Should You Contribute to a Roth IRA or Pre-Tax as a High Earner? (By Tax Bracket!)

Transcript:

On this episode of the Personal Finance Podcast, should you contribute to a Roth IRA or pre-tax as a high earner?

What's up everybody, and welcome to the Personal Finance Podcast. I'm your host Andrew, founder of Master money.co. And today on the Personal Finance podcast, we are gonna talk about should you contribute to a Roth ira. Or pre-tax as a high earner. If you guys have any questions, make sure to hit us up on Instagram, TikTok Twitter at Master Money Co.

And follow us on Spotify, apple Podcast or whatever podcast player you love to listen to this podcast on it. If you want to hop out the show, leave a five star rating and review on Apple Podcasts or Spotify. Now we got this question in on should you contribute to a Roth IRA or pre-tax if you are a high earner.

And as we started to dive into this question, I was going to add it to a money q and a, which is our episode. So we have four or five different questions and we answer those questions, and then I quickly realized how complicated this subject can get. So what I wanna do today, in today's episode is I am going to go through this episode.

I'm gonna give you all the considerations that you should be making based on a number of different factors. A, if you're a high earner, B, Even if you're not a high earner, this episode is packed with value. A ton of different things that you are going to learn, including how some of these accounts can really save you taxes in different ways that we have not talked about yet.

But in addition, you're also gonna learn how taxes actually work within some of these accounts. But I'm going to simplify this. As much as possible. This is a complicated subject that I'm going to try to simplify as much as possible and try to give you all the considerations and so that you can make the best informed decision.

And we're gonna go through this by tax bracket as well. And I'm gonna give you a couple of opinions based on tax bracket on some of the things that you should do. Now, I've read a ton of different books. We've dived into this in a bunch of different ways. Read tons of studies. There are so many differing opinions on this subject on which direction you should take and what truly matters is your personal financial situation.

So before we dive into this, one thing I want to note is if you are really struggling with this, it is worth it to talk to a tax professional or a C P A based on your personal financial situation so that they can look at it and say, Hey, maybe in your situation is going to be better to take this route.

Or maybe in your situation it's better take the other round, but you really have to have a clear understanding cuz this really does matter. It's thousands and thousands and thousands of dollars per year as you are going to see here. And I'll even go through, Hey, how much are you saving or paying in taxes based on which direction you take first.

Now I love taking advantage of both. Accounts no matter what, but sometimes you're trying to figure out, Hey, should I be contributing to a pre-tax 401k, for example, or should I go with the Roth 401k that my employer offers? And if you're battling with some of those situations, then we're gonna dive into how you can actually assess those situations.

So I'm gonna try to make this as simple as possible. We're gonna go through this and try to simplify it for everybody listening. And if you have any questions, make sure you reach out and we will do our best to answer those questions. So, without further ado, let's get into it. Alright, so before we dive in, I need to explain how these accounts work.

So if you know how pre-tax accounts work or if you know how Roth accounts work, then you can skip forward like a minute or two. But I'm gonna do the basics here to make sure that everybody has an understanding. So, Roth accounts, Or accounts that you contribute money in that's already been taxed and typically it's money you've already been taxed based on your paycheck or whatever else you contribute that money, the money grows tax free.

Then when you retire at the age of 59 and a half, you can pull that money out tax free. Now you can see there's a massive benefit here with Roth accounts, and it is that tax-free growth. And we've talked about this a number of times, but if you invest your dollars and say you're maxing out a Roth ira for example, at $6,500 per year, you're gonna have well over a million dollars in that account if you do this over the course of 30 years and invest in something with an eight to 10% rate of return.

And when you do that of that million to 1.1 million, you're gonna have. $800,000 of that is going to be tax-free money, and we run these simulations in Index Fund Pro. We talk about this a little bit also, and you can see that these are going to be ways where you have tax-free money, a big chunk of money that is gonna be completely tax-free.

This is the power of the Roth ira. Now there's also a Roth 401k, which works in the same way, but you can get $22,500 per year. Inside of that Roth 401k, and if you're over the age of 50, you can get up to $30,000 per year at the time recording this. And those have been going up steadily every couple of years.

So make sure you are checking current rates. If you are listening to this episode in the future, then there's pre-tax accounts and pre-tax accounts. There is a bunch of different types depending on where you work. So most people who work at private companies, they'll have what is called a traditional 401k.

But you also have things like your ira. You have 4 0 3 Bs. There's so many different things, SEP ira, solo 401ks. There's so many different options here. So just make sure that you understand that these are pre-tax accounts. 4 57 s are another option. So all of these, this is how they work. The money you contribute is tax deductible, or it's pre-tax, meaning money that you put in there, you're not gonna pay any tax.

It comes directly outta your paycheck in most situations. So 401k is a great example of this. Your money is getting deducted from your paycheck and getting put into this 401k, and that money is not being taxed. Then the money grows. And when the money grows, we're gonna talk about a tax implication on that growth of the money later on in this episode.

But your money's gonna grow. And then when you pull the money out, then you pay taxes when you pull that money out. And we're gonna talk about the tax rates when you pull that money out later in this episode also. So this is something where if you're a high earner, you can reduce. The amount of money that you're paying in taxes by putting money into these accounts, and therefore you can reduce your tax liability for that given year.

And I'm gonna go through and tell you how much money you can reduce based on what tax bracket in your marginal tax bracket as we go through this. So that is how that works for the 401k or the pre-tax accounts, all the different pre-tax accounts that we just mentioned. So you have your Roth where you're gonna be paying the taxes upfront, and if you're a higher earner, there may be a higher tax within and if you're a lower earner.

And so most people will start to argue, well, if you make a lot of money, if you make hundreds of thousands of dollars per year, then maybe you should consider pre-tax. Whereas if you think you're gonna make more money in the future, then you should be maxing out those Roths so that you can pay the taxes now at your current tax rate.

So here's some things to consider. Number one. Is your current and future tax rates like we just talked about? So for a lot of people, this is not a cookie cutter answer, but for a lot of people, if you plan on paying more taxes in the future, then a Roth is a great option for you. Because with a Roth, you are already going to be paying taxes and if you plan on earning more money.

So for me, for example, when I started my career, I was earning $30,000 per year. When I started my career, I definitely planned on earning more money than $30,000 per year. So at that time, a great option for me was to max out my Roth. IRA so that going forward I can make different decisions if I needed to.

Now, I maxed out my Roth IRA no matter what. Even now I do a backdoor Roth IRA every single year. But for a lot of people, you have to consider that current tax rate to see what you think is the best option for you. Number two is income limits. So income limits come into play when you have a Roth ira, but one thing you consider with these income limits is a Roth 401k does not have those income limits.

But secondly, you can always do a backdoor Roth IRA if your income is really high. You cannot contribute to a Roth ira, so you have to do the backdoor version, which is a very simple process and something I do every single year. The third consideration is required minimum distributions. What are RMDs at the time?

Recording this. By the time you turned age 72, you have to do what are called required minimum distributions. This is in pre-tax accounts in the Roth 401k, but all this is is that the government is saying, listen, You gotta start pulling money outta this account. We gave you this tax deduction. You now have to start pulling this money out because you need to start paying taxes on this money.

Specifically with those pre-tax accounts. They want you to pull your money out so that you can start paying taxes. Cuz Uncle Sam always wants his money. So you have to make sure that you factor in required minimum distributions because that can change the amount of money that you're paying in taxes in retirement, especially if you are retired and if you're withdrawing social security at that point in time.

It's also gonna impact the taxes on your social security. So we have a bunch of different factors that we have to consider as we go through this. The fourth consideration when you go through this is your desire for tax diversification, and this is my big argument when it comes to this, is I like to have both of them so that I can have this tax diversification and have both options available to me.

I think maxing out both of them is an absolute amazing thing that you can do, but making sure you have that tax diversification is really important. Number five is your employer match. You should always get that employer match no matter what. If your employer only offers a match with your 401k, then open up that 401k, get that employer match, and then move through the steps with the.

Stairway to Wealth. If you haven't heard of the Stairway to Wealth, it is our step-by-step guide on what to do with your money. That's why it's called the Stairway to Wealth, because you take each step one at a time and it's gonna give you the order of operations for your investing. It's always linked up, down in the show notes.

If you ever wanna check that out, then you wanna make sure that it also is going with your financial goals. In plans. So maybe for example, your financial goal in the long run is to retire early. Well, having both of these available to you is gonna give you that flexibility because you're gonna need to do either a Roth conversion ladder with this money, or even having a tax or brokerage account open to give you some more flexibility is gonna be a big factor for you.

If you haven't heard our episode or we talked to Katie Gaddy from Money with Katie recently, That episode goes through how to actually optimize some of your accounts, and I want you to kind of look into that to make sure you have that available to you and then in the future, legislation risk is also another factor are taxes is going to increase over time, most likely, but this is not just the sole reason why you should contribute to a Roth, even though taxes may increase over time.

You also have to consider a number of different factors so that someone who just says, because taxes are gonna increase over time is the only reason why you should contribute to a Roth. That's just a cookie cutter approach. It's not correct. You need to kind of think through all of your options as you go through this.

So those are just some of the considerations that I want you to think through. And now let's dive into some considerations by tax bracket. So we can kind of think through, Hey, how would I think about this if I was in. Most people's situation. In addition, you can do this and pair this up with your accountant, and you're gonna have a Bulletproof Financial plan.

So making sure you go through some of these considerations is gonna be very, very important. So let's dive into that next. Now, I cannot stress this enough that it is really important to talk to your cpa a or tax strategist about this stuff, but pair this up. Here's my considerations as I go through these types of things.

So the first one is the Roth, and if you're gonna consider the Roth. If you expect to be in a higher tax bracket in the future, or you expect taxes to be higher in the future, then generally a Roth is a great option for folks who are in that camp, because what's gonna happen with a Roth is you're going to pay taxes upfront and you're gonna just get it outta the way.

So if you make less than six figures, for example, Roth is an amazing example of a way for you to kind of defer those taxes, and it may be a better choice, but it is very situation dependent. So you pay those taxes now at the lower rate, and then you can withdraw your funds completely tax free when you're in that higher tax bracket.

Now, with pre-tax, if you think you're gonna be in a lower tax bracket when you retire, then you are in right now. Then it may be a better option for you to look at pre-tax first. Now, there is a smaller number of. People who will fall into this camp than there would be in the Roth camp because most people make less than some of the marginal tax rates that we're gonna talk about here.

Especially some of those really, really high ones. The majority of the population falls into some of those middle class tax rates, so I want to make sure that we. Have that upfront. But if you're an optimizer, you're a really, really high earner, then maybe looking at that pre-tax will be something that you should consider because you get the tax break now and then you pay taxes later when you think that your tax rate is going to be higher.

Now, in most situations, if you talk to your C P A or tax strategist, they're gonna want you to take that tax deduction right now, a, because it makes them look better, cuz they're reducing your taxable rate by thousands of dollars every single year, especially if you're maxing out those accounts. But B, it's also typically a good.

Move for most people, depending on their situation, there's pros and cons to each. But with the Roth, some of the pros to the Roth, and I want you to consider this, is that tax-free growth and withdrawal. There's no required minimum distributions inside of a Roth ira, and you have ability to withdraw contributions before retirement and penalty.

The cons are, the contributions are not tax deductible now, and there's income limits for eligibility. So you gotta do a backdoor Roth if you make too much money. Now for the pre-tax, the pros are that they are tax deductible contributions. You have tax deferred growth and there's no income limits for eligibility.

But the cons are they are taxable upon withdrawal. You have those required minimum distributions, meaning the government wants you to pull that money out and start getting taxed on that money after the age of 72. So those are some of the cons when it comes to this. Now I'm gonna give you a couple of quick examples as we go through this.

And if you're watching on YouTube, we will put this graph on the screen so that you can see this if you're considering Roth or traditional. So if you're looking at this, you could see someone, maybe a young person in a low tax bracket who is likely gonna be in a higher tax bracket later, and their income is $50,000 per year.

So if your income is $50,000 per year, you are in the 12% tax bracket. If you are single, the next higher tax bracket. Is at 22%. So you would likely benefit from being in a Roth ira. Now the second example would be someone who has already had a large traditional retirement account balances and wants to minimize required minimum distributions in retirement.

So this person is gonna make somewhere around $160,000 per year in this example. And if they're married, then they are in the 22% tax bracket. And this could be someone who maybe is approaching retirement and they have 3.2 million available to them, and if they took an R M D of around $181,000 at age 83 plus social security is more than the spending they need, and they could bump their household into the 24% tax bracket, then maybe the Roth is a good consideration here.

Now let's look into another scenario. Maybe there's someone who's making $135,000 per year and they are a big time saver. Who can afford to contribute the IRS maximum either way. And so if you make $135,000 per year, you're gonna be in the 24% single tax bracket. And so this may be a scenario for someone if they have an uncertain outlook for the future tax rate, then they can comfortably save $22,500 and put this into a 401k, and then their after tax savings are effectively $5,400 higher per year.

With Roth contributions. So you gotta think through some of these as you go through some of these scenarios. So if you're watching on YouTube, I encourage you to look at some of these other scenarios that we've provided here. I don't wanna go through all these on the podcast because these are number heavy and I wanna make sure that people can kind of follow along.

But as you go look through some of these, they may be something of interest to you as well. Now, The next thing we're gonna look at is how much would you actually pay in taxes by tax bracket? And this is one where we will also put on the screen on YouTube, but for 401k contributions of $22,500, which is the max, if you're under the age of 50 this year, at the time recording this, it may go up in the future.

And if you're listening to this in the future, make sure you go check out what the current ones are. But if you're in the 12% tax bracket and these are the marginal tax rates, and you put money in a pre-tax account and you max that out, Then in the pre-tax account, you would save $2,700 in taxed now, and then you're taxed upon withdrawal.

But if you put it in a Roth account, you would pay $2,700 tax now, but no tax at withdrawal. Now, not a lot of people in that 12% tax bracket are maxing out their accounts based on their income, but that's something that you should consider. Then if you're in the 22% tax bracket, your tax savings go up if you put it into the 401k instead of a Roth 401k where your tax savings are gonna be 4,900.

$50 in a 401k, or you could pay that money now and no tax upon withdrawal if you put it into the Roth 401k, and then the numbers keep going up. If you're in the 24% tax bracket, you could save $5,400 in taxes, 32% tax bracket. You could save $7,200 in taxes. 35% tax bracket, 7,875, and if you are lucky enough and privileged enough to be in the 37% tax bracket, $8,325 in tax savings now and then you're taxed upon withdrawal in the future.

Now for IRA contributions, the savings are going to be less because the limits that you can contribute to them. Are gonna be less. So say for example, 12% tax bracket, you'll save $780, 22% tax bracket, $1,430, 24% tax bracket, $1,560, and so on and so forth. If you're privileged to be in the 37% tax bracket, $2,405.

And we will post these on the YouTube channel, so you can check it out. The Androgen Cola YouTube channel is where you can watch the podcast if you want to. Uh, we will have these charts on the screen on the podcast if you wanna check that out as we go through this. Now, one thing I wanna consider here is, does contributing to a 401k reduce your taxable income?

How does it actually do that? Cause we've only dived deep on the front end how it saves you money. But there's actually three ways that this can actually save you money. And so I wanna talk about those three ways here next. Now this is a tax heavy and number heavy show, so I just wanna make sure that you are following along with me.

This is one we're gonna talk about the three different ways that you can actually reduce your taxes when it comes to the 401k. I could do an entire episode on this, so I'm gonna try to condense this down so it's an easily digestible way where you can kind of think through this. So number one is the upfront tax deduction.

So this is the most significant way, which is why it is the way that we talk about it the most is because of that upfront tax deduction, which we just went through. So for example, If your marginal tax rate was at 32% and you contribute $10,000 to your pre-tax account, then you would save $3,200 on your taxes that year.

Now we use those numbers cuz it's very easy math for me to do in my head. Now there's critics to the 401k. He will say, you're just delaying the taxes there. But even if that were true, delaying the taxes is still incredibly valuable. In fact, in the past we've run simulations on just how much you would save delaying those taxes and you would.

Still come out ahead just by delaying those taxes instead of actually contributing to a taxable brokerage account. There's other reasons to contribute to a taxable brokerage account. We have entire episode talking about why those reasons are available, including flexibility is the main one, but making sure that you understand the difference is the big thing here.

So, The concept here is the time value of money, which basically says money is worth more now than it is later. So you have to think through what your time value of money is and kind of consider that as you go through this. Now number two is tax protected growth inside of a 401k. So in a taxable account, the dividends and capital gains distributions that your investments kick off each year are actually taxed.

So when you sell an investment with gains, You also have to pay taxes on those gains. So dividends and capital gains are generally taxed at a rate lower than your marginal tax rate, but the drag on your returns can still be significant. So for example, if you have an investment with gains of an 8% rate of return and you haven't yield of 2% and you're taxed at 15%, then it actually only grows at 7.7%.

So on a hundred thousand dollars investment, that drag totals to $26,000 after 20 years. This is a major factor here, but in a 401k, that tax drag is actually eliminated, allowing faster accumulation of your nest egg. So this is very important to understand. It's not as impactful as number one, but number two is still impactful because you are protecting the growth of your 401k over time.

And then number three is you actually have tax rate arbitrage when you're contributing to a 401k. So you save taxes on the marginal rate. So say for example, your marginal tax rate is at 32%, which is a very high marginal tax rate, if you're in the 32% tax bracket, you are likely either. Killing it at your job.

You're a doctor, you're a lawyer, something along those lines. Now, this is the rate that your last dollar you make is taxed. However, when you withdraw money from your 401k, especially if you do not have a pension or taxable income and you haven't started taking Social Security, the money will be taxed at a far lower rate.

It is actually taxed at your effective tax rate. So this is another way to have this tax rate arbitrage. So there's three pillars of how you can save taxes. Number one is the most important. Number two is still very important. Make sure you reduce that tax drag. And then number three is having this tax rate arbitrage so that you can be taxed at your effective tax rate instead of your marginal.

Tax rate. Now, what about required minimum distributions? This is one thing you want to consider as you go through this process. I want you to think through your required minimum distributions, cuz this is something on the back end that a lot of people forget to consider when they go through this. Should they be contributing to their Roth or their 401k?

And like I said, really I think you should be doing both. But if you can't do both, I want you to kind of think through all of these considerations we talked about in addition to required minimum distributions. Now, here's how RMDs actually impact your tax situation. Number one is they increase your taxable income.

Meaning because you have to take these required minimum distributions, they do increase that taxable income. So you gotta make sure that you understand what is the optimal rate that you should be taking them out. Number two is they have an impact on your social security taxes. So if you're collecting social security, adding more taxable income through your RMDs could make a greater portion of your Social Security benefits.

Taxable. This is a big one that a lot of people just do not consider. Your RMDs could make your social security that much more taxable at that point in time. So making sure that you optimize all of these is gonna be very important, which is why it is so important to have a tax strategist, especially in retirement, someone at least putting a plan together for you to reduce those taxes.

Number three is Medicare premium. So a higher taxable income could also lead to higher. Medicare Premiums four part B and part D, which are all based on income. So your Medicare premiums, the amount of money that you have to pay when it comes to your healthcare, which is gonna go way, way up in retirement age, especially when we hit these RMD ages, is going to be higher if you have to pull these RMDs out.

So you gotta make sure that you consider that and hopefully at some point in time we have reduced RMDs or RMDs may effectively go away. But I doubt it because Uncle Sam always wants their money. And then the last one I want you to consider is tax on investment growth. So when it comes to your traditional 401K or your ira, the investment growth will be taxed when distributed as are MDs.

So the contrast is in Roths that growth is not taxed. You just gotta make sure that you understand that that investment growth is going to be taxed as well. So there is a lot of tax implications to consider here. But there are no RMDs for Roth IRAs. Now, right now, Roth 401ks still do have RMDs. There are a couple of things in the works to change that, and when they do change, we will let you know.

But right now the way to get around this is if you have a Roth 401k. The cool thing about this is you can get around this RMD by rolling it. Into that Roth ira, and then you just have to wait that five years before you can take that money out. But then you have those contributions there are available to you where you can start rolling them in, and then you don't have those RMDs.

So that is one cool thing about having the Roth 401k is you can avoid those RMDs by rolling it into the Roth ira. You're not having to pay taxes on that money because it's Roth to Roth. Then you don't have to worry about those RMDs and. Dead. You just have that money there, but you have to worry about that five year rule if you need the money right away.

So this is why it's important to have this flexibility available to you, why you should have an HSA, maybe, or even a taxable brokerage account to get you through those first five years. So then after that, you get to the point in time where you can obviously optimize your tax situation. You don't have RMDs.

You can continue to let that money grow, which is really, really powerful, especially if you've been maxing outta Roth 401K for a long time. So, I love the Roth 401k. There's so much flexibility built into it and that fact that you can roll it into a Roth IRA and not have those RMDs is just another major benefit to the Roth 401k.

Listen, I hope you guys learned a ton in this episode. I know this is a heavy episode, but I hope you learned a ton about some of the considerations that you should be making, especially if you're a high earner when it comes to some of these accounts. If you guys have any questions though, make sure to reach out.

I'm sure a lot of you will have questions on this one, so make sure you reach out and if we left anything out, let me know if you think there's some other things that should be cons. Considered when you go through this and we will continue to add to this episode and increase the value to our listeners.

So if we left something out, please let me know and we'd be happy to add it into this episode. Listen, thank you guys so much for listening to this episode. I truly appreciate each and every single one of you. Our goal is to bring you as much value as we possibly can and we will continue to do that. We can and week out.

Thank you again for listening. We will see ya on the next episode.