Is a Roth 401(k) Better Than a 401(k)? [Case Study] - Cravitz Financial & Insurance Solutions

Is a Roth 401(k) Better Than a 401(k)? [Case Study]

For some people contributing to a Roth 401(k) is a better option than contributing to a pre-tax 401(k). It all depends on your overall financial situation. In this video I will take you through a case study of a hypothetical couple where we take a look at not only contributing to a Roth 401(k) instead of a pre-tax 401(k) but also doing Roth IRA conversions as well. You will see how they pay much more income taxes this year, and we will see how this potentially benefit them tremendously in the future.

Full Transcript:

Hey, what's going on, everybody? It's Ryan here. Okay, so let me ask you a question. What if I told you that one strategy, one pretty darn good strategy in order to put yourself in a good position financially, in order to put yourself in more solid and secure ground, in order to help make sure that your financial future and that your retirement, that it has a higher probability of achieving success, what if I told you that a way to do that was to pay a whole lot more in taxes this year? Would you think that I'm completely crazy? It's okay if you're thinking yes, because, I mean, who wants to pay any more in income taxes than you have to, right? Believe me, I'm the same as, maybe not all of you, but certainly most of you. I don't want to pay any more in income taxes than I legally have to, so I understand. And why would I voluntarily pay a lot more in taxes?

So stay with me. What I want to do is I'm going to share my screen with you. I'm going to walk you through a sample case study, and here's what this is based upon. I've had numerous conversations over the years, and I had another one the other day, that really was the impetus to make me put together this video here. But the conversation I had the other day, again, was like a lot of conversations I've had over the years was, "Ryan, we're doing pretty well financially. My wife and I, we're in our 50s. We're making about $200,000 a year. I just don't know why I and my wife, we would choose instead of funding a pre-tax 401(k), that instead we would fund an after-tax 401(k), or, in other words, a Roth 401(k)?" So the answer is, well, it depends. It's going to depend on a case-by-case basis. It's going to depend upon your financial situation. So, again, I said I was going to share my screen with you. So let me go ahead and do that right now.

So what I've put together here, this is a hypothetical couple, and they are both 55 years old. We've got John Sample and Jane Sample, and their expenses right now during their working years are $8,000 per month. That's just what they need for regular expenses and things. Their savings, they're contributing $20,000 per year to a 401(k) plan each. Again, they're both contributing to the pre-tax 401(k) plan. They're not contributing to an after-tax, to a Roth 401(k) at all. So you see I have those marked zero right now. Their income, made it real simple. I said Jane's making a 100,000, John's making a 100,000. And then we put it in the Social Security here as just the estimated amount that they will get from Social Security, just based upon their income. So it's just a very simple calculation. Don't want to get into the detail on this part, at least not for what I'm showing you here today.

Their goals, they want to retire when they're 65 years old each of them, and when they retired, they want to retire on $9,000 per month. Also though, they want to have additional money to cover the national average healthcare expenses, which are currently $5,513 per person. So that's on top of the $9,000 per month. Now, this long term care cost, this is actually not factored into here. So I went ahead and put, "No long term care." You'll see that right at the top, "No long term care," so that's not in there. Their current net worth, again, I made this very simple. It's just all round numbers. They've got 200,000 that's in savings, and they each have $600,000 in a 401(k) plan. All their money's in U.S. Equities. I just did this to make it a very simple type of scenario. So, again, both exactly 600,000 and a pre-tax 401(k) plan.

So the question first off is, based upon what they're doing, what is the probability of their success in retirement? They want to retire when they're 65, and you'll see that right here. It's 65 and Jane's 65. And their planning horizon, in other words, how long do we need this money to last? Well, we're assuming we need this money to last until 95. Now, certainly if we made any tweaks here, as far as we needed to make this money to last longer or shorter, that would decrease or increase the probability of success. We could also play around with some other numbers here as far as how much they need in retirement. Maybe instead of 9,000, it's a number higher than that, or lower than that, for instance, or maybe healthcare costs are different. So there's different things here that could certainly affect the probability of success.

But if we just assume these are our numbers, we're not going to change these for the purpose of this video that I'm doing right now, and over here, you can see this is their current plan, and this is the proposed plan. The current plan is going to stay exactly the same based on the inputs we already looked at. The proposed plan is going to change with some things that we're going to propose, that we're going to put in here. So, first off, the very first thing that we want to look at is down here. So they're putting $20,000 each into their 401(k) plan. So let's say instead of doing that, they each put in $13,600. Instead of funding a pre-tax 401(k), they're going to fund a Roth 401K where you have to pay the taxes first on the $20,000. So they're going to go ahead and put in $13,600. So let me press Refresh, and look at our probability of success here. So it didn't go up a lot, but it went up a little bit. It went from 61% to 63%.

So in other words, by now starting to contribute to a Roth 401(k), still keeping the pre-tax 401(k)s intact, not changing anything there, but just starting to fund a Roth 401(k) increased their probability of success. Now, the question that always comes up is, again, we're making pretty good money, why would I choose to pay less in income taxes? So let's take a look at that. Now, with their current plan, what they have right now, if they continue to fund this $40,000 right here on a pre-tax basis, what we can see is their total tax payment is estimated to be $46,206. Now, this is based on federal taxes, state taxes, which is in California, which is where they live, and FICA taxes, which, of course, includes Social Security and Medicare and all the rest of it. Now, again, this is a basic, simple example. If you need specific tax advice, talk to your tax advisor certainly before doing anything tax wise. But based on these inputs, this is what the program is determining are their taxes.

So at $46,206. So their total inflows again are 200,000 that's coming from their salaries. Their expenses are the 8,000 a month. That's what they're living on in their pre-retirement years. 8,000 a month is 96,000 a year. So plus their tax payment, plus what they're putting in for their 401(k), at the end of the day their total outflows are $182,206. So what does this mean? This means that they have $17,794 left that they don't need in order to meet their expenses. These are their unsaved cash flows. So remember that number, 17,794, and I've already written that down. Now, let's take a look at the proposed plan. The proposed plan is where they are not funding the pre-tax 401(k)s, but instead are funding the Roth 401(k)s. So if they did that, and this is just coming slowly here, we're going to see some changes as far as what they're going to owe in taxes. It's certainly going to go up, because they're not going to get the deduction. But let's look at how the rest of the numbers as well play out here.

So their tax payment went up to $58,821. That's an increase of over $12,000 for the year by funding the Roth 401(k) instead. And now they only have $27,200 that they're putting into the Roth 401(k), because they're doing $13,600 each, remember. Okay, so total inflows, 200,000 from the salary, the 96,000 from expenses, add their tax payment, their money going into the Roth, and their total outflow is 182,021. So what does that mean? After the end of the day, they net what they need for expenses and they still have $17,979 left over. So they actually have about $200 more for the year leftover than they did under their current plan. Okay, so that's already an improvement cashflow wise. Not a lot. It's basically the same, $200 difference, but what we're really concerned with, and this is what I referred to as tax forward planning, is, why are we doing this? Why do we pay so much more in taxes? And so what we want to take a look at is, let's look at the ending balance of accounts based on their current plan.

It's coming. It's coming, but it's coming slowly here today. I don't know if you can see that little green line right there at the top, it's got to get all the way to the right and then it calculates. So there it goes. Okay, so let's say they both live to 95, just for the sake of comparison. Not both, but at least that one of them lived to be 95, there would be $2.4 million approximately in their 401(k) plan. Remember, all that's pre-tax. So all of it's fully taxable. So some of it's going to them or to their kids or their kids inherit it, and some of it's going to the government, depending upon the taxes that need to be paid. Now, let's compare that $2.4 million number at 95 over to the proposed plan where we're starting to put into the Roth 401K. So now what's happening? Well, now the numbers aren't hugely different, because now we have it's about 2.3 million, so it's about $100,000 less actually, but $350,000 is now into the Roth 401(k). So not a huge difference, but it certainly is a little bit of a difference at this stage.

Now, what I want to do though is I want to kick this up a notch. Now, remember, just by doing this, when we go back to the analysis here and we see the percentile, it actually increased our probability of success a little bit by going ahead and redirecting that new money that's going in into the Roth 401(k). Understand, it's not going to be as dramatic, especially when we compare by the age of 95 how many dollars were into the Roth 401(k) the versus the pre-tax 401(k). And the reason it's not that significant is they already have $1.2 million in their pre-tax 401(k). They're just barely starting to put money into a Roth 401(K) and they're only going to do that for about 10 years until they retire. But what if we bring this up a notch and what if we introduce what are referred to as a distribution strategy? And this is where they're going to start to do some Roth conversions.

Now, right now, the money's in a pre-tax 401(k). But let's say that money was actually in a traditional IRA, which is taxed the same way. When you take the money out, you have to pay the taxes. So let's say that they're at a company. Maybe they can roll the money to a traditional IRA. They can do an in-service distribution perhaps, what some companies allow you to do, or they just retire or they change jobs and then they do a rollover into a traditional IRA and then decided to do a Roth conversion. Obviously, every situation is different, but let's say they were able to go ahead and do a Roth conversion with this money. And so if that were the case, the distribution proposal now increases this up to 65% probability of success on this side. So it's still not a huge increase in probability of success, but it's still definitely increasing their probability.

But let's also take a look at this, and now that we're really starting to look at doing some Roth conversions, you're going to see this as really going to increase their tax payment this year. So this year, they're going to owe $109,727 in income taxes. That's huge. Originally, it was going to be 46,000 and change, so that's a huge increase in the amount of taxes that they're going to have to pay if they go ahead and do the Roth conversions. And what's the increase? What did they actually do as far as how much are they actually converting? Well, real quick, let's take a peak at the page. So the first year, they're converting $150,641, and then they're doing various amounts year by year. Now, understand, this is not a "set it and forget it" type of thing. You set it up, you decide what makes sense for the first year, and then certainly every year thereafter. You really need to evaluate to see what makes sense within the plan, but this is the initial calibration as to what could make sense for them.

So they're converting a lot more money. That's why the tax bill is going to be so much higher in those earlier years. So the question is really, what is the payoff? We're going to pay all this money in taxes, but what does that do for our financial future? Okay, so let's take a look and see how it looks. So this is the ending balance of accounts. By the time they are 95, or at least one of them lives to be 95, they would have a $2.4 million in a 401(k) plan, in a 401(k) plan that's all subject to income tax. If we compare that to the proposed plan where they're starting to fund the Roth 401(k) and they're starting to do some Roth conversions, let's look at the difference. Programs going slow. So, again, 2.4 million fully taxable in a 401(k), if they just continue doing what they're doing, versus all in Roth money, 4.6 million completely income tax free.

Now that's huge. That's at age 95. And understand, one of the reasons that's so big is that, if they never need that money during their lifetime and that money goes under their kids, if they have kids and they're concerned about that, that when their kids get that money, under the new rules now, kids have to go ahead and take the money out of an IRA or a Roth IRA within 10 years. And so even if they split that up in the pre-tax 401(k) and took out a little bit over the course of 10 years, they're still having to take out quite a bit of money. And so, as a result, they're have to pay a good amount in income taxes on that money. No longer can you stretch out that money over the course of your lifetime. That's just not available anymore, unfortunately. Now, the other question that comes up, "Okay, but what about me? What about my financial future? So what happens, let's say, when 75 years old? What's the difference if I were to do this?"

Well, let's say you're 75. You did these conversions and you started contributing to the Roth 401(k). You now have about $3.6 million in your Roth IRA. Compare that to the current plan at 75. Instead of $3.6 million all completely tax-free, at 75, you've got $4.2 million all subject to income taxes. Okay. So yes, it's a little bit more money. Well, it's 600,000 or 700,000 more, but it's all subject to income taxes. So it ends up making it a big difference. If you look over here at the tax payments under the current plan, you can see how much you're having to pay in taxes. Even by the time you're 75, it's 50,000 a year. By the time you're 80 years old, 65,000. Age 90, 89,000, basically. If we compare that to the proposed plan, what's happening is they're not having to pay any income taxes by the time they're 68 years old. At that point, all their income is coming from their Social Security and from their Roth IRA or Roth 401(k).

So, as a result, they're not having to pay anything in income taxes whatsoever, zero. And you'll see that all the way down. Tax payment, zero all the way down. So this is all assuming the tax rates stay the same, that the Tax Cuts and Jobs Act sunsets and the tax rates do go up after 2025, and all that. But could tax rates increase even more so in the future? I believe that they will. That's certainly my opinion. But if tax rates do go up and you have your money in a Roth IRA as opposed to a pre-tax 401(k) that's fully subject to taxation, certainly, in my opinion, that's putting you on much more secure financial ground, a better financial position. So every situation is different. Your situation could certainly vary. If you have questions on this or anything else, don't hesitate to reach out. Take care, and I'll see you in the next one.


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