Pre-Tax 401(k) vs. Roth 401(k): Which is Right for You?

In this episode of the Retire Early Return Out podcast, host Hunter Kelly from Palm Valley Wealth Management delves into one of the most common financial questions: 'Should you contribute to a pre-tax or Roth 401k, or a traditional IRA versus a Roth IRA?' Hunter discusses the basics and differences between these contribution types, factors to consider when making a decision, and how your current and future tax brackets impact your choice. Real-world examples and practical steps on evaluating and planning your retirement contributions are provided to help you optimize your financial strategy. Hunter emphasizes the importance of seeking professional financial advice tailored to individual circumstances.

00:00 Welcome to the Retire Early Podcast

00:27 Understanding Pre-Tax vs. Roth Contributions

01:12 Tax Implications and Strategies

04:56 Employer Match and Tax Flexibility

11:34 Real-World Scenarios and Examples

20:20 Practical Steps for Financial Planning

22:44 Conclusion and Next Steps

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Transcript

0:00

And welcome to the retire early return out podcast. I'm your host hunter Kelly owner, Palm valley wealth management. And thanks for making this podcast. Your listen, every single Tuesday. I enjoy doing this, uh, to give you financial education LP, either retire early or retire now. And so today we're going to tackle one of the most common questions I receive. In fact, I received this question yesterday. Um, and that is tackling a common question. Should you contribute to pretax or Roth, 401k or traditional IRA versus Roth? IRA, which one should you choose? Which one's the best for you? And so hopefully I can give you some education today on how to go about choosing that, um, route for you. What's best for you. Based off of your situation. And obviously this is not financial advice. So obviously seek a professional if you have more questions. But, uh, like I said, this is the most common question that I get, uh, on a regular basis. Um, so one of the, to answer this, especially as we get toward the end of the year, you may be looking to make changes or revamp your financial plan. Um, so this could be a question that you're trying to answer. And so really the question you're trying to ask yourself is. Um, should I pay taxes now? Or should I pay taxes later? And so this is the ultimate question that we're trying to, to answer today, or at least get a process in a way so that we can answer it. And so. Uh, So let's start with a question, right? Um, if you, if I were to say. Pretax 401k like I did earlier, or if I said Roth, 401k. Uh, what comes to mind? Do you have an idea of what that really means how that works? Um, so let's clarify some of that. Um, and what that looks like. So. We'll start with an example, right? Um, imagine you earn a hundred thousand dollars and you put$10,000 into your 401k. What is your tax picture? Look like? If it's pre-tax. Versus Roth. And so, um, Take a second and think about that. Consider your options. Right. Um, what does that look like? Um, and so pre-taxed is exactly how it sounds, right. Those contributions are going to come out. Uh, of your paycheck before taxes are taken. Um, from those dollars. So it's not going to be included into your taxable income at the end of the year. And when you go to pay taxes, During the following year. Taxes will be deferred until you withdrawal it. So. Whatever goes into that 401k, uh, you will not pay taxes on. So if you get dividends, you sell and you have quote, unquote capital gains, whatever. Uh, taxes would normally be incurred, uh, in these types of investment accounts. They will not be, uh, Incurred until you take that money out. And so generally. Uh, the rule of thumb is that. Pre-tax 401ks are best for when you're at your highest peak earning years or you're in higher tax brackets. Um, because you're deferring more taxes, right? So if you're making$50,000 a year versus$500,000 a year, your tax bracket is going to look quite a bit different, right? And so, um, generally speaking, if you're on that upper end, like I said, that example of$500,000, uh, the, the tax deferral might be more advantageous for you. Then if you're at$50,000 and just paying that tax bill now. And so, uh, the other option obviously is your Roth. And so you're going to pay or contribute that money into that 401k via payroll deductions. Uh, in an after-tax manner that money will grow. And any qualifying withdrawals later on down the road will be tax-free right. So both growth and those qualifying withdrawals will be tax-free. And so there's really two factors that you want, uh, when considering Roth. Um, is one being in a quote-unquote year, low, lower tax bracket or a lower tax bracket, and then to time for growth, right? So the longer you have, uh, for this, uh, RA to grow, um, the more fruitful. Um, that it can be over time and obviously with pre-tax it's the same thing. Um, but you're going to get more bang for your buck. Uh, assuming there's no taxes owed on that Roth IRA or Roth 401k. Correct. So, so just think about that. If I'm doing the Roth 401k. I want to be in a lower tax bracket. What I think a lower tax bracket would be. And then I want, uh, as most time as possible. Um, to get there. And then one thing to consider, we're not really going to jump into this at all really today, but I do want to mention it because a lot of people miss out on this sometimes. Do what you can or do what you need to do to get your employer match. Um, that employer match has always, uh, for the most part, going to be. Uh, before tax dollars going into that account, uh, maybe down the road, the IRS can change that and you can maybe opt and pay those taxes now. Um, but as it stands now, if you're putting. Let's say 10% of your a hundred thousand dollars into your Roth, a 401k. Then, uh, anything that you get matched on that 10% would go in pre-tax. So you'll start building two different buckets there. Uh, for money. So just want to consider that as well. And so, um, hopefully that clarifies, we've talked about. Raw versus pre-tax quite a bit on this podcast, but did want to clarify that to kind of lead us into what should we consider, um, when, where you want to pick either one or the other. Right. And so. Uh, What's your gut feeling? Do you feel that taxes are going to be higher later? Um, whether that's because of what the laws are and the tax code is later on down the road, or because maybe you're making a higher income later on in life. So think about that. What is your tax rate now? What is it going to be in the future? And this is where you kind of start to think about, okay. Should I be considering a Roth 401k whore should be considering deferring those taxes for later and a pre-tax manner. So. Think about that. And so, uh, the other thing that you have considering what we talked about a little bit last week is your tax brackets. Like we just talked about, right? So, um, What is your marginal tax bracket? And, and so what does that impact. Uh, or that. Have on impact on how much you're paying in taxes and things of that nature. Because if you're in the 32%, 35%, 37%. Any, any, any money that you put in pre-tax you're essentially saving. Uh, somewhere between 32 and 37% on each dollar that you put in there. So if you're maxing out your 401k at, let's say 23, 20$4,000, um, That's seven, potentially$8,000 a year. Um, if my mental math is correct there on. On taxes and that's that's money back in your pocket that you can invest for later. Um, now you will have to owe that later and that's the whole topic of this. This podcast episode is all. Does it make more sense to pay that now or defer it and pay that later? Right. And so some other things that you want to consider, uh, just thinking about the future. Whether that be legislative changes with the tax code or, uh, if your income is going to significantly. Increase over time. And so, um, the other thing. Uh, just kind of rules of thumb. Generally, we like to. Uh, be a little, a little bit diverse, right? So whether you're talking about your, your investment allocation or even your tax location or investment location, And we wanted to be diverse. So, uh, we do want to end up potentially having. A mix of Roth versus traditional, which we'll get here in just a second. And the reason why is because that gives us tax flexibility, um, and. Uh, your, your distributions that you take on your retirement accounts and things of that nature later on. We'll have an effect on Medicare rates, how your social security is taxed. Um, and then ultimately, um, how much you'll need to take, how for RMDs required minimum distributions when you reach that age. So all of these. Things need to be considered when you're thinking about, should I put into pre-tax or Roth? And also, um, how is that going to affect other parts of my life? Right. And so. Um, What we want to consider, like I just said, as a blended strategy, we want to. One have flexibility. So having both Roth and traditional, um, type of counts will give us that flexibility. And so a couple of examples here. Um, where you can kind of work your way into having both a mix of Roth and traditional, let's say that. Uh, you are one of those high income earners. And so this is. Um, where you may have an issue getting into Roth, right? So maybe you're already maxing out your 401k because, um, what you need to save to reach her as Harman, uh, goals is, uh, over and above the limits of your 401k. Well, then you can start looking at potentially doing some backdoor Roth, some after tax contributions to your 401k is if the plan allows it. Um, things of that nature. Uh, and all of that can certainly help you get someone out Roth money in. Um, And then also early in retirement, you can look at doing. Some conversion ladders. Um, and so maybe you've put in, you've decided to go pre-taxed and you put in. Pretax for a number of years. And when you retire, your tax rate is much lower. So you start doing those conversions, which we'll dive into much deeper, a little bit. Um, we'll dive in deeper next week. Um, but you can start to do that and this can help you get a mix of both from the back door. Uh, Roth contributions and from potentially a Roth conversion ladder early on in retirement can help you get kind of a mix between that pre-tax and after tax or pre-tax and Roth money. To give you that flexibility. And. Uh, retirement. And if you're unsure on how to blend these accounts and what you should be doing. Uh, I would seek an advisor, right. Um, you can easily go to my website, Palm valley, wm.com. Schedule call. We can have a more detailed conversation about your situation, um, but ultimately find someone that you trust, uh, that you can talk about and run projections and things of that nature. Um, but, but these strategies can get a little bit complex. Um, but ultimately, uh, An advisor should be able to help you. Uh, create a path and a plan to, uh, help you kind of optimize. Whether that be that Roth or traditional scenario. And so what I want to do now is go over some, uh, three real world scenarios. And hopefully you'll fit into one of these categories, whether you be, whether you're a young professional, maybe you're still in residency. Getting ready to move on to becoming an attending physician. Um, and we're early on in career of some sort of, um, kind of startup position. Maybe you're in your mid career. Um, where you're starting to make some real money. Um, and, and you're re starting to reach your earning potential. Or maybe you're nearing retirement and I'm not sure exactly how to do those Roth conversions. Right. And so, um, for example, number one, let's say you're somewhere between. Call it 23 to 30. Uh, you just graduated college, maybe you're finishing up medical school. Uh, you're, you're getting your first job. And you know, that this is the lowest income that you're ever going to have again, right. Most of the time, the vast majority of time, get the money into Roth. Anything that you're saving towards retirement. It should be pretty cut and dry. Get as much money as you can into Roth because you got both of the two factors on your side. You have a low tax bracket and you have a more, the most time on your hands that you're ever going to have. Right. And so, uh, if you're 25, Most likely if you can get somewhere between an eight and 10% return and you're blasting in, uh, 10,$15,000 into your Roth 401k. It's going to be pretty likely that you're going to be well over a million dollars in that account. Uh, when you turn 65, so. Um, You have both of those scenarios. So if you're a young professional, you're just starting out. Do the Roth 401k right now, as you move into your thirties. Maybe you get a promotion, you move into an attending physician job. You're working more hours and you're starting to hit kind of closer to that peak earning potential. And generally what I say a rule of thumb is when you're hitting over. Um, The the amount for the Roth income limits. Now you want to start to think about, okay. Well, do I need to start deferring some of these taxes for later on down the road. Now, if you're still closer to that in your twenties or early thirties, The Roth may make more sense. Um, if your, uh, income is getting quite a bit higher, but you're still kind of in those lower ages, younger ages, then the raw is still make Mason make, may, may make more sense. Um, but as you continue getting closer to your forties, your income starts to creep up more and more. Now we want to start running some projections to say, okay, Well, I've been saving well, uh, I think I have a potential to be able to retire fairly early. Um, so yes, my income is high, but I'm going to have opportunities to maybe do some Roth conversions down the road. Um, so I want to defer these taxes. Now. I don't want to pay these taxes now because I think I can get this money out at a much lower tax rate later on down the road. And so. Um, Another example in this kind of scenario. Uh, actually just got asked this question yesterday from a client. Client is a physician. Uh, her spouse is a fussy physician as well. Um, but they have a family business. The wife has a family business. That generates quite a bit of income on there. Their tax return. So she asked the question, well, should I be putting in Roth or, or pre-tax money? And for her. The business is going to generate quite a bit of income for the foreseeable future. So putting in pre-tax makes a lot of sense for her. And her goal is one, the family business will, uh, she will be bought out of the family business so that income will be gone here soon. Also, she wants to go to down to PRN. Uh, here in the next few years, so her income will drop dramatically. So right now it makes more sense for her to go ahead and put as much into pre-tax as possible. And then later on, uh, start to re contribute to the Roth or do some Roth conversions. Um, depending on how her income shakes out, when she wants to retire things of that nature. Um, but. What I'm getting at here is you, you have to look at your personal situation, right? Um, and, and so understand what is my tax right now? What do I think it is going to be later? And you're not always going to be a hundred percent correct, but we can take some good guesses and we can be less wrong. Um, or at least, least wrong as possible. Uh, to make sure our situation or we're trying to maximize our situation for the financial goals that we're trying to reach. Right. And then the last scenario. Uh, is you're nearing retirement. And so this would go one or two ways. If you're in your early fifties, mid fifties. Um, and you have quite a bit of a pre-tax money. In there. And in those accounts. Then it's likely going to be a good idea to look at some Roth conversions, right? Um, that would be one way to get your Roth bucket built up. Um, because what's going to happen is eventually when you get to your RMD age, the government is going to require you to take distributions off of those pre-tax accounts, no matter what. Right. And so. What you don't want to get to is if let's say you have about a million dollars in your traditional 401k, and you're 55, you're retiring. Maybe you have a spouse that's working, or you have other sources of income where you don't necessarily need this money. And this is very similar to a client I work with right now. Um, and she is retired. Uh, she had a job at a big energy company. And she has a 401k with quite a bit of money. Now, her situation, they don't have any debt. They don't spend a lot of money. So the money that her spouse makes plus his military benefits that he receives. Uh, they don't necessarily need any income off of her retirement. So what we are doing, or we are doing Roth conversions because let's say we take that million dollars. And again, we invested for 15, 20 years at an 8% conservative, 8% clip, um, that that money should have doubled. Once, maybe even twice by the time she's 75 and those RMDs come around now, she does not need that income. The government is going to make her take distributions off of that account. Um, and now she's making unwanted tax payments on these particular, uh, distributions where we can keep her tax rate steady. And we can do these conversions. Build up her Roth bucket. And then now this will be either, maybe a long-term, uh, care, play, a legacy play. Or fun money down the road, things of that nature. Um, and again, we'll get into Roth conversions. Uh, more specifically next week, but, uh, this is a good kind of leeway or get introduction to Roth conversions. Uh, just mentioning this and so. Roth conversions. Are a good way to build your Roth bucket up, especially if you are, uh, deferring those taxes, putting in a bunch of pre-tax money early on in your career. Uh, maybe you just didn't have the option for a Roth, a. 401k option or a, you felt it was better to, to contribute to pretax whatever that case may be. But the Roth conversions are better. The earlier you retire. Um, or maybe you just take some time off work and you have a low. Income bracket year or years. Um, and then as you get older, they're not as fruitful. So you may want to think of those conversions. As more of a long-term care option. Um, later on that maybe if you need to use or, um, certainly a legacy play where. You're essentially paying those taxes now and your, your family members to inherit that money. I will not pay those taxes later on down the road. And so, um, which scenario fits you best? Which bucket do you fit into most? Um, hopefully you found some value and either of those scenarios, whether you're a young professional, um, you're mid career earner, maybe you're starting to. Kind of peak at your earning potential. Um, or you are one of those people that are nearing retirement and need to consider. Oh, man, I have a bunch of money in this. Pre-tax 401k. How do I get this out? The most tax efficient way? Um, either as a legacy play or for my own personal use. Right? And so. Uh, last thing I want to leave you guys with today are some practical steps to help you. Uh, make decisions about your situation. First step is obviously. Think about your tax situation now, what you think it's going to be later on down the road, whether that be, um, with kind of your work and income, what that's gonna look like, or even in retirement. Um, and kind of. This determined. Do I want to pay the tax man now? Or do I want to pay the tax man later? And that will definitely help you determine. Uh, which one you should pick, run those projections. So, uh, there's a bunch of calculators online. You can just go in and go pre-tax. Versus Roth calculator. Um, and you can kind of play with what you think your tax bracket will be. Later on down the road. Um, obviously, if this is confusing, you're like, I don't even know where to start. I don't have time for this. I'd rather be doing something else. Whatever consult a financial planner. I've built a system around this, a planning system. I call it the Palm LA pathway. Um, to help my clients answer these types of questions. Um, you can see that process on my website, Palm valley, wm.com. We'd love to help you. Uh, if, if that's what you decide. Um, but, but go find a financial planner. This is the thing that financial planners probably do. One of the things the most that they do. So. Um, go ahead and do that. And then every year monitor this, you're going to need to make changes as your income grows, as you get geared up for retirement. Um, income changes, whatever that case may be, you're going to need to make changes. And that is the biggest thing with financial planning. And it's not a static thing. It is ever evolving. The plan you have today is going to be incorrect for the plan that you need tomorrow. So continue to look and evaluate that and make those changes. And that's really why I wanted to do this episode today is because most people are going to be evaluating those financial plans here. In the next few weeks after the holidays. And just want to give you some food for thought on, Hey, w where do we go from here? Right. So. Again, just to recap, figure out your tax brackets. Understand what your future expectations are as far as income. And then run those projections to figure out, should I go Roth? Or should I go pre-taxed and so I appreciate you guys listening. Uh, we are on YouTube. So go on YouTube and tell me what you're doing. Are you doing Roth? Are you doing, uh, pre-tax traditional type contributions? Um, go ahead and, and let me know in the comments, but, uh, enjoyed this conversation and this podcast today. Next week, we will go again more in depth to Roth conversions and what that looks like. To give you more tax flexibility in retirement. So. Thanks again for listening and we'll see you in the next one. This podcast is for educational purposes only. It is not meant to be financial planning or investment. Or tax advice, please seek a professional. To consider your own specific situation, do not make decisions solely based on this podcast alone. Please keep Palm valley wealth management in mind when making those considerations.