Ready For Retirement

Pretax vs Roth- Which is Better for You If You're in the 24% Tax Bracket?

October 24, 2023 James Conole, CFP® Episode 186
Ready For Retirement
Pretax vs Roth- Which is Better for You If You're in the 24% Tax Bracket?
Show Notes Transcript Chapter Markers

If you're in a high tax bracket now and expect to remain in a high tax bracket after retirement, should you prioritize pre-tax retirement accounts or Roth retirement accounts for individuals? 

James answers this and discusses various factors to consider in making this decision, including current and future tax brackets, required minimum distributions (RMDs), charitable giving, life expectancy, and the impact on heirs. Using a real-life scenario, James offers a thoughtful approach to help you make an informed decision based on your unique circumstances.

Questions Answered:
Should individuals in high current tax brackets prioritize pre-tax retirement accounts or Roth retirement accounts? 
What impact will required minimum distributions (RMDs) have on your future tax situation?

Timestamps:
0:00 Intro
3:48 Considering Roth contributions
7:05 Example
13:25 Charitable giving
15:42 Life expectancy
18:18 What about your heirs?
20:52 Outro

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Speaker 1:

Are you in a high tax bracket now, but you expect to still potentially be in a high tax bracket after you retire? If so, you're probably wondering whether to prioritize pre-tax retirement accounts or Roth retirement accounts. Trying to plan out the most tax-advantages retirement strategy is overwhelming for even the most financially astute. But in today's episode of Ready for Retirement, I'm going to walk you through how you should think about what account type is best for you. This is another episode of Ready for Retirement. I'm your host, james Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Today's episode is based on a listener question. This question comes from Karen, and Karen says the following. She says do you think someone who is in the 24% federal tax bracket, who is planning to retire in two years, should max out their 401K and set a contributing to an after-tax brokerage account? And if the 401K has Roth option, should we take it? I'm the money person in our household and I feel like I have everything figured out as far as our retirement income and expenses, but I'm at a loss when it comes to taxes and RMDs and it's freaking me out. My husband plans to retire in December of 2024 at the age of 64, and I plan to remain working in additional 2-4 years part-time, just enough to give me full health benefits, as I'm 4 years younger. We have a lot of our portfolio in pre-tax accounts. We have 1.8 million in 401Ks, 550,000 in my traditional IRA. We also have $20,000 in Roth IRAs and my husband maxes his out every year with a backdoor Roth. He will also be getting a pension which we plan to take as an annuity when he is eligible, and this will be approximately $3,370 per month. I plan to take Social Security when I'm 65, and that will be approximately $2,680 per month, and we will wait until he is 67 for him to take Social Security, which will be around $5,000 per month. Wouldn't this put us in the 22% tax bracket when we need to start taking RMDs, and what amount would we have to withdraw if we throw this over the 24% tax bracket anyway? Kind of feels like all the same pain just later in our lives. This may or may not be relevant, but our expenses to do everything we want to do in retirement will be approximately $10,000 per month to start. I am sure inflation will quickly increase these expenses. We both currently contribute 10% of our income to our 401K accounts and I contribute an additional $200 per paycheck to the Roth 401K, but I'm wondering if this is a bad strategy, given our tax bracket, or a good strategy, given the amount we will have to withdraw for RMDs. I hope you think this question is worthy of your podcast. I look forward to your guidance. Thank you, karen. All right, so a lot there to unpack, but Karen really appreciate that question and we will dive into some context of how to think about this in just a few moments below. Before we do that, I'm just going to highlight the review of the week. This comes from Gretchen in Ohio. Gretchen from Ohio, who's a five-star reviewer and says so very interesting. I'm about four to seven years out from retirement, I'm recently widowed and I started listening several months back to see if I may be on the right track. This show is so interesting. I started over from the beginning. I have listened to practically every episode. It is clear, easy to follow and really has me become more educated in what to anticipate over the next few years and on into the next few decades. Thank you Well, gretchen from Ohio. Thank you very much for that review. I'm glad it has been so helpful. I think this is episode number 186 today, so that is a lot of podcasts to listen to. I'm glad you've done it. Thank you, gretchen. If you have not left a review and you've enjoyed this podcast, I would really appreciate you taking a couple moments just to leave that five-star review if you've gotten a lot of benefit out of this show. I also encourage you to share this with friends, coworkers, people who are thinking about retirement. I get a lot of good feedback and people saying I wish I found this information sooner, which is so hard to find a good, reliable source of information For. Those of you who have left reviews and have shared this with friends and coworkers and family and neighbors and whoever else you want to share it with, really appreciate you doing so. Let's now get on with the show. Today, karen left the question. She's got a lot going on, she and her husband. They've saved well, they've got money put away, but a lot of that money is in pre-tax retirement accounts. Karen knows that in retirement, when they withdraw that money, that money is going to be taxable, not just when they withdraw it, but at some point they're going to be forced to withdraw it, maybe even amount more than they really need to withdraw to meet their living expense needs. The concern is gosh, what do we do? We're in a relatively high tax bracket today. They're in a 24% tax bracket today, but she's not that convinced that they're going to be in any lower of a tax bracket in retirement. When you add up pensions plus social security, plus required distributions, plus any other incidental income sources, it's really easy to see how they could quickly become in a higher tax bracket later. How do you even go about thinking about this Option number one? My first instinct here is there's so many different variables here. When you're looking at your retirement strategy, nothing exists in a vacuum. It's not like here's a tax part of our plan, here's the income part of our plan, here's the investments part of our plan, here's the risk mitigation part of our plan, here's the security part of our plan. All these things are so interconnected and interrelated so you can't just pull out one part of your plan and say here's what you do here without having a corresponding impact on everything else that's going on. So my first thought, as I hear Karen read this off, is I would work with the financial planner to get a good strategy in place to go over this, because there's far too many details to say. Here's the one singular thing you should be doing, and this is the only thing you need to know. There's a whole bunch of nuance and a whole bunch of context and what if scenarios you want to run. So option one in my opinion, the best option go work with the financial planner to actually get a detailed plan in place to see what to do. Option number two, though, and what we're going to focus on on this podcast, is sometimes the best way to tell it if you should do something is by eliminating all the reasons you shouldn't do it. So do you want to know why you should contribute to Roth 401k now? Well, let's understand the reasons you shouldn't do it, and if you can successfully eliminate all those reasons, well, by process of elimination, that maybe tells me we should do it. So the approach I'm going to take to this question, karen, because it is so nuanced and there is so many, well, it depends on this and this, and that I don't want to take that approach. I want to take an approach of why shouldn't you contribute money to a Roth account instead of a pre-tax account, and if we can successfully eliminate those reasons, then what that tells us is maybe you should be doing that. So I'm going to give you some reasons that you shouldn't contribute to a Roth account, and then we can start working through this together. So before I add on to any more of the confusion about all these double negatives of eliminate the reason not to, let's just start working through. I don't probably make more sense. So why shouldn't you contribute money to Roth accounts or to brokerage accounts? Well, you shouldn't, number one, if you're going to be in a lower tax bracket in the future. So if you're going to be in a lower tax bracket in the future, then what you're better off doing is get the deduction today. Put money into pre-tax 401ks, put money into pre-tax IRAs, put money into pre-tax health savings accounts today. Do the things you can today to lower your tax bill today, because in the future you'll be in a lower tax bracket. Here's the hard part about that is, we don't necessarily know exactly what tax brackets are going to be in the future. Let's go back to Karen's example. Even in Karen's example, she knows what their income sources will be. She knows that her husband will have a pension. She knows approximately what her social security will be. She knows approximately what his social security will be. She knows what they'll need to take out from their investments. So when you look at that, you can get a sense of, okay, what would that put me in in terms of a tax bracket today? But we know that in a couple years, tax brackets are probably going to revert to where they were prior to 2018. So part of this and recognize this, even when you're doing this with a financial planner or CPA or someone giving good tax analysis part of this is still just a guess. Where are tax brackets going to be in three years? Where are they going to be in 10 years? Where are they going to be in 20 years, once your required distributions have actually kicked in? We don't really know. So what you can do is you can make good estimates of what you think they might be. You can make estimates based upon what if things stay as they are and by stay as they are, I mean we know that current tax laws is going to sunset at the end of 2025. So really, the brackets that we have today will go up. So if you're in the 24% bracket today, well, that's going to be the 28% bracket down the road. So, in Karen's situation, if she knew that they were going to have, hypothetically, the exact same taxable income today as they do in the future, well, even though taxable income is the exact same, that would lead me to wanting to do more Roth today, because even the same taxable income is projected to pay higher tax rates in the future because tax brackets are going up. Compare that to if, in the future, karen was going to be in the 12% bracket in today's dollars. Well, the 12% bracket is scheduled to go back to 15%. So even though that's rising, the higher bracket then is still lower than the bracket that Karen and her husband are in today. So, as you're looking at this, it's a projection of. Okay, it's easy enough to know where we are today. We simply have to look at last year's tax return, making the adjustments for this year based on higher or lower income. We can have an estimate of where we're going to finish off the year. The more important thing is where we're going to be in the future, which is a factor of two things. One, how are you going to make up your income? So, between pension, social security, ira, roth, ira, savings, brokerage, what's the tax implications going to be based on where you're pulling income from. So that's one side the taxability of your income sources. Hey everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment tax, legal or other financial advice. It is for informational purposes only. The other side is tax brackets themselves. So there's two variables here and it can be a little bit difficult to estimate it, but try your best to get a sense of where are we today, where are we in the future? And you wouldn't do Roth today if you're expected to be in a higher tax bracket in the future. You would want to do pre-tax today. You want the tax savings where you're in the highest bracket. So that's the first thing to think about. Now that ties into the second thing that you want to think about. The second reason you would not do a Roth contribution today, or you would not prioritize that, at least as compared to a traditional 401k contribution, is if your required distribution isn't projected to be an issue. So what do I mean by that? What does it mean to be an issue? Well, people have this understanding, or this fear that, okay, I turn a certain age anywhere between 72 and 75, and at that point I'm going to be forced to start taking money out of my pre-tax accounts, and they get afraid of that. Now, in some cases that fear is justified, but in others it's not. So, for example, if you're already planning to take, let's say, 40,000 per year out of your IRA and your required distribution is going to, say, start at 25,000 per year, that's not something really to be too concerned about. You're already going to be taking more than your required distribution, so it's not going to push you above and beyond what you were already expecting to take out. If, on the other hand, you were planning on taking 40,000 per year out, but your required distribution is going to start at $100,000 because you have a large IRA balance, that is an issue. That's an extra $60,000 per year above and beyond what you need or what you want to take out, and it's likely going to push you into a higher tax bracket. So one of the things that you like to have a Roth for is one, you're not going to be taxed on that money, but, two, there's no distributions that are required from those accounts. So take a look at your situation and see what might my required distribution be. If we go back to Karen's example, they have a fairly substantial pre-tax account. They have $1.8 million in 401ks. They have $550,000 in traditional IRAs. That's $2.35 million. That could easily be, depending on how much they withdrawal $4 million by the time the required distributions kick in. Now, the first few years of distributions when you're at the age you're going to be required to start taking distributions, use 4% as a rough approximation of how much you're going to be forced to take out. Starts a little lower, but each year it gets a little bit higher. So if Karen and her husband have $4 million in pre-tax accounts, multiply that by 4%. That's around $160,000 that they might be forced to take out. Now there's inflation and all this other stuff that's happened by then. But if I'm Karen, I'm looking at that saying, okay, when I add up pensions plus social security, plus other income sources, plus $160,000, even if I don't need all that $160,000, I'm going to be forced to take it. Is that going to push me into a tax bracket that I don't want to be in? So, going back to part one, am I going to be a higher tax bracket in retirement. Well, it's not just about the tax bracket that you would be in if you had full control over where your income's coming from, but it's about what tax bracket will you be in when you're required to start taking distributions from some of your accounts. If your required distributions are going to be an issue, say all the setting, you're going to be pushed into the 32% bracket or 35% tax bracket because of how much you have to take out of your IRAs. That would lead me to prioritizing Roth contributions today, even in a relatively high tax bracket like the 24% bracket, it's all relative. It's what am I in today? Versus what bracket will I be in when I'm forced to start taking money out of some of these accounts? The third thing that I would look at when it comes to determining should I do Roth contributions or pre-tax contributions is whether or not you do a lot of charitable giving. Now, that may sound completely irrelevant to the decision to do Roth versus traditional, but here's why it matters. There is a great planning tool called Qualified Charitable Distributions. You might see that abbreviated as QCDs. Qcds allow you to gift money right from your IRA as soon as you've attained the age of 70 and a half. The beautiful thing about that is that distribution never counts as income, but it must go directly to the charity that you're gifting money to. So let's say you're gonna gift a large amount of money, you wanna gift $25,000 per year to charity, and you've projected what your required distribution is gonna be, and it's gonna be, let's say, $45,000. You're saying I only really need $20,000 per year to do everything that I wanna do, but I'm gonna be required to take $45,000 per year. Well, here's the beautiful thing about QCDs is you could gift $25,000 per year directly from your IRA to the charity of your choice and that counts against your required minimum distribution. So in this example and yes, I cherry-picked these numbers to make the math work, but if $45,000 is what you're required to take you gift $25,000 directly to the charity. It never touches your bank account, which means it's never actually taxed to you. It just goes right to the charity completely tax-free. $20,000 is the remaining amount that you can take out and that's what you do pay taxes on, but that's the amount you were looking for anyways. So if you do a lot of charitable giving, then the better off you are to put more of that money into traditional accounts today, because you're getting the tax deduction today, that money's gonna grow tax-deferred going forward and then in retirement you're not gonna pull it out and pay taxes. That's just gonna be your giving account Kind of becomes like a little mini donor-advised fund if you use it the right way, where you get the tax deduction for that money going in and then you can just donate directly to the charity in the future via a qualified charitable distribution and not have that count against you from a tax standpoint. So if you do a lot of charitable giving or you plan to do a lot of charitable giving in the future, that would lead me to wanna prioritize pre-tax accounts over Roth accounts, because I can get the deduction for that money and I'm not gonna pay taxes on it when I'm using that money to gift a charity in the future. So that's another thing to think about. The fourth thing that I'd be looking at in terms of reasons to contribute to a Roth or not to contribute to a Roth is life expectancy, and again this may not seem like it has anything to do with your decision to go pre-tax versus Roth, but what Congress has done is they have pushed out over the last few years. It used to be age 70 and a half that you started taking required minimum distributions from your account. But now for people who are born in 1960 or later, that age has been pushed back to 75. So if you're thinking about this and required distributions are your main concern, for whether you go pre-tax or Roth, required distributions are absolutely concerned. They're typically not at the front end of your retirement assuming early or even normal retirement. It's not until 75 that many people will now have to worry about these required distributions. So if you have a long life expectancy, well you might have many years of required distributions. But if your life expectancy isn't super long let's say, for example, we knew for a certain you were only gonna live till age 78, well, that's only four years of required distributions. And again, the earlier years, the less your required distribution as a percentage of the total balance in your pre-tax accounts. In later years, that's when your required distribution becomes a much larger percent of your overall pre-tax accounts. So if you're looking at this and saying I'm gonna live to 100, well, that might be 25 plus years of required distributions. Another good reason to maybe put more money in Roth accounts, where that money is gonna be sheltered from required distributions and taxes in the future. But if you say I don't have such a long life expectancy, I don't really need to worry about required distributions, pushing up the tax bracket that I'm going to be in might be a reason to consider pre-tax accounts instead. One big thing here. It's not already abundantly obvious? All of these reasons enter play into one another. It doesn't matter how long your life expectancy is. If you have very little balance in your pre-tax accounts, required distributions aren't going to be that large. But if you do have a significant balance in IRAs and if you do have a long life expectancy, that's where you're dealing with some of the issues of many years of required distributions pushing you into tax brackets you don't necessarily want to be in. Then the fifth reason. The fifth consideration really doesn't have anything to do with you per se as much as your heirs. This is kind of a follow-up to this point. Number four what if you don't have a long life expectancy? Well then you're not going to be paying taxes on the required distributions that are coming out, at least not for that many years. But the follow-up question is well, who is? If my kids inherit this money? They're then going to be paying the taxes on the pre-tax accounts and they only have 10 years to fully distribute the IRA balances that they might inherit. So the next thing to consider is how do you do tax planning, but also with your heirs in mind. Some people look at this and their kids are the main component of their tax strategy. They're saying look, by the time that my kids might inherit these assets, they're going to be in their peak earning years. If they're already in some of the highest brackets, then the required distributions that they're going to be forced to take from any inherited IRAs are just going to exacerbate the issue. So I want to do good tax planning today to save them from having to pay much in taxes. Well, that's going to be very different than if your kids aren't in a very high tax bracket. In that case there's not as much of a need to prioritize getting money into Roth accounts that they inherit those tax-free, and in that case you could be more okay with more money being in pre-tax accounts. Or maybe you're going to leave money to charity. Well, in that case, charity doesn't pay any taxes on pre-tax accounts. So if you left them a million dollars in an IRA, that would be taxable to an individual if you left it to them, but if you left that to a charity, that full million dollars goes right to the charity. So, looking at legacy, looking at heirs, looking at what you want to leave the money to, that's also a consideration in all of this. So, as we go through this carrying out none of this addresses specifically what you should do in your situation, but what I would try to look at is all of these different points, whether it's what tax bracket are you in today versus where will you be in the future Point number two what impact will required minimum distributions have on your future tax bracket? And take that into account. Number three do you do a lot of charitable giving? If so, then the bigger IRA balances aren't going to hurt you as much as they otherwise would have, because you can mitigate some of those required minimum distributions through qualified charitable distributions. Life expectancy is a consideration here. How long might you be taking funds from your portfolio? Does none of us have any idea how long we'll live, but do we have a general sense of what life expectancy is like in our family? And then, finally, even family considerations of any assets we don't spend. You know, karen, looking at your assets and your IRAs and 401ks and Roth and your pension and social security, there's probably a decent chance you will pass with a decent amount of money, even after a long, healthy retirement that may go to children or heirs. Whatever the case might be in your situation, do you incorporate their potential tax brackets into any aspect of your planning here? So not an actual specific recommendation or even answer, as much as here's the considerations I would make, and if you can look at each of those things, then you can hopefully come up with the right answer for you and your situation. So, karen, I hope that was helpful. I hope for all of you listening, that was helpful. I really appreciate you all taking the time to do so, to tune in here today. If you haven't done so already. Check us out on YouTube, where this episode will live. Every Tuesday, a new podcast is posted there and every single Saturday a video is posted there, all with the goal of helping to get the most out of life with your money by addressing common retirement topics. So check out our YouTube channel. It's under James Kanol. Subscribe to this channel on podcasts ready for retirement If you've not done so already, and with that I will see you all next time. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.

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