because I'm sure going into the 2024 election, they'd like to have a way to bring oil prices 

[00:03:52] Lori: down.

[00:03:52] And now they were at the mercy of Saudi Arabia or whomever. I mean, 

[00:03:57] Lisa: we, Saudi Arabia is clearly not playing in our camp. He's fired 

[00:04:02] Lori: that bullet, and he said he was going to, or the administration said they were going to refill it when it got to 70, it got below 70, and they didn't do it. It's kind of like a portfolio manager saying they're going to buy a stock and not doing it when it gets to the price they want to pay for it.

[00:04:19] And we actually had a chart in the Trees Don't Grow to the Sky, but one of the biggest problems with inflation has been. food and energy. And energy really has been the primary driver of slower inflation in the U. S. So if, until now, right, if energy prices start to come back up and you're starting to see it with gasoline prices, it's going to be a problem.

[00:04:41] It's going to be a problem for the election. And he, he's already shot his bullet, so to speak, by taking the strategic petroleum reserve down to levels I don't think that have existed since it was created. I think it was a miscalculation. On the administration's part, to say the very least, and something that we are, are concerned about.

[00:05:00] Lisa: And actually, when you look at how the market has changed from a month ago, the most obvious thing is, well, the tech stocks have moderated. Energy stocks have actually improved fairly significantly. A lot of energy stocks are up, you know, 10%. They had basically done nothing year to date, and now they're closing the gap between their performance and the performance of the S& P 500.

[00:05:24] So 

[00:05:25] Lori: I, I guess what we would say is people can speculate on whether Powell's going to not raise again or going to in fact not raise interest rates. Not raise interest rates, or in fact going to lower interest rates. But, you know, I'm gonna read his lips. He says he's not, he's going to continue to fight it.

[00:05:42] Yeah, and actually, 

[00:05:43] Lisa: I think that's what, that's exactly what everybody should be doing. You know, the market actually is pricing in one more rate hike this year, probably not in September, probably in November. But if you look at forward pricing, it looks like people very much expect cuts next year. And that is not what Powell is saying.

[00:06:02] And he will continue to say that he's data dependent and he is not going to cut rates. Until he sees some of these basic. Components of inflation come down now and he knows he can't control some of you can't control energy and food But he can actually well, he doesn't control shelter prices either but one of the things that's rolling in his favor is that shelter prices are starting to come down and there are A very big part of the CPI and they were a reason why it took so long for the CPI to roll over when we had inflation, which is that those prices don't change very fast, but as they come down, they will have a pretty big impact and they won't go up.

[00:06:46] As fast as something like energy or food could turn around. So, so, housing is really going to be, and rent is going to be a stabilizing force next year. 

[00:06:55] Lori: But it might not be enough. Unless you live in New York City. Because New York City prices are still crazy from what I understand while a donor lives there.

[00:07:02] But 

[00:07:02] Lisa: overall, if you look at the data sets, there's some pretty clear trends. So, so I, I think he's just going to remain data dependent, which is really the only thing he can do, and it has been what he's been saying. 

[00:07:12] Lori: all along. So what does this mean for your portfolio? What it means is that you want to have a diversified portfolio and you don't want to put all your eggs in one basket.

[00:07:22] And, 

[00:07:23] Lisa: and you know what, if you buy the S& P 500, you actually don't have a diversified portfolio. As we've just pointed out, it's now almost 30% tech related stocks, right? 

[00:07:33] Lori: So, so that's changed. It's a problem, let's just say. So, you know, as you, as you look at your 401k options, or you look at your savings. You and and how it is allocated in the market.

[00:07:46] We have been recommending that you you know Look for value value funds value 

[00:07:52] Lisa: stocks. Another way of going at that is dividend growth stocks, you know Because they're not exactly value, but they have very stable characteristics They're companies that have been able to grow their dividends for Anywhere between 5 and 30 years, depending on which fund you pick.

[00:08:08] And a 

[00:08:09] Lori: number of the Magnificent Seven don't even have dividends. Yeah. So, um, anyway, it's just, so what we would say is you want to be diversified. You want to make sure that you're not too heavily in technology at this point. And you want to look and see what you can do within your 401k, which is our subject today.

[00:08:37] Lisa: We're talking about changes that are going to happen to the tax status of your 401k contributions. Before we get into the details of legislative changes, we thought it would be good just to talk about like how, how 401k plans work. Why the funds that you get to pick from are there, who chooses what they are, are they good choices?

[00:09:00] Thank you. for you. And we just thought it'd be nice to have a, an overview conversation about that. So 

[00:09:05] Lori: they're providers that are, they're 401k providers and companies contract with 401k providers. You're going to know a number of them, Empower, Fidelity, Vanguard, Schwab does it, number of other. And then the employer actually chooses the funds from the offerings that the provider has.

[00:09:27] And this is a real bugaboo with me. Because it's like, you know, my husband was a doctor and he used to say, that people pick their doctors on affability and availability, because they had no idea about ability. 

[00:09:42] Lisa: Right, because you know it's very hard to get any reviews of 

[00:09:44] Lori: ability. Right, and the problem with, I mean, but really, how do companies, is there somebody in company that's a financial planner or, or has been an investor for all their life that's doing it?

[00:09:55] Most of the time it's a human resources person who's doing it. I mean with the 

[00:09:59] Lisa: guidance of the 401k plan provider, but everybody's conservative. I think that's the bottom line is that. They're going to pick investments that are, you know, broadly diversified, either U. S. or outside the U. S. funds. They'll have index funds.

[00:10:18] They might have some actively managed funds. Maybe they'll have a growth fund and a value fund, but we've seen plenty of plans. That actually don't do that. Finding 

[00:10:27] Lori: value funds is very hard to find in plans and commodity funds, forget it. You can't, you can't find them and I think I use the analogy that this is a little bit like in the old days when all of the chief technical technology Officers would always go with IBM because they weren't going to get fired and they knew that IBM didn't have the best product.

[00:10:47] But if they picked IBM, nobody was going to fire them. And I 

[00:10:51] Lisa: think and those companies are employers are responsible for having, you know, an uncontroversial plan. They can't just go and pick a lot of wild, you know, funds like, you know, speculative. Small cap funds or gold and silver funds. I mean, they're just not going to do that.

[00:11:10] And in fact, one of the things that firms have done in order to make things simple for their employees is that they offer a lot of what are called target date funds. And the reason they do this is that, you know, the average person is really not confident about their choice of investments. In fact, there was just a recent survey that said only about 40% of 401k participants are confident about their choices.

[00:11:40] So one thing that is made available is a target date fund where you don't have to choose anything. You just say when you're going to retire. And then the fund has kind of a track path where it starts with high equities when you're young and goes to lower equities as you age. And then as the equities go lower, they add in more bonds and.

[00:12:01] Things that are supposedly more stable in the portfolio. I think last year people learned that bonds might not be so stable when interest rates are very low, but now that we're back around 5%, it's a little less problematic, but, but I think, you know, One of the issues is people don't actually have anyone to talk to unless they hire a separate financial advisor.

[00:12:25] Right. And we find a lot of our clients really don't have a good idea about what to do with their 401k investments and are, you know, not feeling confident about it. And I think part of that is that there's not a lot of money spent on advice in this whole employer provided 401k system. And so a lot of people are in the dark and they just go for the easy solution.

[00:12:48] They pick the target plan and, you know, it's not going to kill them, but it just might not be the best way to go. 

[00:12:54] Lori: So how does this apply to you? Well, if you're younger and just starting in your career or putting money into your 401k plan, we always say at the very least put in the amount that your employer matches.

[00:13:08] You know, ideally you'd be able to put in the maximum, but you know, you may not have to be able to afford that. So we tell you to put in as much as you possibly can, but at the very least to try and get Take advantage of the match because it's free money, basically, and the younger you are, the more you want to have in equities and over time, you definitely want to have growth in your portfolio.

[00:13:33] So you definitely want to have, and particularly the younger you are, you may favor growth over a dividend type of fund because, you know, That might be a better choice. It's going to be in there longer. You have a lot more chance for it to go up and down. And 

[00:13:46] Lisa: but today we're going to talk about, okay, so what has changed about 401k contributions?

[00:13:54] Not only are 401k plans somewhat challenging because people don't really know what to invest and they're not really sure which options to pick. But there's another challenge that some people aren't even aware of, which is there are two ways to save. You can either save in a traditional 401k or a Roth 401k.

[00:14:16] And 10 years ago, Roth 401ks weren't particularly prevalent. But now about 80% of all 401k plans have something called a 

[00:14:27] Lori: Roth. But the problem is that most Employees. A, aren't aware that their employer offers a Roth 401k plan, or B, they, they think that there's an income limit to a Roth 401k plan, which there isn't.

[00:14:45] There is for a Roth IRA plan, but not for a Roth 401k plan. So that, that's another misconception, and I guess the last one is, you, you get a deduction Putting money into a traditional 401k plan, whereas a Roth 401k plan, like a Roth IRA, is an after tax contribution. A lot of people, particularly people in very high income brackets that believe they're going to be in lower income brackets when they retire, are really...

[00:15:15] want to put their money in a traditional 401k plan. It's possible that you may be in a higher bracket when you retire than you realize and the government may decide that they want your, you know, made you something to get make it more expensive like raise taxes. Novel concept, right? All right. So let's talk about what change is coming to the 401k contribution 

[00:15:39] Lisa: tax status.

[00:15:40] So the background for this is that As many people know, there are a lot of competing demands for retirement savings. Often, young families are trying to buy a home, they're funding their kids education, and just when they think they're going to be saving money, they may be spending money trying to take care of their elderly parents.

[00:16:00] So, quite a few people fall behind. And, and their retirement savings. And, for this reason, actually the U. S. government has done everyone a favor, and they allow you, once you're 50, to make something called a catch up 401k 

[00:16:19] Lori: contribution. I also think that was done in part because people worried about Social Security not being around.

[00:16:25] Lisa: So if you looked at this year, a 50 year old can make a 22, 500 regular contribution to a 401k plan, and they can make an extra 7, 500 in catch up contributions. So they can make a total of 30, 000 of contributions this year. And that's. That's a nice substantial way of boosting your retirement savings. We have a nice little chart that shows how much you actually need to save at different points in your life to kind of Keep you at an income level that's similar to where you are when you retire.

[00:17:04] Not everybody has that goal, so you should keep that in mind when we go over those numbers. But Laurie, you can talk to, um, what some sort of generic suggestions are. Well, at about, 

[00:17:16] Lori: at age 40, you should, um, probably have about three times your salary saved. Um, and age, um, 50, about six times. At age 60, about eight times, and by age 67, about 10 times your salary in 

[00:17:34] Lisa: savings.

[00:17:35] And the good news about this is that you didn't actually have to save that much. The whole idea of investing in equities is that if you're saving over time, A lot of that multiple of your salary comes from the growth and the value of your investment, not just the money that you 

[00:17:52] Lori: save. And it's not being taxed while it's in these, either sheltered or in the Roth cases, never pay taxes on again.

[00:17:59] Right, 

[00:18:00] Lisa: right. So none of, none of the investment growth is taxed while you're in the 401k plan or when it's in the retirement plan. So, 

[00:18:08] Lori: so the change that's coming is that it used to be That you would put your money, you could put your money in a 401k plan and you could put the additional catch up contribution in a four, in your 401k plan as well.

[00:18:22] And the law is Changing. So now what you can do is you can put your 22,500 into a traditional 4 0 1 k and put the catch up contribution of 7,500. With the change in the law, you can put the 22,500 in a traditional 4 0 1 k, but the catch up contribution has got to go into a Roth, which 

[00:18:42] Lisa: as long as your salary is.

[00:18:45] Above a certain level. So just to know the background of this when they pass when Congress passed the secure act they had to find ways to fund some of the changes in there and This is a funding mechanism because in the past if all Everyone who did a catch up contribution made it a pre tax contribution.

[00:19:07] The government got no revenue. But now what they're saying is if you make over 145, 000 in the prior year for the employer where you have your 401k plan, you cannot Make a pre tax contribution of your 7, 500, you know, catch up or whatever it is in in future years You know for some people who are in high income brackets They're they're really unhappy about this because they think they're gonna well, they will have to pay more taxes today But we don't necessarily think it's the most awful thing because there's a silver lining to making Roth catch up contributions, even if you are in a high income tax bracket 

[00:19:51] Lori: A Roth is one of the best assets that you can have.

[00:19:55] Lisa: It is because in a big picture kind of way, we believe it's prudent for clients to have a couple different kinds of retirement accounts. You know, you can have a pre tax account, you can have a Roth account, and you can also have taxable investments. And we like It, when people have all three because it gives you a lot more flexibility to minimize your taxes when you're starting to withdraw money from those accounts.

[00:20:25] And the Roth is the best because you, whenever you've put the money in there, it grows tax free and then you can withdraw it completely tax free as long as you have met some of the time minimums you have to have had to count for over, for over five years. But, for example, you could have a year where for some reason you have a higher income and you may not want to withdraw from a taxable account or a, or a, um, a pre tax retirement account.

[00:20:57] You may want to just use your Roth because that will keep your income low, maybe keep you in a lower tax bracket. And also could help you with your Medicare premiums. So it's, it's a, it's a really great financial flexibility tool. It's also great 

[00:21:12] Lori: for heirs. If you have a traditional IRA that. Um, you have to drain the account within 10 years and you have to take annual withdrawals each year.

[00:21:26] If you inherit a Roth, you still got the same 10 year withdrawal period, but you pay no taxes on qualified distributions. 

[00:21:35] Lisa: So, and the problem is, you know, a lot of people inherit their IRAs from their parents when they're middle aged, maybe in a higher income tax bracket. So, it can really. Boost the tax bracket to an even higher level because they have to take out all this money over a relatively, you know, short period of time.

[00:21:55] It used to be, you could take it out over the rest of your life. But there's also some more basic reasons that a Roth is good. One of them is. People can underestimate how much their 401Ks will grow over time. And especially if you're not withdrawing them right away, you can actually wait until you're 73.

[00:22:14] And at that point, your required minimum distributions might just put you in a tax bracket that's at least as high as where you are today when you're saving. And a big surprise for people, too, is that if their spouse dies, They will immediately go from filing their taxes as married to filing as single and their tax brackets will change.

[00:22:38] Much far less. Right. And so, therefore, having this flexibility that you have some Roth savings in order to try and keep your, your tax bracket down when you're withdrawing money to live on, it can be really helpful. Okay, so what do we think is going to happen with this legislation? 

[00:22:57] Lori: Well, the problem is not all plans have Roth 401k, um, not all employers have them.

[00:23:03] So the government is trying to figure out how they can, how much time is needed to get all of these companies to be able to offer these and do the paperwork. Because otherwise what happens 

[00:23:13] Lisa: is if you can't offer your employees who need it a Roth, then you can't offer anyone a ketchup. contribution. And that obviously is not what the government is trying to do.

[00:23:23] So. A lot of these people have to change their systems in order to offer different kinds of plans, and then they have to, they also have to change their systems to figure out who gets it. Who has to, you know, contribute to a Roth versus who can continue to contribute pre tax. So this is a lot of work for companies and unions actually have to vote on this.

[00:23:44] So right now the legislation says it goes into effect January 1 of 2024. And we think that's highly unlikely, but we do expect it to go through at some point. It's just a matter of timing. But one of the things we would say is, it's just a good time to have a conversation about Roth because this has brought up a lot of thinking about whether people maybe just knee jerk reaction put money into a pre tax 401k when they might want to be thinking about putting it into a Roth.

[00:24:14] And you can do that anytime if your plan offers it.

[00:24:27] Lori: After we published our blog, the IRS gave high earners 50 and up a two year reprieve. on the 401k catch up contributions to a Roth. This happened late Friday, August 25th. We continue to recommend that it would be prudent for high income earners not to wait for the law to change. If your company offers a Roth 401k, it may make sense to consider making regular or catch up contributions to Roth 401ks now.

[00:24:58] That's all for now, so until next time. Please, if you enjoyed this, rate us and write us a review wherever you listen to your podcast. And, uh, check out our blogs, including the one associated with this and then another one called To Roth or Not. Yeah, that 

[00:25:16] Lisa: really helps if you're trying to figure out, in fact, whether you should be saving more money in a Roth versus a pre tax retirement.

[00:25:24] Lori: Our website is www. 2xwealth. ingles. net. Until next time, we will see you. Bye!

[00:25:50] Lisa: Bye!