Are you making the most of your 401(k)? In this episode of The Agent of Wealth Podcast, host Marc Bautis dives deep into the 401(k) – a cornerstone of retirement planning that has transformed how Americans save for the future. Tune in to discover the nuances between Roth and pre-tax contributions, including their immediate and long-term implications.
The second part in this series will be live on November 8, 2024.
In this episode, you will learn:
- The evolution and history of the 401(k) and its impact on retirement savings.
- The key differences between Roth and pre-tax 401(k) contributions and their tax implications.
- How to determine whether Roth contributions may be more beneficial based on your current and future tax situation.
- The significance of employer matching contributions and how the Secure Act 2.0 has changed matching rules for Roth accounts.
- The concept of required minimum distributions (RMDs) and the recent changes affecting Roth 401(k)s.
- The Mega Backdoor Roth strategy, allowing high earners to maximize contributions to Roth accounts beyond standard limits.
Resources:
Checklist: Should I Contribute to My Roth 401(k)? | Checklist: Can I Make a Mega Backdoor Roth Contribution? | Bautis Financial: 8 Hillside Ave, Suite LL1 Montclair, New Jersey 07042 (862) 205-5000 | Schedule an Introductory Call
Disclosure: The transcript below has been edited for clarity and content. It is not a direct transcription of the full episode, which can be listened to above.
Welcome back to The Agent of Wealth Podcast. This is your host, Marc Bautis. Today, we’re going to talk about your 401(k) and how to maximize it to set yourself up for a successful retirement.
401(k) Plans: Background and Importance
There’s about $8 trillion in 401(k) plans, and a recent Fidelity analysis concluded that there are approximately 500,000 people in the U.S. with over $1 million in their 401(k). Before we discuss how the 401(k) has become the centerpiece of many retirements, let’s take a moment to look back at how it originated.
The 401(k) was born out of a tax code change in 1978 when Congress passed the Revenue Act of ’78. This legislation included a section that allowed employees to avoid taxation on deferred compensation — specifically, Section 401(k). This provision enabled employees to defer a portion of their salary into a retirement account on a pre-tax basis, meaning the money isn’t taxed until it’s withdrawn.
With a 401(k), you receive a tax deduction upfront, and your account grows tax-deferred. Initially, the 401(k) was not intended to be the comprehensive retirement plan we know today; it began as a tax break for executives receiving bonuses or deferred compensation. Before this change, pensions were the dominant retirement plan. Following the 1978 legislation, 401(k) plans gained traction in the 1980s, becoming an attractive alternative for companies compared to traditional pensions.
With a pension, employers were obligated to ensure the funds were available for promised retirement payouts. In contrast, the 401(k) shifts that responsibility to employees, who must save adequately for their retirement. By the 1990s, 401(k) plans had become the primary retirement savings vehicle for millions of Americans, serving as a cornerstone of retirement planning. If you’re not saving in your 401(k), you’d better have a plan elsewhere; otherwise, you may face an awakening when your income stops.
Given their importance, I wanted to dedicate a podcast to this topic. I’ll break it into several episodes because there’s a lot involved in 401(k)s. Often, participants view their options too simply. You must decide whether to make pre-tax or Roth contributions, consider automatic enrollment features, think about contribution increases, and explore different options like loans. While these plans are accessible, they are also customizable for participants. Today, I want to focus on three questions I frequently receive regarding 401(k)s.
Roth vs. Pre-Tax Contributions
The first question we’ll address is: Should I make my contributions to my 401(k) as Roth contributions or pre-tax contributions? Let’s provide some background. Many people look at their 401(k) balance and see the large amount they’ve accumulated through pre-tax contributions. However, they often overlook that not all of that balance is theirs. They have a partner in their 401(k) — Uncle Sam.
If you utilize pre-tax (or traditional) 401(k) contributions, you receive a tax deduction for each contribution. For instance, if someone earns $100,000 a year and contributes $5,000 to their 401(k), they would only be taxed on $95,000 for that year. The government will eventually collect its tax when you retire and withdraw money from the 401(k) plan.
In contrast, the Roth 401(k) allows for after-tax contributions. For example, if you earn $100,000 and contribute $5,000 to a Roth 401(k), you pay taxes on the full $100,000. The benefit of the Roth 401(k) is that while you pay taxes on your contributions upfront, you do not pay taxes on withdrawals in retirement, including earnings, as long as you meet certain requirements — typically being over age 59½ and having had the account open for at least five years.
If your employer offers a match, those contributions can also go into the Roth component. The advantages of a Roth 401(k) include tax-free withdrawals in retirement and tax diversification. Many individuals initially choose pre-tax contributions for the immediate gratification of a tax deduction. However, the Roth option allows for tax diversification, helping mitigate future tax uncertainties. If tax brackets rise in the future, having a Roth means you can withdraw funds tax-free, whereas withdrawals from a pre-tax 401(k) will be taxed at whatever rate applies at that time.
Advantages and Disadvantages of Roth Contributions
There are disadvantages to Roth contributions as well. The primary downside is the lack of an immediate tax break. The rationale behind choosing pre-tax contributions is the assumption that you’ll be in a lower tax bracket upon retirement, thus allowing you to benefit from a higher tax deduction now and pay less tax in the future. However, that’s not always the case; some people find themselves in higher tax brackets during retirement.
If you believe you’ll be in a lower tax bracket now than in the future, Roth contributions may be more beneficial. For instance, if you are just starting your career, Roth contributions are advantageous since you’re likely to be in a higher tax bracket later. Conversely, if you are currently in a high tax bracket and expect to be in a lower one during retirement, pre-tax contributions might be the better choice.
Additionally, tax diversification doesn’t have to be all or nothing. You’re not locked into one type of contribution; many people split their contributions between pre-tax and Roth or alternate between the two over the years.
Understanding Matching Contributions
Now let’s discuss matching contributions. Matching occurs when your employer agrees to match a portion of your contribution. Traditionally, even if you made Roth contributions, the employer match would be directed to the pre-tax component of your 401(k) due to tax implications. However, under the Secure Act 2.0, employers can now match contributions directly to the Roth portion. It’s important to note that these Roth employer matches will be considered taxable income in the year they are made.
In terms of required minimum distributions (RMDs), this is another recent change. Previously, Roth 401(k)s were subject to RMDs, unlike Roth IRAs. Now, neither Roth IRAs nor Roth 401(k)s are subject to RMDs.
The Mega Backdoor Roth Strategy
I also want to touch on the Mega Backdoor Roth strategy. This allows investors to contribute an additional $46,000 to a Roth IRA or Roth 401(k) in 2024. This strategy is particularly useful for individuals who want to exceed standard contribution limits. Not all plans offer this feature, but at one point, it was projected that around 50% of plans would allow for it. Check with your HR department or plan sponsor to see if this is an option.
The Mega Backdoor Roth strategy involves making your maximum pre-tax contribution to the 401(k) (which is $23,000 in 2024, or $30,500 if you’re over 50). Once you reach that limit, you can make additional after-tax contributions to the 401(k). The overall limit for the year is $69,000 or $76,500 if you’re 50 or older. This includes both your contributions and any employer contributions. The final step is rolling over that after-tax contribution into a Roth IRA or converting it directly into a Roth 401(k) if your plan allows it.
This strategy is beneficial because it allows you to contribute a significant amount of money into a Roth account. Roth IRAs have income limits; for individuals earning over $161,000 or $240,000 for married couples, contributions to a Roth IRA are generally prohibited. The Mega Backdoor Roth bypasses these limits, allowing high earners to save more in a Roth.
As a reminder, the plan must permit in-service distributions or conversions to a Roth account, meaning you can make that distribution while still employed. Additionally, you must have the cash available to make the contributions.
Checklist: Can I Make a Mega Backdoor Roth Contribution?
I hope this discussion helps clarify whether to make Roth, pre-tax, or a combination of contributions. If you’d like to discuss the specifics of your situation, I’m happy to help. You can set up a free consultation at bautisfinancial.com/call.
In the next episode of this 401(k) podcast series, we’ll cover two other common questions I receive from participants:
- How much should I contribute to my 401(k)?
- How should I allocate my 401(k) funds?
Thank you to everyone who tuned into today’s episode. Don’t forget to follow The Agent of Wealth on the platform you listen from and leave us a review of the show. We are currently accepting new clients, if you’d like to schedule a 1-on-1 consultation with our advisors, please do so below.
Bautis Financial LLC is a registered investment advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.