Today’s post contains an unconventional, if not controversial approach. Prior to implementing any financial planning solution, consult with your CFP® as this approach may not be appropriate for your personal situation.
For decades we’ve been told to first max out our 401(k) or other qualified workplace plan, then save more in an IRA and a taxable brokerage account. But, is this really the best approach? Having long since crossed the infamous age 50 milestone, I am rethinking how I would have liked to have saved. I generally relied on the approach of 401(k) first, any additional savings into an IRA, and then a brokerage account. Mostly because when I started working and saving, we didn’t have a Roth account option. Now, I am starting to think we’ve relied too heavily on the workplace plan and that we should maybe give more thought to our saving and investing approach. Especially for those under age 50, and especially until the end of 2025.
The 401(k) plan, or qualified workplace plan, has become the default savings vehicle for most American workers. While it does have some great perks (like employer matching if offered, automatic payroll deduction, and current tax break), we may have relied too heavily on this vehicle at the expense of a more well-rounded, long-term savings and investment approach. The elephant in the room with a traditional 401(k) is the instant gratification of current reduced taxable income. And that may be the trap! For an easy example, let’s say you earn $100,000 per year. Let’s further assume you contribute $20,000 to your traditional, pre-tax 401(k) through payroll contributions. This means, your taxable income is reduced to $80,000 for the year. You have deferred paying tax on the $20,000 until after age 59 ½ and you have deferred paying tax on any growth on that $20,000 until you begin distributions after age 59 ½. Therein lies the rub. That future distribution (both contribution and gain) is taxed as ordinary income. To make the current tax deduction valuable, the deduction amount would need to be invested. Hold that thought.
Now, let’s look at Roth accounts. Remember the beauty of Roth accounts? No tax on the growth provided you play by the rules and your distribution is qualified. Generally speaking, this means the account is at least 5 years old, and you are at least 59 ½. And remember, with Roth accounts, you can access your contributions at any time without owing tax! You can have a Roth IRA, or potentially a Roth 401(k) if your employer offers one. If it’s a Roth IRA, the most you can contribute for the year is $6,500, with a $1,000 catchup for those over age 50, in 2023. With a Roth 401(k), your maximum employee contribution is $22,500 ($30,000 age 50) for 2023. Keep this in mind.
Last in our lineup, the taxable brokerage account. I like to call these accounts the happy-medium account even though they are way more practical than people give them credit. With a brokerage account, you have access to various investments, you can tap the account when needed without running afoul of qualified retirement plan rules and penalty taxes, and there is no limit to how much you can invest! So, if you are highly paid and can save and invest more, you are not bound by the limits on qualified plans and IRA accounts. Another great benefit is that if your investments are over 12 months old, and you take a distribution, the tax is either 0%, 15%, or 20% based on your income bracket. Brilliant!
With that summation of investment vehicles in mind, you may be asking what’s the point? For some Boomers, they’ve had a really good run. They maxed out their 401(k) plans and are now having to take distributions in retirement. For many, when coupled with their Social Security, any other pensions, earned income, or other sources of income, they are discovering that their effective tax rate in retirement is sometimes higher than their working years! This is mostly due to tapping those qualified accounts that are taxed at ordinary income rates. This is kind of cruel given that many Boomers did what was advised and didn’t really have access to Roth accounts as a planning tool. Roth accounts got approved by Congress in 1997 and rollout was in 1998. Of course, it took much longer to become commonplace.
Remember I mentioned 2025? Our current lower tax bracket rates are set to expire December 31, 2025. Let me give you an example. If in 2017 you earned $150,000 and filed single, you were in the 28% tax bracket vs 22% in 2023. This means that when we awaken on New Year’s Day 2026, we face one of three likely scenarios: the rates remain and continue as is, or the rates revert back to the higher rate, or the rates are changed. Who knows what Congress will be thinking at that point.
It's true that many online calculators show contributing equal amounts to either a Roth 401(k) or Roth IRA will end with roughly the same account value as their traditional pre-tax counterparts. But for the traditional pre-tax accounts to really be advantageous, you need an absolute guarantee that your tax rate in retirement taking all income streams into consideration will absolutely be lower than your current tax rate (often by at least 2% in many calculators). You also need to be investing the current tax savings from the pre-tax accounts (which many folks forget or simply don’t do). That’s a lot to hope for when we know that qualified distributions from Roth accounts are tax-free.
If I were in my twenties, thirties, or even my forties, I would max out every Roth account I could at the moment. In a Roth 401(k) you can stash up to $22,500 for 2023. Add a Roth IRA for another $6,500. High earners, there’s always the backdoor Roth IRA approach but do keep in mind the pro-rata rules if you have a traditional IRA. If you are over age 50 and have no Roth money set aside, consider adding Roth accounts to your portfolio. If you have no Roth 401(k) access, contribute at least to the match level in your 401(k) to get the free money, then max out a Roth IRA, then build a taxable brokerage account with as much as you can contribute.
It seems to be a no brainer to me. If you are under age 50, I would build as much tax-free future income as possible; followed by investments taxed at the lower long-term capital gain rates, and finally, those taxed at ordinary rates. Even for those over age 50, if you plan to work into your mid-60s, consider adding as much in Roth investments as you can. It may not have the same impact, but it will give you some planning opportunities.
This is not to be considered lightly. Seek out guidance and discuss your goals, timeline, and current ability to save and invest with your financial planner. As an independent Certified Financial Planner™, I can help you establish and maintain better financial habits and plan for the next stage of life. Contact me and let’s get started! #talktometuesday #education #Hireaplanner #financialsavvy #stressfree #savings #moneyeducation #Roth #retirement #401k #LTCG #IRA #financialeducation #CFPPro