Why High-Income Clients Should Halt Pre-Tax 401(k), IRA Contributions

Investing Strategies Retirement Investing
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{{ Taxpayers with the largest IRAs (and their beneficiaries) will be in higher tax brackets in the future. Doing nothing now is a bad plan. Tax-deferred traditional IRAs will continue to grow, and so will the tax bill that eventually comes due. The SECURE Act is a giant wake-up call to do the long-term thinking that should have been done since the beginning. }}

If you’re a successful retirement investor, you’re going to wish you had more of your money in a Roth IRA, or BRK in the taxable account.

intercst

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On the other hand, I don’t think my employer’s 401k offered anything other than post-tax contributions. And I could contribute more than I could to a ROTH, or a regular IRA. And my employer contributed to the 401k too, matching funds, that I never would have received any other way. So yes, I am in the comfortable, enviable circumstance of having enough in my IRA that there will be more taxes.

In 2009, when my employer was going to switch to a different 401k manager, I was already retired. Instead of accepting the switch I decided to take control of things. Since I was retired no new money was going into that 401k, and so no employer contributions, so there was no reason to keep it I had the 401k account converted to an IRA at the same broker where it had been, joined Motley Fool, and got started managing it all myself. Yes, 79% of my retirement money is in the IRA, pre-tax, and I couldn’t be happier because the amount is such that I never have to worry about money, and my heirs should manage alright too. Yeah, lots of taxes will be paid, but it it wasn’t for the 401k / IRA I wouldn’t have accumulated those funds in the first place.

(It worked out for me. What I have now, IRA (79%) and ROTH (21%), totals seven times what I had in 2009, despite withdrawals of 124% of what I started with. Perhaps nobody can expect to do that now, I don’t know. But I do know it was only possible because I accumulated it in the first place.)

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What most people don’t understand is that a “skim-free” investment in the S&P 500 historically grows much faster than the average worker’s wages.


Of course, many workers are poorly advised, or lose too much to a financial advisor’s fees, market timing, etc and make a lot less than the S&P 500 return. (Dalbar put the average retail stock and mutual fund investor at less than a 4% annual return during a 30-year period when the S&P 500 was delivering 10.4%.

If you’re able to follow the simple advice of Buffet and Bogle and avoid the noise, you’re very likely to be in a much higher tax bracket when you retire. Don’t make the mistake of converting a lot of compounded investment returns that could be taxed at the much lower capital gains rates into ordinary income taxed up the wazoo.

When I quit working in 1994, the Roth IRA hadn’t been established yet. So I have a lot money in an IRA that I’ve been converting via Roth conversions. If you have access to a Roth IRA, use it early in your career while you can.

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95% of 401(k) plans offer an S&P 500, total stock market or similar index fund, as an investment option. And many large 401(k)s offer these funds at even lower costs than individual investors can get them at. As an example, the lowest expense ratio an individual investor can get on VTI is 0.03% Yet, my 401(k) offered VTI to me at 0.01% because they were an institutional investor and could negotiate lower expense ratios than individuals were offered. And my 401(k) had no fees other than the expense ratios on the investments.

So claiming that 401(k)s are bad just because of the skim isn’t really valid.

AJ

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That’s not what I’m claiming (though only a small number of 401k investors find their way to a low-fee S&P 500 index fund – that’s why the average investor is getting 4% instead of 10%+.)

I’m claiming (and so is Ed Slott) that you need to realize that if you are a successful investor (i.e., someone who invests in a low-fee S&P 500 index, or is among the 4% or so of investors who equal or beat the S&P 500 by doing something else) you are very likely to be in a higher tax bracket after you retire, unlike 95% of your work colleagues.) It makes sense to max out your Roth early in your career if you can, rather than take the tax deduction of the traditional IRA. And then depending on how you’ve done, at some point, it may make sense to reduce or eliminate further contributions to a traditional 401k in favor of something like BRK in a taxable account which is taxed as capital gains.

Just an observation from someone who been riding the zero wage & salary income, lightly-taxed, qualified dividends and capital gains “grift train” for 30 years.

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Yes, when I worked for Exxon in the early 1980’s, there were no 401k fees and the funds they offered had expense ratios of 2 basis points or less. (Of course, most employees were 100% XOM stock) The other four Fortune 500 companies I job-hopped through in the 1980’s had much higher fees in their mutual fund options.

Although many people think the US Gov’t can do nothing right, the Thrift Savings Plan for Federal Employees matched Exxon’s low 401k expenses, probably beating 95% of private company 401k plans out there.

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The Roth 401(k) is a wonderful invention and I’ve been teaching my kids about that wonderful invention as they each enter the workforce. Later on, if they hit higher wages that result in higher tax rates, they can re-evaluate and THEN perhaps decide to direct some of their retirement savings to tax-deferred accounts (trad 401k/IRA) instead of to only tax-free accounts (Roth 401k, Roth IRA). As a rough (VERY rough) rule of thumb, if your current tax rate is under 25%*, use the Roth options, if your current tax rate rises above that, consider using tax-deferred options. And, of course, as usual, if you intend to live well in retirement and/or retire early, you also have to invest substantial amounts outside your retirement plans as well.

* People don’t realize how much you can earn and still be in a low-ish tax bracket. A single can have taxable income of $182k and still be in the 24% bracket. And that means, after considering the standard deduction, a single can earn $196k and still remain in the 24% bracket. That covers 98.6+% of singles out there. Married is even better, way better. A married couple with 2 kids can have a taxable income of $364k and still be in the 24% tax bracket. That’s income of well over $400k when you account for child tax credits and standard deduction. That covers 98.3+% of all married couples.

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Why would someone in the highest federal tax bracket want to pay income tax NOW on their excess income instead of delaying it until the future where it MAY be lower? It is unlikely to be higher.

That doesn’t seem to make a lot of sense - especially when those in the highest tax bracket can both retire earlier and better take advantage of Roth conversions.

This would seem to be terrible general advice. I read the linked article and it is heavy on opinion and light on facts. Additionally, it is contradictory. It recommends a person stop making contributions to a 401k by using the “preferred path” of doing Roth conversions - effectively creating even more taxable income while the person is working (keep in mind, the advise is to stop contributing to at 401k which would require earned income so this advise/action is happening simultaneously).

And, if you are a high income individual, all the lower tax brackets have already been used up!

To quote:

Take full advantage of the current 12%, 22% and 24% brackets while they are available.

They are not available!

Again, terrible advice. Sloppy.

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This is true if you know, decades down the line, that you will be in a high tax bracket when you retire. We might all aspire to this, but life intervenes. Industries disappear, life priorities change, health issues arise.

Consider two options, trad IRA or Roth, and two possible outcomes, wealthy and high tax bracket at retirement, or poor and low tax bracket at retirement

trad IRA Roth
high tax rate less $ more $
low tax rate more $ less $

So a trad IRA gives more $ if you are poor at retirement and need it, and less $ if you are rich at retirement when you don’t need it. In short, the trad IRA comes with poverty insurance.

At some point, perhaps in your 50s, when your financial trajectory becomes clearer, it may makes sense to shift to Roth. But when you are early in your career, the traditional IRA makes more sense.

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If you look at the taxes relative to the money going in, this may not be true.

  • Age 20-30 (single, later married): Tax bracket 10%, can put $1000 into Trad 401k or $900 into Roth 401k.
  • Age 30-40 (married): Tax bracket 15%, can put $1000 into Trad 401k or $850 into Roth 401k.
  • Age 40-50 (married): Tax bracket 25%, can put $1000 into Trad 401k or $750 into Roth 401k.
  • Age 50-65 (married): Tax bracket 35%, can put $1000 into Trad 401k or $650 into Roth 401k.
  • Retirement (married): Tax bracket ~15-20%, start withdrawing strategically. Maybe even do some Roth conversions if it makes sense.
  • Retirement (single, after death of spouse): Tax bracket 25+% most likely. And worse, a whole bunch of the income is likely in the higher bracket, not just a small amount at the end.

Seems to me that it is quite a bit better to do the Roth contributions early on while in the lower tax brackets (because wages are lower), and then do the Traditional contributions later on when the tax reduction is more meaningful (after you have more experience and earn more and are in a higher tax bracket). Furthermore, much later on, when you retire, even if you are in a 25% tax bracket, your early Roth contributions that cost you 10% or 15% in taxes are worth A LOT more. They’ve grown tax free for 30+ years, AND you got to pay a lower tax rate on all of it 30+ years earlier!

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Since for the vast majority of the workforce, the return on the S&P 500 is going to be much higher than their wage & salary income growth, if you’re able to save and invest money early in your career, it almost guarantees that you’ll be in a higher bracket when you retire.

I quit working 30 years ago, and I’ll be in a higher tax bracket when the RMDs start in 5 years at age 73. Imagine if I worked to age 65?

intercst

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I find that factually suspect and likely false.

While the premise is likely correct, the conclusion is very likely not. The “vast majority” are not going to be saving anywhere near the income needed to have their retirement income exceeding their best earning years. It is a simple fact that the overwhelming majority of retirees are in a lower tax bracket in retirement.

https://taxsim.nber.org/byage/

Your anecodotal experience is not evidence to the contrary.

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It’s not anecodotal [sic] evidence, just arithmetic. But I agree that the vast majority of Americans are not able to make the arithmetic work for them rather than against them.

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This is absolutely true. But this discussion isn’t relevant to the “vast majority”, it is only relevant to us, the people who save much more than average, the people who tend to retire better and earlier than average, and are thus more concerned about taxes, among other things that reduce our net income (like fees, etc), than average. Heck, the very title of the post even has “High-Income” in it!

That said, even average people, perhaps with slightly above average retirement savings, will eventually face potentially higher tax rates in retirement … after their spouse dies. I’ve seen it up close, and it is very jarring for the surviving spouse to see how much more taxes they suddenly owe each year, especially if the surviving spouse is the one with the higher pension and/or social security!

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One the other hand, owing a lot of taxes is kind of a first world problem, especially if the surviving spouse is still occupying a grand home much bigger than she needs.

I was talking to my brother yesterday and he was saying that one of our friends from high school (a very successful personal injury attorney) was moving out of his grand home overlooking a lake and transferring it to his son who is also a partner at the law firm. He and his wife will move to a smaller home down the street better suited for retirees. I said, “That’s fantastic. They’re completely eliminating the real estate skim from the transaction”

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Maybe. 'Transferring it to his son" rather than having his son buy the property at a fair market price means that the son gets his basis in the property. By avoiding a sale, he gives up the ability to use $250k/$500 capital gains exemption.

And that doesn’t even look at the step up basis that would have occurred if the son had inherited it.

So a lot of skim in taxes seems to have been added to this property.

AJ

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They’re both attorneys. And one has a current interest in getting out of a large home into a smaller home, and the other the reverse. I’m sure they’ll figure out how to structure the transaction in the most cost efficient manner between them. I don’t see how adding a real estate agent to the mix is any benefit to them.

Come to think of it. I remember that he told me to make sure that I acquired my current home through a revocable trust to avoid probate. I was going to do that anyway, but it was good to have legal advice that that was a good idea. Perhaps his home it’s titled in the same kind of trust with his son as beneficiary? Could he get away with letting the son live there rent free until his demise? The value of that would be well within the limits of the $13.6 MM lifetime gift tax exemption. I’m sure they’ll figure it it.

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It is relevant when the prior poster is making a claim regarding the vast majority. :slight_smile:

And if we are using anecdotal experience as evidence, then I will use someone I know that has a household income of $400k in their late 40s/early 50s. To replace that taxable income with a SWR of 4% would require $10,000,000 saved in a 401k or other tax sheltered vehicle.

That couple would have needed to save over $30k a year (at 8% ROI) for the last 30 years in such an account - even when they were not making any where near $400k a year.

Again, I refer you to the premise of the OP - that someone that is already in a high income tax bracket would somehow find themselves in an even higher tax bracket in retirement because of their tax deferred savings. That just isn’t very likely - especially when someone may already be in the top bracket.

Take that same couple I referenced. If they were lucky enough to have saved $10,000,000 in their early 50s, they could easily retire and take advantage of roth conversions for the next 20 years. They have enough wealth to get proper tax planning. They are very unlikely to ever have taxable income in excess of their current $400k a year.

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Depending on your state, you can add TOD to the title of the property to achieve the same probate avoidance without the cost of a trust.

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Yes, if you want to retire early and you need $10M invested to produce enough [safe] income for what you need, then you will indeed need to save quite a lot over 30 years. That’s not a major revelation to people who have discussed this topic for decades (almost 3 decades now!) Heck, in general a 10% savings rate is nowhere near enough ($40k on a $400k income), usually a 20% savings rate is the minimum when considering early retirement, so that would be saving about $80k of a $400k income. Obviously, this is for typical cases, normal saving, normal investing, maybe 7-10% a year gains, it doesn’t refer to “lucky” folks, like those who happen to work for Nvidia (or similar) for 5-10 years and have been granted stock and options that are now worth many millions over just a few short years.

As I mentioned earlier (I think in this thread), $400k income for MFJ+2 kids doesn’t have a particularly high tax bracket today at 24%. I think there is quite a good chance that in retirement their bracket could be higher in many years, and it will almost surely be higher once one spouse dies (and even if not higher per se, much more of the single’s income will be taxed at the marginal rate, than what their joint income was taxed at before the death of one spouse).

I don’t think this is true. There will definitely be years in which they have higher taxable income. For example:

  • The year they sell their house (for $2M that they bought it for $300k twenty five years ago). Total income = $250k from investments + ($2M - $300k basis - $200k improvements - $500k exemption) = $1.3M income that year.
  • The first year after retirement, when the 6 month time period has elapsed and they have to dispose of all the stock options they’ve earned over the last 10 years (and held because their company stock price was steadily increasing). Total income = $250k from investments + $1.2M option exercise (all ordinary income) = $1.45M income that year.
  • Six years later, one of the stocks they hold in their taxable account has shot up by 10X and is now 75% of their account. They are strongly urged to diversify, so they sell 80% of it resulting in a long-term capital gain that year of about $1M. At least that is taxed at only 23.8%, but it pushes up ALL their other ordinary income (pensions, social security, interest, non-qual divs, etc) into the highest tax bracket.
  • Fifteen years later, they are getting older, and they realize that an entire year has passed and they haven’t used their second home by the lake, they just don’t have the energy to pack up and set up home there anymore. So they decide to sell it. They sell it for $750k, the basis is tiny because they bought it way back after a big financial housing crisis for only $135k. Income that year = $300k from investments + $38k from social security + $19k from spouse social security + $25k from pension + ($750k - $135k - 50k improvements) = $947k that year. In very high tax bracket.

So there will be some years with a higher tax bracket. And then suddenly 18 years in, one spouse dies. BOOM, almost all that income, and since most of it is derived from investments it remains, is taxed at higher rates, and you are permanently in a higher tax bracket (unless you get remarried, of course). Therefore, this couple is VERY likely to be in a higher tax bracket for quite a few of the years after retirement.

(And I didn’t even mention that there could easily be various changes in tax law over that period of time that could increase their tax bracket.)

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