401(k) vs Roth 401(k). Case Study Example – What If Tax Rates Rise? – Cravitz Financial & Insurance Solutions

401(k) vs Roth 401(k). Case Study Example – What If Tax Rates Rise?

Video Transcript:

Hey, what's going on, everybody. It's Ryan here. Okay. So if your employer gives you the option of either funding a 401k on a pre-tax basis, or on an after-tax basis, meaning a Roth 401k, which option should you choose? Well, I'm going to tell you right up front that it depends upon your overall situation, but one thing that comes up a lot is that, and I find this particularly with people that are making a pretty good income here today, the thought of redirecting money that they're contributing to a pre-tax 401k today, over to a Roth 401k, oftentimes seems crazy to them. And that could be you as well, because if you redirect those funds, you're going to pay a lot more in income taxes. No doubt. And does it really make sense to do so? You're going to pay more in FICA taxes, more in federal taxes, and maybe state taxes if you're in a state where there are state taxes.

So does it really make sense? And it's something that needs to be determined on a case by case basis. But one of the other factors that we need to think about in this, is where do we think tax rates are going to be in the future? Now, the fact is nobody has a crystal ball. I mean, it's anybody's guess as to where tax rates are going to be a decade from now, two, three, four decades from now. We don't know, but we do know that historically, tax rates are about as low as they've ever been, historically speaking. We also know that our national debt is quite large. We know that social security and Medicare are way underfunded. We know all these things, so what's going to happen in the future.

Are taxes going to go up in the future in order to help pay down the debt, and help be able to fund these different types of programs, social security, Medicare, and such? None of us know for sure exactly what's going to happen. But what we do need to do is plan and prepare in case tax rates do go up. Obviously there's other things we need to plan for as well. But in this video, I just want to talk about the differences here between the pre-tax 401k, the Roth 401k. And we're also going to look again, if tax rates do rise, what would the effect be on retirement plans? So what I'm going to do is I'm going to share my screen here with you. I'm going to walk you through a sample case that I put together, and we'll take a look at the difference between the 401k versus the Roth 401k in this couples case.

All right. So let's take a look at our hypothetical couple here. So we've got John and Jane Sample and they're both 50 years old, and their expenses right now, in their pre-retirement years, are $7,000 per month after taxes. So that's how much they need every month just to pay the bills and such. And they're currently saving $20,000 each into their company's 401k plans on a pre-tax basis. And I'm increasing that by 3% per year, by the way. I'm doing that for each of them. And what I'm also doing is, for their income, I'm assuming their income is $100,000 each. I'm also increasing that by 3% each as well. To account for any future raises and such, and account for overall costs of living adjustments over time. So combined their salaries today are $200,000. Social Security, so we're planning for that, them going to go ahead and take that when they retire.

And I'm just using what's called a simple estimate here. I don't want to get into detail on Social Security in this video. So we'll just use a simple estimate. And what my program does is just assume what their Social Security would probably be, based upon what their income is now today. And that's the case for both of them here. Their goals in retirement, so they want to retire at age 70. They want to be able to live on $7,000 per month after taxes. And again, that's accounting for inflation. So in the future, that's going to be a lot more money than $7,000. And also we're factoring in annual retirement healthcare costs. And we're just doing the basic estimates. These are national averages that are put in here. One thing to keep in mind, and we'll touch on this perhaps towards the end of the video, is that part B and part D premiums are dependent upon what your AGI is, your adjusted gross income.

So, keep that in mind, just for now. We're not going to talk about long-term care at all. We're going to assume they never need long-term care expenses. So I've got no long-term care built into the program here for both of them, and finally their net worth. So again, I just made this very simple. Their total net worth is $500,000 and their investments are the 500,000. They each have $250,000 in a 401k plan, a pre-tax 401k plan. And I'm just assuming that the money that they have that invested in is all in US equities, all in US stocks. So a broadly diversified assortment of US stocks. And that's it, so that's the setup for their situation. So again, remember what's their goal? To retire at age 70, on $7,000 per month after taxes. And again, we've got to account for healthcare costs as well on top of the $7,000.

So let's go to the retirement section here. And what we can see here is that there's an 86% chance, 86% probability of success. In other words, of making sure that their money is going to last all the way through retirement. Now, the one thing I did forget to tell you is that what we wanted to presume in here is that their planning horizon was till age 95. So in other words, we want to make sure that there's enough money available to them so that they can live on that $7,000 per month after taxes with inflation presumed until they're 95.

Now, if they were going to only assume that they're going to live, let's say until age 90, then the probability of success would be even higher, because the money wouldn't need to last as long. And vice versa, they wanted to make sure that they had enough money until they're a hundred years old. Then the probability of success would be less.

But again, as a recap, they want to make sure this money lasts until they're 95. They want to retire at age 70, and they want to live on $7,000 per month after taxes, of course, we're factoring in inflation again. And what are they doing? They're funding a 401k each, each of their 401ks, for $20,000 on a pretax basis. So all in all, 86% is pretty good. If we're 80% or above, especially 85% or above, we're looking pretty good. Because there's little tweaks that we can always make to get into the nineties and even beyond to make sure that our probability of success is very, very high, to achieve what we need in retirement, but for the purposes right now of this video, just know 86% is pretty good, but let's now take a look here at the cash flows.

So their income, remember, combined is $100,000 each, so you can see that here in the inflows, it's 200,000. Their expenses are $7,000 per month. So again, that's $84,000 after taxes on an annual basis. Now their tax payment is estimated to be 49,585. So that's the program calculating this based upon federal taxes, state taxes, they live in California. Obviously state taxes are going to differ depending upon what state you live in, and then FICA taxes, which includes Social Security tax, Medicare tax as well. So again, total tax is 49,585 and their plans savings again, $40,000. $20,000 each to their 401k plans.

So if we're looking at this situation right here, and if this is you, and I were to say, "Hey, maybe it makes sense. Instead of you funding that 401k plan on a pre-tax basis, maybe you should fund it on an after tax basis, the Roth 401k." And you might think, "Hey, I'm crazy. Because if I do that, I'm going to increase the amount of taxes that I'm going to have to pay, because I'm not going to get the tax deduction on this $40,000 right here." So why would I want to do that? That seems crazy to me. So right now let's take a look at a couple of things. I'm going to write this down. So their expenses, again, are $84,000 per year. And their unsaved cashflows are 26,415. So in other words, after they've met all their living expenses, paid their taxes, contributed their 401k. They still have $26,415 left. and their total tax, so that's the unsaved, and their total tax again is 49,585.

Okay. So let's come back over to here. And let's say instead of funding a 401k, we'll put that at zero, let's say we fund a Roth 401k. And let's say they put in 13,600. So not the full 20,000, just 13,600, because they're going to have to pay some income tax on that 20 grand if they're putting it into the Roth 401k.

Interesting. So what happens when we do this? Well, first thing that happens, their probability of success just dropped. Instead of having an 86% probability of success, now they only have an 83% probability of success. So does it really make sense to do this? And the answer is maybe, maybe not. So let's take a look here again at cash flows and what we're going to look at is now they're plan savings is this 27,200 in the Roth 401k, and their total tax payment is now 62,228, before it was 49,585. So I'm not going to get out my calculator, but that's roughly $13,000 more in income taxes they have to pay by not funding the pre-tax 401k now this year. But let's take a look at this, their expenses, again, are 84,000. They're able to meet that. And also their unsaved cash flows, so even after paying for their expenses, paying the income taxes, even the higher income taxes they have to pay, they still have an extra $26,572.

And if you remember from before, when they funded the pre-tax 401k, they had $26,415. So it's actually a little over a hundred dollars more of extra money that they have available now by doing the Roth 401k instead. Now I know what you're thinking. Well, okay. So maybe cashflow wise, they're actually in basically the same situation, but now they only have an 83% chance of achieving success as opposed to an 86%. So how in the world would this ever make any sense? And it may or may not. And why may it make sense or why may it not? It depends on where future tax rates are going to be. Now, where future tax rates are going to be, again, is anybody's guess, but let me write this down, 83% and 86%, but let's just say the tax rates went up 30%.

Now understand, that isn't as large as it might sound. Because, if I get out my calculator here, let's say that you're in a 12% tax bracket, and the tax rates go up 30%. That's not like it went from 12 plus 30 up to 42. It's not 42. A 30% increase on a 12% tax bracket right now, you're only now at 15.6. So in other words, a 12% tax bracket, plus increasing by 30%, you're now only at 15.6. So 12 up to 15.6 that's a 3.6% difference. Not huge. If you're a 22% today and we increase that by 30%, that goes up to 28.6. So 6.6% higher. So it's not as large as it might sound, but let's take a look at what the impact might be, or will be, on the current plan, as well as the proposed plan.

So again, remember that. Current plan, 86% probability of success, proposed plan 83%. Okay. So let me adjust it to account for the increased tax bracket. I'm going to go right down here, and what I'm going to assume is that tax rates increased by 30% in the year they retire. And if I go back to the retirement, let's take a look at what the probability of success is now. Whoa. Now see that difference.

So remember, before, this number was 86%, there's now only a 53% probability of success. It has dropped considerably, versus on the other side, there was an 83% probability of success, but now it's down to 77%. So it only went from 83 to 77 versus on the other side that went from 86 all the way down to 53. So does it make sense to contribute to a 401k, or a Roth 401k? It's going to depend upon your overall situation. Again, I can't stress that enough, but it makes sense always to do an analysis, and really take a look at what are the what ifs, what might make sense here. I will say that a lot of times, we all hear about diversification when it comes to investments. And a lot of times that can make a lot of sense, but it can also make a lot of sense when it comes to income taxes.

In other words, having some money that is going to be taxable at ordinary income tax rates, some money that's going to be taxable at capital gains rates, and other money that's going to be tax-free. So if we can reduce the amount of income taxes that we have to pay over the long-term, not just the short-term today, but over the long-term, we could potentially increase the probability of success of our retirement plan staying intact and doing what we need it to be able to do. So I hope all this made sense. If you have any questions on it, don't hesitate to reach out, and I look forward to seeing you in the next one, take care.


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