Roth accounts include the Roth IRA and any Roth employer-sponsored accounts, such as a Roth 401(k). While HSAs aren’t technically Roth accounts, they can still be used as tax-free apex predators, like Roth accounts, when used for qualified medical expenses, so they fall into the same bucket. Following the Financial Order of Operations, you will maximize your Roth IRA and HSA, if you have the ability to do so, at Step 5. No matter your income or tax bracket, we believe it makes sense to maximize these tax-free accounts at Step 5. 

Step 6 is where it gets tricky. This is where you maximize your employer-sponsored retirement account, like a 401(k), 403(b), TSP, or other plan. About 93% of 401(k) plans offer a Roth option, in addition to the traditional pre-tax contribution option, so the majority of those with an employer-sponsored plan have a decision to make. Do you contribute to Roth or pre-tax?

If it makes sense for most to contribute to a Roth IRA over a pre-tax IRA, shouldn’t it also make sense to contribute to a Roth 401(k) over a pre-tax 401(k)? Not necessarily. Pre-tax IRAs have lower income phaseouts than Roth IRAs, which means if your income is high enough that contributing to a pre-tax IRA would make sense, you don’t have the ability to do so. However, high-income individuals can contribute to a Roth IRA through what is commonly referred to as the backdoor Roth strategy. It’s not necessarily always better for everyone to contribute to a Roth IRA over a pre-tax IRA, but those that would be better off contributing to a pre-tax IRA likely don’t have the ability because their income is too high. Plus, we believe in tax diversification of your assets, and even if you could construct a portfolio solely consisting of pre-tax accounts, it may not be wise.

The decision to contribute to a Roth 401(k) or a pre-tax 401(k) is a bit different. Both have no income phaseouts, so those with higher incomes have a choice. Choosing which account is more beneficial for you is actually quite simple: is your tax rate lower now than it will be in retirement? If so, contribute to Roth. Is your tax rate higher now than it will be in retirement? If so, contribute to pre-tax. It is impossible to know with certainty what your tax rate in retirement will be, which creates an advantage for Roth accounts: they create tax certainty.

Roth creates tax certainty

If you contribute to Roth retirement accounts, it doesn’t matter what your tax rate will be in retirement. It could be 10%, 50%, or 98%; no matter what, qualified Roth distributions will not be taxed at all (barring any unprecedented changes to Roth accounts by the government). This is a big advantage, even for those that could be looking at lower tax rates in retirement.

We are currently experiencing a period of historically low taxes on high-income individuals. The only extended period of time with lower rates on the highest income Americans was right before the Great Depression. We don’t like to speculate about future tax rates, but it is easy to look at a chart like this and see that tax rates could be higher in the future, even if your income stays the same. Roth accounts are a way to essentially pre-pay your taxes and lock-in whatever tax rate you are at now. That could be a great thing if you are uncertain whether your tax rate will remain the same in retirement.

Pre-tax could lower your tax burden

The obvious benefit of contributing to pre-tax retirement accounts is they lower your tax burden in the present, which could be more beneficial than delaying that tax benefit until retirement. It is very difficult to know with certainty if your tax rate will be higher or lower than it is now in retirement, so we created a rule of thumb to help you decide if contributing to pre-tax accounts is worth considering. We believe if your combined marginal income tax rate, including any local income tax rate, state income tax rate, and federal income tax rate, is above 30%, you should consider contributing to pre-tax employer retirement accounts instead of Roth. That’s a little confusing, so here’s an example:

Mary is single and makes $150,000 per year. Her highest federal income tax rate is 24%, and she lives in California where her highest state income tax rate is 9.3%. She does not pay any local income tax. Her combined marginal income tax rate is 33.3%, so it may make sense to consider contributing to pre-tax over Roth.

If your combined marginal income tax rate is under 25%, it may be worth considering contributing to Roth accounts over pre-tax accounts. If you are in-between 25% and 30%, take a closer look at your personal tax and retirement account situation. How much do you currently have in Roth accounts vs. pre-tax accounts? Will your taxable income be significantly higher or lower in retirement than it is now? How much are you concerned about the risk of tax rates rising in retirement?

Roth accounts are an incredible tax and retirement-planning tool that we believe everyone should take advantage of. However, high-income Americans especially should consider the advantages of contributing to pre-tax retirement accounts. It is very possible that the present tax benefit of contributing to pre-tax accounts outweighs the benefit of tax-free growth and tax-free distributions in retirement.

When deciding between contributing to a traditional or Roth 401(k) based on your current tax situation, and for the Mega backdoor Roth conversion, you need to check if your employer’s plan allows it and consider other options if you are in a high tax bracket.

Want to know what to do with your next dollar? You need this free download: the Financial Order of Operations. It’s our nine tried-and-true steps that will help you secure your financial future.

The question is whether to prioritize maxing out the company 401K (pre-tax and Roth) to hit 25 percent or to contribute to a personal Roth IRA instead; the answer lies in considering investment choices, control, and flexibility for emergencies to make the best decision for your financial goals.

Want to know what to do with your next dollar? You need this free download: the Financial Order of Operations. It’s our nine tried-and-true steps that will help you secure your financial future.

When to contribute to a Roth IRA

Almost everyone that has the ability to contribute to a Roth IRA should do so. Choosing the tax deduction of a traditional IRA over contributing to a Roth IRA rarely makes sense (or is not even possible in many cases). The full deduction for pre-tax IRA contributions is only available to those without a retirement plan at work or those with income below a certain level, who may benefit more from contributing to a Roth IRA. Those with higher incomes (currently over $76,000 for single individuals and $125,000 for married couples) covered by qualified retirement plans at work are not eligible to make pre-tax IRA contributions.

Eligibility for Roth IRA contributions is determined solely by income, and it does not matter if you are covered by a retirement plan at work. Even if your income exceeds the threshold to make direct contributions, you may still be able to build Roth assets. There are no income limits for making non-deductible IRA contributions, and there are currently no income limits for converting eligible assets to Roth (although if you have pre-tax IRA assets, the IRA aggregation rule may make this strategy unfeasible or more complicated; this is something you want to get right on the front-end since there can be unexpected tax consequences, and reaching out to a tax professional or financial advisor may make sense). The window for conversion opportunities may be closing soon for those with higher incomes. If you are currently able to use this strategy you should give it a good look, as it may not be there in the future.

Roth IRAs have a few other advantages over pre-tax IRAs besides just tax-free qualified distributions. Roth IRAs also have no required minimum distributions (RMDs), which can make them an ideal vehicle for transferring wealth to heirs, and you are allowed to withdraw contributions at any time with no penalty (although you would never want to).

Should I make pre-tax or Roth contributions to my 401(k)?

Unlike pre-tax and Roth IRA contributions, pre-tax and Roth 401(k) contributions are not restricted based on income. Higher income individuals with a qualified retirement plan are excluded from making pre-tax IRA contributions, but may want to consider making pre-tax 401(k) contributions. Tax rates are the biggest factor to consider when deciding between pre-tax and Roth 401(k) contributions; if your combined marginal tax rate (state + federal + local) is under 25%, consider Roth, and if above 30%, it may make sense to consider traditional. The decision is often more nuanced, though, and there are other factors you should consider as well.

1. How does your current marginal tax rate compare to your future rate?

If you are in a higher tax bracket now, it may still make sense to make Roth 401(k) contributions if you expect to be in an even higher tax bracket in retirement. No matter your age or current tax rate, if your tax rate will be higher in retirement, it makes mathematical sense to get dollars in Roth while you’re taxed at a lower rate. There’s a case to be made that tax rates will be higher in general in the future; the chart below shows both the highest and lowest federal income tax rates throughout U.S. history, and as you can see we are currently enjoying historically low tax rates. Building tax-free Roth assets now is a hedge against tax rates going up in the future. It’s worth keeping in mind that even if you choose to make Roth 401(k) contributions, employer contributions (match or profit sharing) always go in pre-tax, so your pre-tax bucket is building either way.

On the other hand, if your combined marginal tax rate is below 30% right now but you expect it to be even lower in retirement, pre-tax 401(k) contributions may be more beneficial.

2. Do you plan to max out your 401(k)?

Roth dollars are worth more than pre-tax dollars; $100,000 in a Roth account is equivalent to $100,000 after taxes if taken as a qualified distribution, but $100,000 in a pre-tax account could be worth significantly less after taxes. If you plan on maxing out your 401(k), making Roth contributions is worth considering since you can essentially get more money in. Even if you invest the tax savings from making pre-tax 401(k) contributions in a taxable brokerage account, the tax drag on the account means it won’t grow at the same rate a Roth account would. If you are maxing out your 401(k) and expect your tax rates to be nearly identical now or in the future, or if you don’t have the discipline to invest the tax savings from making pre-tax 401(k) contributions, maxing out your Roth 401(k) may be more beneficial.

3. How are your accounts structured?

If you already have a large amount of pre-tax retirement assets, such as a pension or other employer-sponsored plans, it may be wise to consider making Roth 401(k) contributions and building your tax-free assets. The amount of pre-tax assets you have will affect not only your income tax rate in retirement, but also the taxability of Social Security benefits and the amount you pay in Medicare premiums. Your account structure is very important to having a tax-efficient retirement, and all three buckets, tax-deferred, taxable, and tax-free, have a place in your retirement plan. If you are interested in learning more about the three tax buckets, check out this clip from the show: “How to Have a Tax-Efficient Investment Strategy.”

Nobody can predict the future, and it can be difficult to know whether your tax rate will be higher or lower in retirement. Good financial planning isn’t about knowing all of the answers, but about making informed and educated decisions while taking into account all information available to you. There are going to be some curveballs along the way; taxes might go up by more than you expect, or your taxable income in retirement may be much higher than you were expecting.

There are quite a few factors that go into this nuanced decision, and bringing a financial co-pilot on the journey with you is worth considering if you feel like you don’t have enough hours in the day, can’t keep up with the rapidly changing financial landscape, and worry about what happens to your loved ones when you are no longer around to steer the financial ship. If you are wondering if the time is right to reach out to a financial advisor, check out this episode of the show: “How and When to Hire a Financial Advisor!” We offer free education through The Money Guy Show and FYI by FTE, and fee-only financial advisory services for those who are ready to take the relationship to the next level. You can visit our “Work With Us” page to learn more and submit a form.

Tax evasion is illegal, however, tax avoidance is highly encouraged. Roth accounts provide an outstanding opportunity for tax advantaged retirement savings and wealth building. This powerful investment vehicle was created to encourage everyone to save for retirement and see the beauty of investing in their financial future.

This episode will teach you exactly how to take advantage of this opportunity in your own financial life.

In this episode, you’ll learn:

• Where did Roth come from?
• Why is Roth so powerful?
• What kind of Roth account is right for you?
• How to tell whether or not you qualify for a Roth account
• Secret Roth strategies of the rich!

Research and resources from this episode:

• 6 Surprising Facts About Retirement (Investopedia)
• Don’t miss this valuable opportunity in your 401(k) (CNBC)

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After watching Discovery Channel’s Shark Week, we realized the financial world has its own ferocious apex predator. Roth assets sit on the top of the food chain! They get tax-free growth, provide emergency access to your funds, and there are no required minimum distributions for these kinds of assets. 

In this show, we break down how Roth assets can help you grow your wealth exponentially!

In this episode, you’ll learn:

• The powerful growth that happens to $1 when invested at 20, 30, and 40-years-old
• How to reframe your excuses when it comes to saving and investing
• How Mitt Romney’s investment disclosures inspired Brian’s nerdiest financial daydream
• Why Roth and Traditional 401(K) can have different results (as illustrated in the story of Roth Ralph and Pre-Tax Patty)
• Practical steps for setting up your first Roth IRA
• How pre-tax dollars are going to make all the difference on your path to financial independence
• Resources for making the most of Roth assets no matter your income level

Resources related to this show:

• How Did Romney’s IRA Grow So Big? (Reuters)
• Historical Average Federal Tax Rates for All Households (Tax Policy Center)
• Top Secret Wealth-Building Strategies of the Rich (Roth Conversion and Mega Roths)

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If you have any questions (or just want to say hi!), feel free to reach out to us: brian@moneyguy.com and bo@moneyguy.com. You can also join the conversation on The Money Guy Show Facebook page or connect on Twitter @MoneyGuyPodcast.

Stick with us as we navigate the various types of retirement investment vehicles there are and what you should know about each one of them. We’ll tell you how to leverage these tools to build your wealth and take advantage of tax-saving benefits along the way. Here’s what we’ll be covering as we journey down the road to retirement:

This is an episode we explore:

• What to do with your money so you minimize the amount you pay in fees and taxes
• Retirement tools everyone can use
• Retirement tools for employees
• Retirement tools for the self-employed, employers, and side hustlers
• The difference between retirement savings vehicles: 401(k), 403(b), Traditional IRA, Roth IRA, Simple IRA, SEP IRA, and Solo 401(k)
• Which retirement accounts offer the best tax-saving investments
• Why you need to prioritize how you save money now
• The super awesome benefit of 457(b) plans

Tune In and Go Beyond Common Sense with the Money Guys

This show would not be what it is today without the support of our wonderful listeners. We strive to continue making the show better and your feedback is an important part of that process.

If you have any questions/suggestions/comments/concerns (or just want to say hi!), feel free to reach out to us: brian@moneyguy.com and bo@moneyguy.com. You can also join the conversation on Facebook or connect on Twitter @MoneyGuyPodcast.

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Brian and Bo cover different strategies and steps to take when preparing for retirement and review features that are available in your 401k. The motivation for this show is two articles that finance blogger Dana Anspach recently released about 401k’s and other retirement accounts, 7 Things I Wish People Knew About 401k Plans, and 7 to-do’s before you turn 59.

First, the guys give you their view on Dana’s 7 Things I Wish People Knew About 401k Plans article:

1. Rollovers are accepted – If you leave you can roll your retirement assets out of your 401k. This is especially important when your 401k investment lineup is limited.
2. Automated portfolios work – Target date funds are great choices and capture a ton a diversification with professional investment management all wrapped into one holding.
3. Stable value funds can be a great choice – If you are nearing retirement you need to start moving some of your holdings into more liquid and secure investments. These stable value options often pay solid interest rates which are typically much higher than what the bank will offer you on your savings account. Dana recommends having your first two to three years of retirement expenses in these holdings (and we completely agree).
4. Age 55 is special! 401k’s allow distributions when you leave your employer after you reach age 55 without being subject to the 10% early withdrawal penalty. However, you will still owe ordinary income taxes on the distributions. Also, if you took the advice in the 1^st step and rolled your 401k into an IRA, we suggest you have a plan for the age 55-59½ “donut hole.”
5. Credit Protection – That’s right, if your get sued your Qualified Plan assets are protected, even from bankruptcies! OJ Simpson is always a major example when he was sued but was able to save some of his wealth due to the ERISA protection regulations.
6. Roth options inside your 401k are great – There are pros and cons to this option. You forgo the tax deduction that you would have received for normal pre-tax contributions, but you do get the advantage of tax free growth if executed correctly. Remember, it is good to have tax diversification also. No one knows what future tax laws may hold. Therefore, it makes sense to have different “pots” of money (see our last podcast) set aside for the future.
7. NUA treatment is nice, if it makes sense – If your employer offers company stock, you can get special tax treatment on distributions at retirement, called Net Unrealized Appreciation. When you take a lump sum of the company stock, the contributions you received (basis) are taxed as ordinary income and any growth in that company stock receives capital gains treatment, if certain holding requirements are met. You can also roll the other non-company stock portion of your 401k into a Rollover IRA.

The second article that Brian and Bo cover from Dana is, 7 to-dos between 55 and 65 for a better retirement:

1. Prioritize values – Would you prefer to retire early and have less or work longer and have more?
2. Know your net worth – We push for everyone to complete a Net Worth statement at year end. It is a great feeling when you put everything together and are able to high five over the leaps and strides you have accomplished over the past year, two or ten, and longer.
3. Estimate your benefits – Review any pensions that are you expecting and try your best to estimate your Social Security payments. These factors are huge when trying to calculate your current savings goal for your future use.
4. Get a handle on healthcare – We see this far too often when people tell us they would like to retire early, but do not have a plan for healthcare. Medicare coverage does not start until 65 and most of the time you will need additional coverage’s like: Medicare part B, C, D, Medigap, Long-Term Care, etc… Make sure you have options lined up before your decide to retire early.
5. Make an income timeline – Run your personal finances the same way that you would operate a business. In actuality, you are a business and your success depends on your planning. Set income and savings goals and make sure that you are doing everything possible to insure your future success.
6. Outline options – Explore what income sources are available at retirement. Part-time jobs are usually great because they keep you busy and keep your savings untouched to grow a little bit longer.
7. Determine your level of engagement – What responsibilities are you going to take care of and what makes sense to outsource? Everyone’s situations are different and complex, but you need to have a basic understanding of how things change when you near retirement and what new risks you face.

Check back in two weeks for our next show!

Brian and Bo discuss the strategy behind asset location and give you a breakdown of their thoughts when designing investment portfolios. The guys give you the rundown on tax-efficiency and cover the three “pots” of money in the investing world 1) Taxable 2) Tax-Deferred 3) Tax Free.

Here is the overview of how the tax game works across the different investment accounts:

Taxable Accounts – Traditional brokerage accounts (Individual, Joint, Tenants in Common, Tenants by the Entirety, and certain Trusts). This is where you see short-term and long-term capital gains taxation as well as special tax treatment for qualified dividends. We like to see long-term investments, muni bonds, and holdings that generate qualified dividends in these accounts.

Tax Deferred Accounts – This is your 401k, 403b, other employer sponsored retirement plans, and non-Roth IRA’s. When contributions are made into these accounts you get an income tax deduction, and the assets grow tax deferred until you pay ordinary income tax upon taking distributions. The best holdings for these accounts are investments that generate income, like bond holdings, certain MLP’s, REITS, and hedged securities.

Tax Free Accounts – These are the Roth accounts that you are probably continuously hearing about. Assets go into these accounts after tax and grow completely tax free if certain qualifications are met. This is where you want to hold highly appreciable assets so that you never have to pay tax on the substantial gains that you hopefully make.

Along with this topic we feel it is absolutely necessary to cover what-not-to do in these investment accounts:

First, try not to over-complicate your situation. If you need to go back to school to understand an investment, it is most likely an investment that you do not need to make.

Second, if you are already benefiting from preferential taxation inside of a retirement account, it does not make sense to hold investments that have equally preferential treatment in that same account. We often see this when people hold annuities within their IRAs.

Third, be wary of off-shore investments and private placements. Not only do you need to be considered a qualified investor, these investments are often very illiquid and can be hard to find an exact valuation. These types of investments can often be rewarding in the right situation, but generally carry more risk than your more traditional investments. This goes back to our first word of caution; do not get sold on an investment that you do not understand.

This week on The Money-Guy show, Brian and Bo run through a list of items that will help keep you on track throughout your financial marathon. They hit topics from estate planning to negotiating service rates. This is a great show to help establish future plans and to create a checklist to ensure you reach your financial goals.

* Estate planning

• Protect yourself from the falling piano or being hit by a bus:
  • Have a will (especially if you have children)
  • Life insurance- general recommendation is 10x your annual income in coverage.
    • If you have debt make sure you are adequately insured so the insurance will pay off the debt and also fulfill your long-term goals (Children’s education, Mortgage or Car).
    • www.michaelgassesagency.com – Great link to a free website to get an insurance quote with no personal info.

* Disability insurance

• Make sure you have adequate coverage of at least 60% of your income, and you pay the premium with after tax dollars so that, if you need the benefit, it is tax free. There is a 25% chance you will become disabled for at least one year between the ages of 20-67.
  • Own occupation- Cannot perform the regular duties of your own profession, but could enter into another profession.
  • Any occupation- Cannot perform the regular duties of any profession – Covers you if you become totally disabled.

* Emergency Reserves

• Have at least enough money to cover your living expenses for 3-6 months. Where do you fall in that timeline? It depends! If you lost your job, how long will it take to find a new job? If you can find a new job quickly, 3 months should be sufficient. If you work in a highly specialized field, then you should have additional months set aside, more than 6 months may be necessary.
  • Earn interest on you reserves: Some internet based banks will pay close to 1% on cash.
• Check out these website for great rates:
  • www.fnbodirect.com – Bank Brian uses for his emergency reserves for .85% APY
  • www.dollarsavingsdirect.com – Bo’s bank that pays .55%
  • www.bankrate.com

* Debt management

• Try to get debt under control as fast as possible. Prepare a detail of all your debt. List the outstanding principal, interest rate, and minimum payment amount. This will allow you to visualize how to establish a plan in order to accomplish your debt repayment goals. Be strategic with your debt repayment. It does not have to be an all-or-nothing.
  • Brian and Bo share some personal stories of individuals they have worked with and how those individuals’ views on debt repayment were somewhat askew.
  • Nice cars are much more expensive than what you see on the surface. Think about the cost of premium gas, oil, tires, and preventative maintenance.
  • Operate in stealth mode: the expenses are much less. Don’t fake success! It is better for people to think that you’re going broke when you’re not, rather than people thinking that you’re rich when you are actually broke.

* Retirement Planning

• Take the free money in your 401k. It’s cash sitting on the table for the taking. Employers will often give you 3% or more of your income for free, just for contributing to your own retirement.
  • If it is going to cost you to have access to a personal investment account, it may make sense to put more money into the employer sponsored plan in order to get access to cheaper.
  • Once you exceed the 25-28% tax rate, the opportunity cost associated with Roth contributions begins to increase. You will likely have better ability to control your tax rate in retirement than you do now, so sometimes it makes sense to take advantage of current year tax incentives.

* College Savings

• It is extremely hard to find a retirement loan but rather easy to get a student loan. On top of that, you can even qualify for a tax deduction for the interest you pay!
  • Avoid moving into Jr.’s basement by not going broke trying to finance your children’s education.
  • Utilize either a Coverdell ESA or a 529 plan for incentivized education savings.

* Income Planning

• Set short and long term goals- Write them down and review them often.
  • Net Worth statement- If something should ever happen to you it is invaluable. It provides an inventory and dollar values for your assets. Make sure you write down insurance info along with important login credentials. Documenting everything makes life easier (for you and your heirs).

* Negotiate with “ungrateful” service providers

• If you do not shop around, prices go up!
  • Look for new prices on your property and casualty insurance along with your auto insurance. Insurance companies often have great incentives for new policies but do not give existing customers the same deals.
  • Utilities- Natural gas prices are insane; negotiate the price every few months to get lower rates.
  • Negotiate, negotiate, negotiate!

* Analytics do not drive everything

• Dollar cost average rather than dumping large lump sums of money into the market.
• Even if you can borrow money dirt-cheap, a great goal is to be debt free when entering retirement. It has a huge psychological benefit.

* Things that you should be thinking about

• Plant your seed today so that you can watch the tree bear fruit in the future.
•  There is a good chance that you are the most financially responsible person in your circle of influence, solely because you’re listening to a financial podcast.

* Action Steps

1. Establish emergency reserves
2. At a minimum get the full employer match from your retirement plan
3. If possible, max out your Roth
4. After that it’s a great idea to go back to your 401k to max it out and even consider making Roth contributions.
5. If you want additional savings, a brokerage account may be the best option. Don’t overlook Target Date funds or a total stock market index fund in these accounts. They will give you diversification and management at a price.

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