Get ready for a long read, because saving for retirement is extremely important. The government wants to make this as complicated as possible so you don’t do it. When it comes to saving for retirement, the two most popular ways are investing in a 401(k) and Individual Retirement Account (IRA). A 401(k) is a retirement offered by your employer, an IRA is an account that you can open at any brokerage firm. You purchase shares of individual stocks, ETFs, mutual funds, and even bonds with the hope that they increase in value over time and pay dividends. These accounts are popular for retirement because they provide you with a tax advantage.
What Is A Tax Advantage?
A tax advantage means that your invested money has preferential tax treatment. Normally your paycheck is taxed, you invest this previously taxed money into an investment account, and then pay taxes on any capital gains. In this scenario, you are taxed twice: before you get paid, and when you withdraw money. This is just a fact of life. The only two universal truths are that you will pay taxes, and eventually die. Uncle Sam will always get his cut.
When you contribute to to a 401(k) or an IRA, you partially shield your money with a tax advantage. There are two different types of tax advantage: pre-tax (Traditional) and post-tax (Roth). The decision that we all fact is which type of contribution should we make, Traditional or Roth?
Traditional contributions to your 401(k) and IRA are made on a pre-tax basis. What this means is that you contribute income before it has been taxed. This money is invested and then grows over time. When you withdraw these funds, they will be taxed at your marginal income tax rate. Note that this money was only taxed a single time when you withdrew funds, and it was taxed at your regular income rate. You completely short circuited paying capital gains.
Roth contributions to your 401(k) and IRA are made on a post-tax basis. What this means is that you contribute income after it has been taxed. This money is invested and then grows over time. When you withdraw these funds, you pay no taxes. Note that this money was only taxed a single time, before you contributed funds, and it was taxed at your regular income rate. You completely short circuited paying capital gains.
If those definitions of Traditional and Roth contributions sounds similar, that’s because they are. With each type of contribution, you bypass paying capital gains and only pay ordinary income tax. The only real difference is when you pay the taxes. Technically there are more subtle mathematical differences which might make Traditional contributions better, but these require you to be extremely disciplined, and everything changes if your tax rate while making contributions is different than your tax rate in retirement.
Benefits Of Traditional Contributions
The tax advantages of traditional 401(k) and IRA contributions help you out in the “now.” When you make these contributions, it reduces your taxable income. For example, if you contribute $18,000 to your Traditional 401(k) (the maximum allowed contribution), then you decrease your gross income by $18,000. This can be extremely beneficial, especially if you receive income-based benefits. You can even use it as part of a strategy to reduce your federal tax rate to $0.
As an example, let’s say that Jim makes the average salary of $38,000 per year. Jim is extremely frugal and paid off his house long ago. Nearing retirement, he maxes out his Traditional 401(k) to the tune of $18,000 per year. This decreases his taxable income from $38,000 to $20,000 per year. In addition, he takes the standard deductions and exemptions which further reduce his taxable income to $10,000 per year. His Federal tax bill is now about $1,000 (10% tax rate). However, since he was able to reduce his income so low, he takes advantage of the Savers Credit and actually reduces his Federal taxes down to $0, even though he earned $38,000.
However, any money that Jim withdraws in retirement will be taxed as ordinary income, which includes state taxes.
Benefits of Roth Contributions
The tax advantages of Roth 401(k) and IRA contributions help you out in the “future.” When you make these contributions, you do it with money that you’ve already paid taxes on. It does not effect your current taxes. After a few decades when you have several hundred thousands (or even $1 million+), you get to withdraw all of this money tax free.
As an example, let’s say that that Jim’s marginal tax rate is 20%. For him to contribute $5,500 to his Roth IRA, he needs to earn $6,900, pay $1,400 in taxes, and contribute the rest to his Roth IRA. He continues doing this for a few decades until he has $1 million. When Jim retires, he is able to withdraw all of this money tax free.
Mixing Contributions Can Suck
With all of these benefits, which type of contributions should you make? On one hand, making Traditional contributions is great because you can quickly grow your nest egg while decreasing the taxes you currently pay. Building up a sizable position inside your Roth IRA is extremely attractive because you can access your gains completely tax free. In the end, you should determine what type of contributions to make based on your current marginal tax rate, and your expected marginal tax rate. If you believe your taxes are higher now, make Traditional contributions. If you believe your taxes will be higher in retirement, make Roth contributions.
In addition to making a choice about which type of contribution to make, the government regulates what you can do as well. If your company offers a 401(k) plan, then you cannot make deductible contributions to a Traditional IRA unless your adjusted gross income is less than about $71,000. If you make more than this, the only IRA option that you have is a Roth. But wait! If your income gets too high ($127,000+), then you cannot make a Roth IRA contribution either, and must go through the process of a backdoor Roth conversion.
So now that we roughly understand which type of contributions to choose, and what regulations the government imposes on us that actually lets us make these contributions, what do people normally do? Most people (who have access to a 401(k)) make Traditional 401(k) contributions up to their employer max, and then make Traditional contributions to their IRA as well. The reason for this is “most people” make around $38,000 so the government lets them do both. It significantly reduces their taxable income, usually all the way down to the point of qualifying for the Saver’s Credit.
High Income Earners Are Penalized
But what if you have a high income? Most high income individuals will make Traditional 401(k) contributions to reduce their adjusted gross income, and will make Roth contributions to their IRA (either directly or through a backdoor Roth). As long as your income stays below $127,000 (for single filers), this works perfectly fine. However, mixing your contributions like this can be a huge pain in the ass once you no longer qualify for direct Roth IRA contributions.
Once you no longer qualify for these contributions, you are forced to do a backdoor Roth. What this means is you make contributions to a Traditional IRA. However, you do not deduct this income. Hence, you are said to make non-deductible contributions to your Traditional IRA. Kind of weird, right? Then, you initiate a Roth conversion of those non-deductible contributions which directly provides Roth protections. This is great, right? That depends.
Most high-income earners make Traditional 401(k) contributions, right? What happens when you quit a job, you typically convert your Traditional 401(k) into a Traditional IRA so you can 1) directly manage your money in the funds of your choosing, and 2) not pay those annoying 401(k) fees anymore. This creates a problem, because when you perform a Roth conversion, the government considers all deductible Traditional contributions and non-deductible Traditional contributions, and taxes you on their ratio when you perform a Roth conversion.
To make this easier, let’s say that you have $50,000 of deductible Traditional IRA dollars from previously rolling over an old 401(k). You then make a $5,500 non-deductible Traditional IRA contribution and immediately do a Roth conversion. Since your deductible Traditional IRA dollars represent 90.1% of your total Traditional IRA balance, the government will impose 90.1% of your marginal tax rate on your Roth conversion. This really sucks! On one hand, great job that you actually make enough money to deal with this, but it sucks having to pay a significant amount of taxes on money that has already been taxed (remember, you are rolling over non-deductible Traditional IRA dollars — this means you’ve already been taxed on them).
So What Should We Do?
So if you are a very high income earner and must deal with this, what should you do? First, pat yourself on the back and realize that you are extremely lucky. The average income is $38,000 and the median household income is about $50,000. You are doing significantly better than them. Regarding your options, you have two:
- Never roll over Traditional 401(k) balances into a Traditional IRA
- Roll over Traditional 401(k) funds into a Traditional IRA, and pay taxes when you perform a backdoor conversion
As usual, each of these options has positives and negatives. Option #1 is actually pretty good, assuming that your 401(k) plan has good fund options and low account fees. This is actually relatively rare, but if you fit into this category, do this. If you must convert your 401(k) into an IRA, be ready to pay taxes. Depending on your situation, it might make sense to do the rollover and then directly convert your Traditional IRA into a Roth IRA and just pay the taxes. This will let you make future backdoor Roth IRA conversions tax free
So how are you currently dealing with this problem? I opted for #1. My previous company’s 401(k) had a $100,000 balance. Out of the $100,000, 90% were Traditional contributions and 10% were Roth contributions. I directly rolled over the Roth contributions into my Roth IRA, and left the Traditional contributions alone. My 401(k) only costs $30 per year in fees, and all of the funds are extremely good. Converting those Traditional dollars to Roth dollars just doesn’t make sense given my tax bracket and the fact that Maryland and New York state taxes are extremely high. Maybe in the future.
Have you made tough decisions with your Traditional and Roth contributions to retirement accounts? How did you come up with a decision?
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