Demystifying Retirement Accounts: Contributing to Your 401k and IRA on Autopilot May Not Be For Everyone
Confused about the different types of retirement accounts? The names don't make retirement planning easy either; 401k, IRA, ROTH, ESOP and on and on. In this episode we help bring simplicity to a confusing topic by organizing the mess of accounts into two buckets that you can remember. We dive into strategies to reduce your taxes long-term, many of which are contrary to the rules of thumb you may be using. We also discuss these 4 tips for making smart long-term retirement planning and investing decisions:
Contribute to a ROTH IRA or 401K earlier in your career if possible
Check your current employer retirement benefits to determine if you can make ROTH elections in your savings plan
Review your current and future effective tax rates with a financial advisor to determine the best way to reduce taxes and contribute to retirement accounts
Consider moving assetsfrom the tax deferred bucket to the ROTH (tax free bucket) via a ROTH Conversion if it makes sense for your particular situation.
Transcript:
We, I missed the Braves game for this. I paused it though cuz it's, you know, you can pause live tv. So just paused the game and we're gonna talk about retirement accounts, . And then, so basically I'm gonna go back and watch the last inning of the game and see if the Braves can win and then I'll edit this tomorrow.
Okay. So basically everyone is getting a peak inside an evening in the Seay household today. That's right. Were we talking about retirement accounts in between innings of the Braves game? That's correct. All right, then let's go ahead and dive in. . Hello friends. Welcome back for another episode of the Six Figure Investor.
Brian wants me to be super excited about our subject for today, and I have to be honest, I'm not about it, but it's a really important subject and that is the subject that finance is like a foreign language. It is kinda like a foreign language. We like to invent three letter. words and abbreviations and things that people don't understand.
So today Brian's gonna be translating for us all those three letter terms that. You know, if you're a financial wizard, you know very well, and if you're not, maybe like kind of like me you've heard of before, but you're like, heaven, help me. What is the difference between a Roth? I rra an ira, a 401k, a 4 0 3 B, and there's like even more of these things floating out there.
4 57 A TS p Heaven helped me. That's what we're diving into today. We'll see you on the other side of the show open.
Hello and welcome to the Six Figure Investor Podcast. Are you a professional who wants straightforward, trustworthy financial strategies that you can act on? Are you entering your highest income earning years and discovering that your personal finances are becoming too complex? We get it. You're a highly competent.
But you don't have time to go deep on your personal finances the way you do with your day job. Hi, I'm Brian, and helping professionals make smart financial decisions is my passion. I run a financial advisory practice called the Capital Stewards and work with professionals like you who are trying to cut through the noise.
It's time to stop googling every question you have about money and dive into some real professional guidance. So let's get moving.
All right, guys, we're back. To be fair, we never. And Brian's gonna dive in on these. Ira Roth IRA four oh 4 0 3 things. Do you wanna start off with, like, what are they and what is the definition and what's the difference between all these things? So like Saxon mentioned today, we're gonna demystify all these little acronyms that we use for retirement savings and planning, and try to get down to the point of how you should use them, um, to save in a smart way.
I, I think when folks start their career, When you're 22, I think there's a lot of rules of thumb about dump everything into a 401k, dump everything into an ira, and generally that's really good advice. When you're 22, 24 years old or just starting out, your income's not that high, but you, you should start saving early for retirement.
That's really good. But as your income changes and it grows over time, you get into the middle of your career or even later in your career. Some of that wisdom is not necessarily, um, good anymore. And the right thing to do depends on your specific situation. So what we want to do is give you a framework for thinking about the different kinds of retirement accounts, um, to help make some decisions around what you should be contributing to, what you shouldn't be contributing to, those kinds of things.
So we'll talk about what they are and then we'll also talk. How you should use them, which I think is helpful and it's something that you can't find generally when you Google IRA and Roth ira, they just tell you about the accounts and then you get through the list of 35 accounts and you go, I don't know how to use any of these.
So, okay. Well let's start with the 1 0 1 first. I think that's definitions for these foreign terms. So we're gonna put all the accounts into two different bucket. Roths that are taxed to now and tax-deferred accounts that are taxed later. So you will pay taxes. The key is determining whether to pay them now or later.
It's like an now later
I came up with that all by myself. Okay. I don't, that was a good joke. That's such a dad joke. Which you are dad, so it's spinning. Okay. So again, two buckets. We're gonna put everything into two buckets. Roth accounts that are taxed now, um, and tax-deferred accounts that are taxed late clear. Tell me more about these tax deferred accounts.
So tax deferred accounts and the abbreviations there. Individual retirement account, traditional IRA four ohk 4 0 3 . They're all examples of tax deferred. also, sometimes, uh, ESOP plans or employee stock ownership plans will fall into this category. If you work for a privately held company. The federal Government's thrift savings Plan.
4 57 plans for government workers. And then you may also see different kinds of 401ks and IRAs that have like the, the S E P or SEP or SOLO attached to them. All these different types of accounts, they exist and different kinds of companies in different kinds of employment relationships, but the nature of them is the same.
There's a limit to how much you can contribute. And the money that goes into that account today, you get a tax deduction for i e. It's not counted in your income because you're gonna pay taxes later. So let's just recap in that bucket. The money that you invest is a tax deduction. It doesn't count towards your income in the year that you invested.
That's correct. When you pull that money out, say at retirement, you pay your tax rate on those dollars when you pull them. So that's tax deferred accounts. Tell me about Roth. That's the other category. The other category is Roth accounts. When there are Roth IRAs, there are Roth 401ks. There are 4 0 3 contributions to Roth accounts grow tax free, and the distributions down the road are not taxed.
But in exchange for that benefit, you pay taxes on that income now, so you don't get that tax at. This year on your taxes. So the main difference between the two types of accounts that are out there is when you pay taxes. Note again, there's no tax-free savings plan that never requires you to pay taxes.
You're going to pay taxes on the money that you earn the question, it's just when, and we wanna optimize that decision as you go through the course of your saving, investing, um, and spending. So now that you have described these different buckets of accounts to us, Brian, I think you have a few tips or trick.
To share with our listeners today and help them think about how they should manage their retirement accounts investments. So why don't we step start with tip number one. Yeah, so I, I think the tip number one is the Roth bucket is like the holy grail of. Tax deferred savings for retirement because we're paying taxes now on a relatively small amount of money, but that money's gonna grow tax free for a long time, and compound become a much bigger pile of money and we don't have to pay taxes when it comes out.
So for most people making Roth contributions to the extent that you can make them. is the best thing that you can do. The challenge with that is the government has limited the amount of money you can put in a Roth account. It's generally pretty low, and there's also an income threshold to a lot of investors, particularly those higher income earners are not eligible to contribute to Roth's just in the first place.
Okay, so not available to everyone, but if a Roth is available to you, and you're a run of the mill investor, it's likely that's the first thing that you should do. Yeah. And, and I think our, our second tip is you may say, Hey, I, I can't open a Roth IRA because I'm not eligible. I would check with your employer because a lot of employers over the last four or five years have added Roth K or Roth 401k elections that you can make inside of your employer sponsored retirement saving plan.
So you may, you may think, Hey, I, I can't open a Roth ira, but you may be able to add those after tax dollars to your four Oh or, or to a separate savings account that's set up by your employer. And that's a really great option because you can actually put more than $20,000 a year per. into that structure.
So, one tip, if you think you, you're past the income limits for a a, a standard Roth ira, check with your employer and see if you can contribute to a Roth K or a Roth four one. because the Roth K or Roth 401k has the same benefits as a typical Roth. Yeah, it has. It has the same benefits. You pay taxes on the dollars today and then they grow tax free and you take money out tax free.
You can also contribute the same dollar amount to those as you can your standard 401k. So, so that's a really good option as well. Not every employer and the capability to do that, but a lot do and, and more and more have started offering that over the last four or five years. So that's tip number two.
Tip number three is gonna take us into our tax. are tax rates. In, in, in order to determine the the right bucket to contribute money into today, you really have to think about what your tax rate is today and what it's gonna be in retirement. If you have a relatively low tax rate today and you're gonna have a higher tax rate in retirement, you want to pay taxes today and not in retirement.
The same can also be true. If you have a really high tax, um, rate today and you have a lower rate in retirement, then you want to pay those taxes in in retirement, and that's where those tax deferred accounts make sense. You were telling me earlier that this is a place that a lot of people get it wrong because they underestimate their, what their tax rate will be in retirement.
Yeah. What, how does that happen? How does someone underestimate their tax rate in in retirement? I share this advice with mid-career professionals. A lot. Many professionals expect their income will go up over time, and as many of us know as your income rises, so does your tax rate and the conventional wisdom is that in retirement, your income will go back down after all you quit working.
Right? But, and there's a really big, but here, if all of your savings are in those tax deferred accounts that we talked about, like IRAs, 401ks, and through a savings plan, then your income may actually be similar to your last working year. Research shows that early retirees tend to actually spend slightly more money than they did.
In their last year of work. Think about all those places you want to go, the things you wanna do. So it's important to think critically about what your income will really look like in retirement before you just pile all of that money into tax-deferred accounts. If you need to replicate all of your income out of a tax-deferred account, then your income tax rate will be very similar to when you were working.
And that relationship tends to hold, especially true for higher income earners. So the more you make, the more likely your income rates will be similar from the end of your. Throughout your retirement lifetime, and so the, the bigger the tax bill you'll have down the road. So how can we prevent that problem from occurring?
The best way is to plan foreign in advance and pay income taxes when our tax rates are lower. Earlier in our career, you can contribute to Roth accounts like Roth IRAs and Roth four Ohk in your thirties and early in your forties to try to minimize your tax bill over the course of your lifetime.
Earlier you were telling me the story of a. that invested all of their retirement savings in a 401K kind of account. Yeah. A tax deferred account. A tax deferred account. And when they got to their retirement, they had what they thought was like a lot of money cuz they had a million and a half dollars.
Yep. But the reality is they didn't actually have a million and a half dollars because like effectively a third of that is owed in taxes. That's right. They only had a million dollars. Yeah. , which makes a pretty sizable impact in how you think about then those retirement years and what is available to you.
And what you're saying is this is basically at epidemic proportions because for so long people haven't been a advised to invest in 401ks and to use that financial tool, but they don't necessarily think about the fact that they haven't paid taxes on those dollars. And so they're thinking all of it's.
Yeah, but it's really not. It's not. It's, and, and it, that's not to say that you shouldn't be leveraging IRAs at 401ks, tax deferred accounts. You absolutely should. But I think this rule of thumb that you start, you know, investing using when you're 22 or 23, and you just put all of your money into a 401k or into an IRA as your income changes, that may not make sense for you over your lifetime.
So it's just really important to look at what your tax rates are, both now what you think they're gonna be down the road and make a decision. accordingly. I think the most helpful thing to me under this episode, or the thing that I didn't necessarily realize is I am a child of the financial indoctrination, which is like, do your Roth, do your 401k, like max those things out.
It never occurred to me to invest in any other kind of account or that if I thought my tax rate was going to be equal to or higher than it is today in the future of my retirement, that I should use another investment vehicle to. pay taxes on the money today and then pay capital gains on it over time.
Yeah, that's right. That would be a better scenario. Yes. Yeah, and it gets really, like I said, it gets really complex and so it's important to, to have some perspective and some good analysis done on what those tax rates look like. Our, the last tip that we share with folks is you can move money around. So if you've been contributing to tax deferred accounts and you want to move money into that Roth bucket, if it makes sense from a tax perspective, to do that, you can do these things called Roth conversions.
And in a year where you have the right income thresholds and the right tax situation, and I shared with Saxon earlier a couple of examples of those, but say you invest in a business or you start a company or you do something, Your income is reduced significantly for a year. Somebody takes a year off work.
You have children. There's a lot of things that can happen where you're taxable income might go down temporarily. Yeah, those are good years to do Roth conversions and move money from those tax-deferred accounts into Roth accounts and, and all that happens there is you open a Roth account and then your financial professional can help you transfer money from one to the other.
And then the key is you'll pay the taxes. So if you have a hundred thousand dollars that you're transferring and you're paying the 30%. Then $30,000 of that's gonna get written as a check to the federal government. And then your Roth account will have 70,000 in it. But that money will grow and you can, you can take it out tax free.
Um, definitely. So I think the important thing to note here is that, the story Brian told me is that last year I took the year off to. Essentially to have our third and took like a, an extended parental leave. And in us doing that, it noticeably changed our household income to the point where it made sense to take some of the money out of.
a 401k and do this kind of Roth conversion. Mm-hmm. that Brian's talking about. That's right. Which beforehand I would've been completely confused on why you would move between these different accounts, but made a lot of sense because that was an example, sort of an anomaly year for us where we had less income as a household and it made sense for us to.
Pay the taxes on it in the year that we had a lower tax rate and move the money over to a Roth where we wouldn't have to pay taxes on it again in the future. Yeah, that's right. And so again, that's another thing that is worth talking through with your financial professional. Roth conversions are not the right thing for everybody in every year.
It depends on the year, it depends on the tax rates, but it's something you should consider and, and a question that you can ask. You're a pros when you, so to recap, Everything that we've talked about in this episode, the first thing is to contribute to a Roth IRA or 401K early in your career, if possible.
The second thing is check your employer retirement benefits to determine if you can make Roth elections to your 401K or other type of corporate savings plan. If you can't contribute directly to a Roth ira. The third thing is review your current and future effective tax rates with a professional to determine the best way to reduce taxes and contribute to retirement accounts over the long term.
And lastly, consider moving accounts from the tax deferred bucket like IRAs and 401ks to the Roth bucket, the tax-free bucket, if that makes sense for your particular situation. I feel compelled to provide a PSA to our listeners that. . This issue is much more complex than Brian's going to allow to stay In the edited version of this episode of the podcast, I'm sure he will cut many, many minutes of conversation that we had about this out because it would just be confusing.
So my P S A T would be, this is definitely a place where if I wasn't married to an expert, I would go find one because there are a lot of things to consider. from a tax implication perspective, what you're making today, planning for the future. And this is an area where I definitely think that our listeners would benefit from kind of outside expertise.
If someone was looking for a financial advisor to have that conversation with Brian and they thought that you sounded really smart on this episode cuz you are really smart, my love. How could they get in touch with you? Yeah, the capital stewards.com. You can get on our email list and learn more about us.
You can listen to more episodes of the podcast and if you would like or you can schedule some time to talk, we'd be happy to talk to. , and you can do all of that from the capital stewards.com, which we'll also link down in the show notes. Correct? You can. You can do it. All right there. Super easy.
Excellent. Well, thanks so much for joining in, guys. We've been hearing some of your reviews online. We'd like to know that the financial talk is just okay, but the ban between the two of us is high five, so let us know what you wanna hear more of in upcoming episodes and we'll be sure to cover that content.
See you as always. See you soon.
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