Stop saving in your 401(k)

No, I haven’t lost it, but I have been thinking hard about this saving for retirement thing.

Saving for retirement on a pre-tax basis now seems rather short-sighted.

There are several reasons to not save in a traditional 401(k) or IRA and instead use a Roth approach.

  • Tax free income will come in very handy in retirement.
  • You don’t have to worry about required minimum distributions (RMDs) and therefore have more flexibility
  • Distributions from Roth accounts are not included in your Modified Adjusted Gross Income (MAGI) and will not increase your income and possibly cause you to pay higher Medicare Part B and D premiums under the IRMAA rules.

There are, however, a couple of things to consider before going all Roth.

  • If your 401(k) does not offer a Roth option, you sure want to continue with pre-tax investing to get any employer matching contributions.
  • If the percentage of pay you save will be less because you go from pre-tax to after tax savings, you need to do some math. However, even if that is the case, you may want to gradually shift to Roth savings to sustain the higher savings rate.

11 comments

  1. I have two TIRAs which I could have decided to Rothify, but I took a close look that the IRS RMD table, and I noticed that much of the required RMD payments would come after my probable demise. So I decided not to convert to Roths.

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  2. There is another bipartisan bill in the works that will increase the RMD age again – to age 75. And many news reports speculate the ultimate plan is to eliminate the RMD entirely.

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    1. Yes, however, adjusting taxes is a lot like squeezing a balloon, you squeeze it here and it pops out there. Unless they forego “pay-go”, which is possible, someone’s taxes will have to increase to offset the reduced revenue from changing RMD.

      When they moved it to age 72, one of the casualties was the Stretch IRA.

      Remember that Congress has never adopted a national retirement policy. What we have is a national tax policy, of which Congress will adjust, as necessary, any provisions that apply to retirement plans.

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  3. When I started working, the Roth IRA was not available to me. During the mid 2000s, I looked into a conversion but the instant tax hit was not worth to me at the time. Not sure if that was a good move or not, but the market melt down might have made it my best move at the time without me knowing it.

    When I was a young family man, I needed the tax break of the 401K because I could not spare a penny so it helped fund the 401K. I believe I started with only 2-3% withheld. Every pay rise, I increased my percentage until I hit 15%. By that time I was a little more financially secure.

    In my 20s I was told that I would need 60-80% of my current income to retire on. I had no ideal that by my 50s that I would be making 5x the amount I was making in my 20’s. I also believe now you need at 100% of your final net income (not gross income) for maintaining your current standard of living in retirement. Your net income might have been 80% of your gross but it all depends on your deduction for benefits and taxes withheld.

    What I have learned is: 1) The taxman will get his money. How much is the question but it is still a good problem to have vs having no money to tax. You can’t try to out guess Congress and the IRS. You’ll lose every time. They will change the rules on you. 2) Don’t let indecision stop you from making a contribution into a 401k or a Roth IRA up to at least the company match if you get one. The key is to start something even if it is an ordinary IRA or Roth IRA at a bank. 3) Do the math. If you are a high earner by your 30s, get help. It might be wiser to only take the company match and invest outside of the 401k because capital gains tax might be much lower than your income tax rate at retirement. The 401k will give you more money in your pocket over a Roth realizing that both choices will result in a smaller paycheck. The payoff is in the long game. 4) If you are single, start one ASAP and definitely before you get married or have children. You’ll learn to live within your means before you learn to spend that extra money. It is so much easier than trying to determine 401K deposit or buying diapers. When you get better off, you don’t miss the money that you never had in your hand. You can increase your contribution by splitting your raises as in some for me, some for the 401K or Roth.

    I know people in their 40s and 50s who can afford to contribute but won’t. They are missing out on free money with their company match. But at least they didn’t have to pay taxes on the company match.

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    1. Roth conversions are out there. You may find it an option with some value to separate the tax year when the monies are taxed and the tax year when you spend the monies. So, for example, if you are 65 today, seven years prior to RMD, you could convert some of your taxable monies into Roth assets – if that makes sense from a marginal tax bracket.

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      1. Thanks BenefitJack, I’ll have to ask that question. I have been in discussions to find the right place and person to roll my 401K into an IRA or IRAs, hopefully in 2021. Covid has slowed down my progress in 2020 in talking to people. (Some reason I don’t like giving money to a man in a mask). Still working out the best plan and the future tax situation for my expected newer higher income. I have 9 years until I have to do something so I got time to do it right.

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      2. I’ve been doing conversions while taking advantage of Trump lowering the taxes. Once they go back up in 2026 (or if Biden raises the sooner), I’ll hold off until age 60. I’ll try to convert as much as I can between 60-62, but since Medicare looks at your income two years prior, age 62 will have to be my last year.

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    2. You’ll want to consider an in-plan Roth conversion, if your 401k plan has such a provision. And, if it doesn’t have such a provision today, nothing stops it from adding that tomorrow. You may find value in in-plan, staggered, perhaps annual conversions, or other timing sequences. It all varies from one person to another, and don’t forget the income, retirement savings if there is a spouse.

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    1. Roth conversions are out there today. It may, or may not make sense to convert from pre-tax/taxable monies to Roth. Much depends on your individual circumstances.

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  4. This is a very difficult decision. However, typically, when starting out, individuals are likely in as low of a marginal income tax bracket (federal and state, if applicable) as they will ever be (certainly true today, given the likelihood of tax increases, and not just because of Biden, but because of our deficits).

    Other factors to consider include, but are not limited to, “marginal” rates (while employed) versus “average” tax rates in retirement, state income taxes while working versus post-retirement rates (relocation?), likelihood of changes in employers (median American worker age 50 has already had 12 different employers), potential gaps in periods of employment (where the marginal rate may be lower), taxation of Social Security benefits in retirement, Medicare Part B and D income surcharges (today, and likely to be much higher where the tax reaches down to middle-class retirees tomorrow), a spouse’s income and retirement benefits, etc.

    Similarly, the individual may want to defer now and convert to Roth at a later date (timing may be everything in our progressive income tax system).

    So much to consider, and yes, Roth should always be a consideration – even where the plan doesn’t offer Roth, when changing employers, a Roth conversion should be considered, and reconsidered whenever circumstances change.

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