Show Notes

• (00:49) SECURE Act 2.0 401(k) Employer Match Explained for Mere Mortals
• (06:47) Roth Conversions When Company Fails Non-Discrimination Testing for HCEs (Nick)
• (12:49) Mega Backdoor Roth Vs. Employee Stock Purchase Plan (Mitch, Indiana)
• (17:54) Retirement Spitball: We’re 37. Will We Have Enough to Retire at 60 and 65? (Brandon)
• (25:08) Spitball My Tax Arbitrage Plan (Mike, California-Nevada)
• (33:34) FIRE Retirement Spitball: Are We Screwing Up and Creating a Huge Future Tax Bill? (Brent the Fan, Bennington, NE)
• (41:58) The Derails

Free financial resources:

WATCH | The SECURE Act 2.0: Major Changes to Retirement Savings and Tax Planning

READ THE BLOG | 2022: The Year in Review

READ THE BLOG | Should You Still Diversify?

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Transcription

Today on Your Money, Your Wealth® podcast 415, with the new SECURE Act 2.0 rules regarding retirement savings contributions, should your company match go into the traditional or Roth 401(k)? Joe and Big Al also discuss whether you can or should do Roth conversions when your company fails non-discrimination testing for highly compensated employees, the mega backdoor Roth vs. the employee stock purchase plan, and they spitball a tax arbitrage strategy. Plus, a retirement spitball for a 37 year old couple wanting to retire in their 60s, and another couple wanting to FIRE – financial independence, retire early – but are they screwing up and creating a huge future tax bill? I’m producer Andi Last, and here are the hosts of Your Money, Your Wealth®, Joe Anderson, CFP® and Big Al Clopine, CPA.

SECURE Act 2.0 401(k) Employer Match Explained for Mere Mortals

Joe: “Joe and Big Al, thank you for continuing to make my walks along the mighty Mississippi enjoyable, and educational. I drive a 2015 Toyota Sequoia. Have no pets, and I’m single. Surly Brewing Company, Hell Lager. And Controlled Chaos West Coast IPA are the local brews on rotation in my basement fridge.”

Al: Ooh now that’s getting interesting.

Joe: All right, little basement fridge. Midwest guy. “Curious to hear your take on a particular aspect of the SECURE 2.0 Act related to the 401(k) employer match. It’s my understanding that under the SECURE 2.0 Act and effective in 2023, individuals can choose to have employer matching contributions directed to their Roth workplace accounts. It is also my understanding these matching contributions will be considered taxable income in the year of the contribution and at the employee’s current tax rate. Questions. Should an employee have the company match placed in the Roth 401(k) versus traditional 401(k) portion regardless of the employee’s current tax bracket? Any scenario in that an employee should not have the employer match portion directed to the Roth workplace account? May I suggest you dedicate a few shows to enlighten us mere mortals about the nuances of the SECURE 2.0 Act and how it might affect an individual’s personal finance situation?
Andi, continued success in keeping Joe and Big Al real and in check. Thank you again for the awesome spitball insights. Cheers.” A few shows Al, not just one.

Al: Right. So you want to do a few shows on that?

Joe: No. I think we did like a segment.

Al: We could- you know what? You could read Michael Kitces, 30 page summary-

Joe: 30 page. Did that release yet, our-?

Andi: Yeah, there’s a webinar and a white paper available on PureFinancial.com that’s got all the details about the SECURE Act. Well, not all of them, because it’s huge. There’s a lot of the major details are covered on our website. So you can find that in the learning section.

Al: Yeah, you put that in the show notes too, right?

Andi: Yep, absolutely.

Joe: We’re doing a TV show on that soon as well. But-

Andi: Yeah, yeah, you will be doing a few shows.

Al: I guess we already have.

Joe: I guess to answer his question, no, you still want to take a look at your tax bracket. Because it’s going to be taxed as income to you.

Al: That’s right.

Joe: If you take the Roth portion, but yeah, I would say in most cases. But it’s going to be 3 years before most employers figure this stuff out where you’re going to be even able to use the Roth match component.

Al: Yeah, so let’s back up one second. So you have a 401(k) and typically your employer offers some kind of match. Maybe first 3% of your salary, right? They match 3% blah, blah, blah, blah. As long as you’re contributing, okay? So, and in the past, it’s always been a pre-tax contribution, meaning that when you withdraw that money later on, it’s fully taxable, right? So now what the SECURE 2.0 Acts says is, you know what? You can elect to have your employer match, right, or profit share, whatever you want to call it. You could put- you could put that into the Roth, which is great, except that you have to include that as income. So I think here’s how I would think about it. If you would normally do a Roth conversion in this tax year because of your tax brackets, then this is a great idea. If you would not do a Roth conversion, then don’t do it. It’s the same thing. It’s the same exact thing.

Joe: Right. You know, the reason why they didn’t do this before is that employers got a tax deduction for putting the money into the match. So you’re an employee of mine. I’m going to match you a couple of blocks. So maybe I put $5000 or $2000 into the 401(k). I can write that off on my corporate tax return. And then people kind of got, wow, I want to Roth portion of the match. Okay, I’ll give you the Roth portion of the match, but I’m going to include this as income. So you’re going to pay taxes on it.

Al: Yeah, that’s right.

Joe: And so now it’s going to show up on your W2.

Al: Even though you didn’t get it.

Joe: Even though you didn’t get it. So you’re going to have a higher taxable income and it could push you up into a higher tax bracket, potentially. So you just want to be smart with it.

Al: And also realize, Joe what you said right off the bat. So the SECURE Act 2.0 was passed on December 23rd, 2022, 8 days before the year-end for the 1st, right? So do you think companies had enough time during Christmas week to figure all this out? The answer is no, very few companies have this right now.

Joe: I don’t think most companies will have this by the end of the year.

Al: I would tend to agree with you. So I think it’s a little bit of a moot point right now. But to me, it’s like if a Roth conversion makes sense for you, this is the same taxation, right? Because basically you’re getting money into Roth and having to pay tax on it. It’s the same concept as a Roth conversion.

Joe: Right, right, right, right. All right. So there you have that. And then stay tuned. We have more SECURE Act 2.0 stuff coming your way.

Go to the podcast show notes to watch the webinar, download the SECURE Act 2.0 Guide, and to subscribe to the Your Money, Your Wealth YouTube channel and newsletter, so you’ll be among the first to know when that episode of YMYW TV all about SECURE 2.0 airs. You’ll also find other free financial resources, like our latest blog posts on 2022 in review, and whether or not your should still diversify your investment portfolio, right in the podcast show notes as well. Click the link in the description of today’s episode in your favorite podcast app to get there. And do us a favor and share the free resources with your friends and colleagues.

Roth Conversions When Company Fails Non-Discrimination Testing for HCEs (Nick)

Joe: Answering some interesting questions here today. We got Nick, writes in. He goes, “Hello, and happy new year Andi, Joe, Big Al. Hope all is well. This is Nick from Ohio, loyal listener of the show. I’m 48 years old, driving a Jeep Grand Cherokee. And my wife and I have Keegan, an Irish Setter at home. See the picture.” Oh, very nice.

Al: Yeah. That is one cute dog. I got to say.

Joe: “My wife has access to additional after-tax bucket in her 401(k) plan. Her summary plan description describes how she can add dollars to the after-tax bucket and also convert those dollars to a Roth account internal of her plan. This is all great news on paper.” Oh boy. This guy actually reads the plan document.

Al: That’s pretty good.

Joe: “However, her company suggests for her not to do it and limits her dollar amount because they fail the ACP ADP nondiscriminatory testing every year- Nondiscrimination. So even though she’s allowed to add dollars to the after-tax bucket and convert to Roth internally, she has been held back by her plan’s fiduciary. Question. If the after-tax savings bucket was allowed to be converted to a different external institution out of the plan, not internal, will those dollars still be added to the non-discrimination testing total?” Yeah, I believe so. “Since the dollars will literally be gone at different institutions, so no dollars in the after-tax bucket when they complete the test, would those dollars be omitted from the test? This would definitely be a suggestion she could take to them if you think it would help. Thanks again for all your time and everything you do. Love the show. Peace, Nick.” Okay.
Let me see if I understand this question and I’ll have you answer it, Al.

Al: Okay.

Joe: So it appears she works probably for a small company. And so what happens with the after-tax or you know the mega- mega back door, the garage door, the barn door, the megatron. When people can put an after-tax dollars into their 401(k) plan up to right now, I think the defined contribution limits are $56,000, give or take.

Al: Yeah, it’s actually $66,000 with the catchup, but if you take away the $7500, it’s about what $59,500ish, $58,500, something like that.

Joe: So $60,000, he’s 48, so they can put $60,000 into a defined contribution plan. And so the first part of that contribution is just going to be in the normal 401(k) and then everything else can go into the plan after-tax up to that limit. And then you can convert those dollars because they’re after-tax into a Roth IRA.
That is known as the megatron or the big bad garage door. Backdoor Roth, right?

Al: Yes. That’s correct.

Joe: Okay, but if you work for a small company, there’s these testings that the company has to do to see if you could do that. So Al and I work for a small company. And so they’ll look and say, all right, well, can we do after-tax contributions to that limit? Because all the big companies have that. You know, the Qualcomm’s of the world, right? The larger organizations because they have so many participants in that plan, it will pass the testing. But as you have smaller employees or participants, and then you have highly compensated people, then you have the rank and file, then you have this, and you have part time yeah, blah, blah, blah, blah, blah, blah blah. So they do these testings within the overall plan to make it compliant. And so the fiduciary or the plan administrator of this plan is saying, yeah, that is the law, but you can’t do it in this plan because it doesn’t pass the smell test. And so what he’s doing is like, okay, well, I don’t care if it’s passes the smell test or not, I’m going to have my wife put the money into the plan and we’ll convert it out. We’re going to get the money out of that plan before they even can look at it or before the testing’s even done. I think that is a fine idea, but it doesn’t pass the smell test to me.

Al: Yeah, I don’t think it works either. And I will say we are not pension actuaries-

Joe: – or attorneys or anyone close to that.

Al: Correct. But in my understanding, these top-heavy testing that certain 401(k) plans have is based upon the benefit paid, not where the money ends up. So I really- my strong thought about this is, no, this doesn’t work. It’s the benefit paid. And the reason they have this rule is because they don’t want companies to have all the 401(k) dollars or most of them go to the highest paid people. They want it to be spread out. And so if only the highest paid people have big 401(k) contributions, then they’ve got to put some back, right? And so that’s what’s going on here. The other thing I’ll quickly mention is if your company has a safe harbor 401(k), you don’t have to worry about this because you don’t have to do this testing. It’s a safe harbor. But this particular plan is probably not a safe harbor. So I don’t think this is going to work.

Joe: Right. And the reason for that real quick is that Al’s in the 37% tax bracket and I’m in the 12% tax bracket, right? And Al gets a lot more tax savings for his buck because he’s getting $.37 out the dollar- of every dollar he puts in while I only get $.12. So they’re like, okay, well, we don’t want these plans really to tilt more towards a highly compensated. We wanted to have it a little bit more even. So that’s where these testings come from, I think. We’re talking out of our league here Al, but I think we’re pretty close.

Al: I think we’re close on this one.

Joe: All right. Thanks for the question.

Mega Backdoor Roth Vs. Employee Stock Purchase Plan (Mitch, Indiana)

Joe: Got Mitch from Indiana writes in. He goes, “Hey Joe, Big Al, Andi. Love the show. And listen while commuting or hiking. Drive a 2022 Ford Explorer and drink of choice is Miller Lite or bourbon on the rocks.”

Andi: Man, YMYW listeners are all bourbon drinkers. It’s very interesting.

Joe: Wow. So good. As soon as it touches as your lips. “My question is, I fully fund my 401(k) and my plan allows for after-tax contributions that I can convert to a Roth IRA once per year. AKA, the airplane hanger, mega back door Roth – Here we go.

Al: That’s a new one.

Joe: Yeah, I like it. “My company also offers the stock purchase plan that gives me a 15% discount on stock purchases with a max of $25,000 to contributions per year. So far, I have only done the mega backdoor Roth, AKA garage door airplane hangar mega back door. Should I divert some funds away from the after-tax contributions and participate in the company stock offering or simply stick to what I’m doing? I cannot afford to max out both. I believe the total 401(k) contributions for 2022 is $61,000. Should I back off the mega? I like not being so concentrated in one single stock with a mega back door. And I also know- and also like knowing that all the earnings will be tax-free for life with the Roth. But I do not get a discount like I would with the company stock purchase plan. Would love for you to give me a spitball on this. Thanks. Can you make an add onto my comment?” Oh.

Andi: He sent a follow-up email.

Joe: Oh, got it. “I’m 45 years old, married. And I fully fund a family HSA plan. I’m also in the 24% tax bracket. Mitch.” Okay, thanks, Mitch. I would just keep mega mega big- mega back door.

Al: I know you would. I would too. With one exception. And that is if I felt like my company had just an amazing track record that was about to launch into something great. Yeah, I would probably go for that. But otherwise, if I felt like our company, my company was roughly similar to the market, that- it’s too much risk. I’d rather get the money to the Roth IRA and have a globally diversified fund. That’s how I would think about it.

Joe: Yeah, me too. You know, you can’t beat compound tax-free for life.

Al: Yeah. I agree.

Joe: You’re going to get a 15% discount that’s great, but then there’s restrictions on when you can sell and then you’re going to get capital gain treatment. It’s outside. It’s in a taxable account so depending on how you manage it. I mean, is it high dividend paying stock? Dividends come out, you pay taxes on. Where you could buy the stock potentially in the Roth, but you’re not going to get it at that 15% discount. But I would imagine at a 15% discount, it’s probably a Fortune 500 company, so it’s not- the biggest bang for your buck is going to be a small startup.

Al: Yeah, right, that’s going the right direction.

Joe: Right. You know, that has a market cap of $2,000,000.

Al: Yeah. And it’s going to be $1,000,000,000.

Joe: Yeah, it’s going to be a $20,000,000,000 market cap.

Al: That I would buy as much stock as you can.

Joe: Then you load up. Then you go all in. But if it’s a big giant company, it’s probably giving S&P 500 type returns. Yeah, you get it at a little bit of a discount, but yeah, you’re going to load up and we’ve talked about this before. It’s like, okay, well, your income is tied to that company. Now you load up with that stock is going to be tied to that company. You know, do you have a pension that’s tied to that company and everything else? For me, I like the diversity. I like tax-free for life. And yeah, maybe as he gets raises or, some extra capital comes in, then take advantage of both. Another thing to consider too, if you have non-qualified dollars or monies that are sitting outside of retirement accounts, all of this goes through paychecks, right? Or payroll, right? If he’s going to do the mega back door, and so it’s like, okay, well, I can’t necessarily afford to fully fund the 401(k) plan because, I got to live off of my paycheck. But if he does have some non-qualified money, he might want to sell some of that, put that into cash and live off of that while he fully funds both plans. So it’s just another way to get money into the stock plan or more money to get into the 401(k) plan is by using the other capital to live off of versus your paycheck. And then you would just maybe potentially he has no money coming in from his paycheck, but he would live on his- monthly living expenses on other capital.

Al: Yeah. That’s a great idea, Joe. Because a lot of people don’t realize you can basically get your salary- your net salary down to almost nothing. As long as you have other sources to live off of, and then you could potentially accomplish both. And all you’ve really done by doing that is taking money that would have been in a non-qualified account, getting it through the mega backdoor Roth and then getting into a Roth IRA. So I like that idea.

Retirement Spitball: We’re 37. Will We Have Enough to Retire at 60 and 65? (Brandon)

Joe: “Hi, my name is Brandon. I have a wife and 3 kids. We are 37 and plan to retire at 60- I plan to retire at 60. The wife at 65. I’m an electrician, and she’s a teacher. We currently make about a $100,000 a year and assume that stays the same. We have $67,000 combined in two Roth IRAs and $27,000 in a taxable account. We are bare minimum maxing both Roths yearly at $13,000 a year. We bring home $72,000 a year after taxes and spend about $50,000 to $55,000 a year outside of our investing. She will have a pension of 75% of her income. I believe paying out $30,000 to $35,000 a year in Social Security will give us another $2026 a month if I draw early. My question is, will that be enough? I do love to travel and our house will be paid for-”

Andi: -at 50, age 50.

Joe: “-age 50.” He’s 37. He wants to retire 60. Man, this guy’s a planner, huh?

Al: Yeah, he wants the house paid off and save all that extra money.

Joe: Yeah. Were you doing retirement planning on your- were you doing the little financial summit with Annie at 37?

Al: No. I was getting by with two kids.

Joe: Yeah, this guy’s got 3 kids. He’s banging out some Roths. He’s got some money saved. He’s got the spreadsheets going. And then he’s listening to us.

Al: Yeah. I like it. Very good.

Joe: 37. That was just a few years ago. I was pounding Bourbon.

Al: Plus a few.

Joe: Yeah. “My question will be, is this enough? I’d love to travel and our house will be paid off at 50 and may use that money as travel money. I drive a 2003 Tundra and the drink of choice is-“

Andi: Supposed to be Dos Equis.

Joe: Fos Equis-

Al: Fos Equis.

Joe: Fos Equis. What do you think that was spell check?

Andi: I think that’s a typo, yes.

Al: Well, since the second one is Margarita. That would make sense.

Joe: “Thank you for all you do. Sorry, if I sent twice- bad reception.” Does he have enough, Al?

Al: Can he retire at that age? We probably need a little more information. But I mean, on the surface, I like Brandon, where you’re going. I mean, so let’s just say your wife brings in $30,000 to $35,000. We’ll call that $35,000, pension $2000 to $2600 we’ll go kind of on the lower end. Let’s say $25,000. So that’s about $60,000 available. Presumably, let’s see, they’re living- would you sort of surmise, Joe, they bring home $72,000 a year after taxes-?

Joe: He says he’s spending about $50,000 to $55,000.

Al: Yeah, okay. Okay, good. I missed that somehow, but yeah, okay, because the $13,000 a year comes out of the $72,000. Okay. Okay. Well, in terms of current dollars, that seems fine. Of course, it all depends upon inflation.

Joe: So I ran this out. Let’s say 3.5% inflation. Let’s say over 20 years, it’s about a $110,000. He’s going to have- what- this is at 62, he said? $2600 a month?

Al: Well, he’ll retire at 60, and she at 65.

Joe: Okay. But is that $2000? That’s probably-

Andi: Yeah. He says ‘$2026 a month if I draw early’. So that might be 62 and 65.

Al: Or it could just be 62 and he’s kind of guessing.

Joe: So I don’t know. Let’s say he needs $50,000 shortfall, right? If I just take his Social Security at $2000 and her income at $30,000, $110,000 is $50,000 today, inflated 20 years at 3.5% inflation. So that’s the living expense number. His fixed income is going to be her pension at $35,000 plus Social Security of $24,000. So I’m just rounding here back in the envelope. Let’s say they’re short $50,000. Are we good with that? Good enough?

Al: Yeah, but one comment. The pensions, Social Security will be indexed with inflation too.

Joe: Exactly. That’s what I mean. Yeah. But so he needs $1,000,000, a little over a million, $1,300,000. So if he’s already got $67,0000, he’s got about a $100,000 saved and he’s saving $13,000 a year. So let’s say he’s got 25 years. Say he gets 7% on the money. At $13,000 per year, he’s going to have $1,400,000 dollars.

Al: There you go.

Joe: So you’re really close, right? So what the amount of money that he has- and depends on a couple of things, right? These are all assumptions. So let’s say inflation does 3.5% and you get 7% on your money and you continue to save the $13,000 a year for the next 25 years. You’re going to be really, really close. So I think you keep doing what you’re doing, but then just make sure that you monitor this stuff. You take a look at it on an ongoing basis, which I think he does is if he’s already doing this type of planning today. Because things change, you just want to stay on top of it. Some years you might have to save a little bit more because you didn’t get the returns that you thought in the overall market. So you can make up for it that way. Maybe inflation goes sky high like we’ve had now. Whatever. Just keep it steady, keep it simple, and you know the things that you can control is how much you diversify, how much that you save and the cost that you’re paying within the overall funds that you have, right? And then you’re disciplined. So if you just kind of keep on track with that, I think he’s got the right plan.

Al: Yeah, and I’ll just say, one thing, and that is if inflation for your expenses is the same as the inflation increases on Social Security and pension, you’re fine. Because we just calculated that to be $60,000 and you’re spending $55,000, right? So we don’t know. We don’t have enough information, but even the way you did it, Joe, which is conservative, take that as a fixed number? Yeah, I think it looks pretty good.

Joe: All right, keep up the good work, Brandon. Thanks for the email.

Now it’s your turn: click the link in the description of today’s episode in your favorite podcast app to go to the show notes, then click Ask Joe & Al On Air to get a retirement spitball analysis of your own. At the moment 43% of the folks who listen to YMYW aren’t actually following the show, so if that’s you, follow Your Money Your Wealth in your favorite podcast app so you’ll know when Joe and Big Al answer your question. Chris in Scottsdale, Don in Virginia, Rich in NYC, Jeff in San Diego, Sharon, G in Philly, and Jim in Santa Cruz, listen to next week’s episode of YMYW for answers to your questions. The fellas will cover set it and forget it brokerage investments for a 30-something investors, real estate as a substitute for bonds in a diversified portfolio, choosing between state pension options, which funds to use to bridge the gap until claiming Social Security, spousal Social Security claiming strategies, and whether or not you have to register for Medicare if you aren’t going to use it. 

Spitball My Tax Arbitrage Plan (Mike, California-Nevada)

Joe: We got Mike from California/Nevada. “Hello, Joe, Big Al, and the boss lady, Andi.”

Andi: Boss lady, all right then.

Joe: “Love the podcast. Informative and very entertaining. I was hoping you’d spitball my tax arbitrage.” Big words.

Al: Yeah. I like it.

Andi: And you know that one.

Joe: Yeah, a little arbitrage. Very entertaining, Alan. Very.

Al: Yes.

Joe: “Both my wife and I are 63, planning to retire at 67, gross income of a $150,000, which is significantly due- which is up significantly due to recent promotions. We are doing 10%/15% Roth contributions to our 401(k)s. But we are considering upping the contributions to 20% pre-tax. Our employers match a 4% and 5%. Here is my thought process. We have recently moved to Nevada where my wife took a nice higher paying job. I still work in California slaving away as a chef.” All right, chef, I wonder what he’s cooking up.

Al: Yeah. Probably something good. I gotta say.

Joe: Well, he’s calling himself a chef instead of like a line cook.

Al: Right, yeah. So he’s got to be good.

Joe: “We anticipate that we will be Nevada residents when we retire. As I see it, there’s no point in paying California 8% marginal tax rate on my 401(k) contributions when I can pull them out or convert them at the 0% state tax. Also, I anticipate we will be in the 12% federal tax bracket when retired, possibly 15% if the 2017 tax law reverts to prior tax brackets. Our total retirement savings is about a $1,000,000 pre-tax IRAs, 401(k)s, plus a $100,000 in Roth IRAs. And another $200,000 in a taxable brokerage account, which I plan to add to our existing Roth IRAs up to the limits. Seems like a no brainer to me. But figure I better get another set of eyes on this as I’ve been spending my time roasting, grilling, sauteeing, and stewing, not finance. Our RMDs don’t look to be massive. And we could still do some Roth converting if it made sense between 67 and the new RMD age of 73. She rolls in an inherited 2016 Subaru. And I drive a 2019 Ram 4X4 to the golf course and any body of water that holds fish.” Any body of water that holds fish? 4X4? A little fisherman, a little golfer. Drink of choice- Here it is- A little Sierra Nevada pale ale. And a stiff gin and tonic. Thanks for the show, Mike.” Sierra Nevada pale ale. Never really cared for that beer.

Al: You know, it’s funny you would say that. I actually never cared for that either. I do like the Sierra Nevada hazy IPA, but I’ve not required a taste for this one.

Joe: Like I said, I could go for a stiff gin and tonic right about now.

Andi: Joe, your tastes are skewing more hard liquor, the longer we do this show.

Joe: I know.

Al: Yeah, it’s terrible.

Joe: Just bringing me to-

Al: Maybe you should-

Joe: -bringing me to the depths of darkness.

Al: People should tell us their favorite nonalcoholic drink. And then it’ll get you in a better place of- frame of mind.

Joe: No.

Andi: Joe’s gonna have everybody drinking Sunkist and gin and tonics.

Joe: Oh. Okay. What do you think here, Big Al? So he’s a California resident, but what- are they? So they moved. He said they moved to Nevada.

Al: Well, he’s saying, yeah, ‘we recently moved’.

Andi: She moved, he’s still in California at the moment.

Al: Well, it says, ‘we recently moved to Nevada, where my wife took a higher paying job. I still to work in California’. So they have a split return, right? They have California for his income, probably, because the employer is in California, and that’s essentially where he works. And her income is Nevada. So I guess one of the questions is if they do a Roth conversion, what happens?

Joe: He doesn’t even want to do contributions. He’s like if I do Roth contributions in my 401(k) plan, it’s after-tax. So I’m going to pay federal tax in the state of California. I’m going to move eventually to Nevada where there’s no state tax. So does it make sense? And then you know I could take the money out tax-free or convert it state tax-free.

Al: Yeah, it could be. And he’s going to retire at 67 and the new RMD age is 73. So he would have call it 6 years to convert. So yeah, he could do that. He may actually rather convert some of his regular IRA at that same time. So this would preclude doing- it would be at least a little bit less of that that he can do and still stay in the same brackets? But I mean, Joe, I think that’s probably a fine idea. I mean, we’re talking just about contributions part, and when he’s in Nevada, doesn’t have to pay the state tax by converting. So I’m okay with that.

Joe: I think Mike is, yeah, he’s got to get out of the kitchen here. I think he’s splitting hairs.

Al: Well, true.

Joe: What he’s missing is -so it’s 8% on whatever contribution. So if he fully funds this thing, it’s $2000. But what he’s missing is this, is that you get the compounding of tax-free growth. It’s going to far outweigh any tax savings today in my opinion. So he’s got- So would you rather have $800 in a Roth IRA or would you rather have a $1000 in a 401(k)? I don’t know. I would rather have $800 in a Roth IRA because it’s going to compound tax-free and I’m going to get a 100% of that money out federal and state tax-free once I take distributions and that $800 today is going to grow compounding for the next 5, 6, 7, 10 years. So I’ll never ever have to worry about taxes again. It takes the uncertainty of taxes off the table, right? So I get it. He’s going to move to a state that doesn’t have state taxes. So maybe you don’t do large conversions, but I would still absolutely contribute. He’s in the 12% tax bracket today.

Al: Yeah, so there’s not much benefit. So I would- so I’m going to disagree just a little bit because the compounding part happens both on regular 401(k) and Roth 401(k), they just go up in the same percentage. And when you take the money out, if you’re in a lower tax bracket because you don’t have to pay state tax. In theory, you’ll actually do better having it in the taxable 401(k). But now going back to your thought, you get it done. You don’t think about it. You don’t even miss paying the tax. The market is lower than it was. You’re getting stocks, perhaps at a discount. Maybe it is a good time to do that.

Joe: I guess that’s a pretty good point there too. Yeah. I don’t know. Yeah, I think he could go either way. But I think once he gets to 67, a lot of things could change too.

Al: I know. Right.

Joe: So there you go. Two different opinions. I would say I would continue to do the Roth contributions.

Al: But I would say if the 401(k) regular contributions are saving money in the 12% bracket, well skip that. Put it into the Roth.

Joe: Well, what did he say his income was $150,000 or $110,000?

Al: Oh yeah.

Joe: Gross income of $150,000.

Al: Yeah. So he’s probably in the 22% bracket then.

Joe: Yeah, but not much, right? You got the standard deduction and then you got- he’s right there. Maybe what, $20,000, $15,000 is in the 22%?

Al: Sure. Yeah. So if you want to- if you want to reduce the 22% bracket, then you could do some regular 401(k), some Roth 401(k).

Joe: Yeah, so then you would look at brackets. This is, I think, from a federal standpoint, I would look at the brackets and say, do we fully fund the 401(k)s to keep us out of the 22% because he said he’s going to be in the 12% or 15% in retirement. Well, then you don’t do Roth at all, then you fully fund the 401(k) plan to keep you- then you save at the 22%. And then you pull the money on it at 12% or 15%. That’s the arbitrage. But I don’t know, I wouldn’t trip over dollars to pick up pennies on the state tax on the contributions standpoint. But if he was going to do a lot larger conversions, then yes, of course, you want to hold off. So I guess it kind of changed my mind there.

Al: And well, plus, let’s say he’s paying 22% tax plus California 8%. So he’s paying 30%, right? Which is a better deduction than later on when he could convert into 12%.

Joe: Yeah, and then he’s saying we’re going to have a $1,000,000 and then so when we take it out, it’s going to be with- now I’m getting a couple of people mixed-

Al: I think we gave him some good ideas.

FIRE Retirement Spitball: Are We Screwing Up and Creating a Huge Future Tax Bill? (Brent the Fan, Bennington, NE)

Joe: We got Brent the Fan. From Bennington-

Andi: Nebraska.

Joe: New England? Nebraska.

Andi: Brent has emailed us before in the last couple of weeks, but he didn’t call himself Brent the Fan.

Joe: Brent the Fan.

Al: Okay. Cool.

Joe: Brent the Fan. Bennington, Nebraska, Bennington. “Hey guys, can you spitball for me?” Damn right Brent the Fan we can. “My wife and I are 35 years old, one 2yo daughter. We spend about $90,000 a year. I make $500,000 a year. My wife makes $100,000 a year.” You add that two together Al, that’s a pretty big number.

Al: That’s a big number.

Joe: $600,000.

Al: Good for you.

Joe: “I am a 1099 while she is a W2.” Is that how you refer yourself?
I’m a 1099.

Al: And she’s a W2.

Joe: You go to a little cocktail party? What are you? W2? I’m a 1099. What’s up?

Al: Is that what you do first question? At a cocktail party? You a 1099?

Jode: You a 1099? You kind of look like a 1099er.

Al: That’s kind of risky behavior. W2, kind of more steady, slow as she goes.

Joe: I don’t know. “We are savers. FIRE people.” Oh boy.

Al: Financial Independence Retire Early.

Joe: Oh yeah. 1099er. “I save about $280,000 a year.”

Al: Wow. I’ve never saved that much.

Joe: Yeah. That’s more than people make in a lifetime. “We currently- “ wow, never saved that much. That’s Big Al talking. He’s got the biggest wallet I’ve ever seen.

Al: That’s a little rich for even me.

Joe: I’m a 1099. Oh, God, I keep going back to that. That’s funny. All right, “We currently have $1,100,000 in net worth, $320,000 in a joint account, $370,00 401(k)s, $120,000 in Roths, $40,000 in HSAs. I max out the employee and employer portion of my solo 401(k), close to $60,000, all pre-tax. My wife maxes out her 401(k) pre-tax. So I’ll call that $20,000, so that’s $80,000 pre-tax. The rest goes into two backdoor Roths, HSA and our joint brokerage account. With our income where it is, we figure we better take advantage of the full tax write offs,
all the pre-tax 401(k) stuff, now rather than do the Roth 401(k)s. I really like how you guys recommend inflating your expenses to the year you plan to retire. We would like to retire in our mid-40s. Do you guys think we should be taking this tax deduction now and paying taxes later? Or are we screwing up and setting ourselves up for a huge tax bill down the road for ourselves and kids? Thanks so much. Love you guys.” Love you too, Brent, the Fan. Okay, this is interesting. He saves a ton of money.

Al: Yeah, he does.

Joe: So let’s do some simple math, Al. So he’s got non-qualified account. He’s got $320,000 in a non-qualified account. And let’s just assume he saves $200,000 in the $320,000 because we already assume he’s having $80,000 pre-tax. Right. Okay, fair enough?

Al: Yep. Is the 80,000-? Yeah, okay. Got it.

Joe: So it’s $280,000- $80,000 retirement accounts, pre-tax, $200,000 after-tax.

Al: I’m with you. Okay.

Joe: So if I look at $200,000 a year, saved for the next 10 years- And then you have a balance of $320,000 and let’s say you get 7% return on that. It’s going to be what? $3,000,000, $3,500,000.

Al: Yeah. $3,500,000. $3,000,000, $3,500,000, I agree.

Joe: Okay. So that’s at 45. Now he wants to retire. So he can live off the non-qualified accounts because he can’t necessarily touch his 401(k)s and IRAs and things like that until 59 and a half. You can have access to it early, but I’m not going to get in that roll. So he’s saving $80,000 a year into that, right? And so over the next 10 years, he’s got $300,000 in that plan or actually a little bit more. But he saves $80,000. He gets a 7% rate of return. At age 45, the IRAs or the retirement accounts, the pre-tax retirement accounts, could be $1,500,000 to $2,000,000. Do you agree with that?

Al: Yeah, I would say, yeah. Yeah, $1,000,000, $1,500,000, something like that. Yep.

Joe: So he’s only 45. Let’s say you have $2,000,000 or a $1,500,000, he’s got another 15 years until he’s going to touch that money.

Al: At least.

Joe: So he could have $4,500,000, $5,000,000 in a retirement account. Of course, all hypothetically. This is just totally a spitball. This is a big juicy one, right? He’s going to have several million in a retirement account at age 60. So the question he’s asking is that, all right, well, am I messing up? Should I be taking the tax deduction today or should I be paying taxes down the road? The unanswerable question is, who knows what the hell tax rates are going to be in 25 years from now? But do you think they’re going to be higher or do you think they’re going to be lower than they are today? Because you’re going to have a boatload of money in a retirement account by the time you’re 60. And if the rules kind of play out as the same, he’s going to be in a very high tax bracket, just based on the RMDs and if he dies and goes to his wife and so on and so forth. So running some math like that, I would say you probably want to take advantage of some Roth because you’re going to get super compounding tax-free growth forever.

Al: So I would say take the tax break. At age 45, start to do Roth conversions while your lower brackets. But the only reason I would depart from that is the market’s lower than it was a year ago. So maybe you do some Roth right now where the market’s low, you invest in equities, you let it grow with the market. But I think that’s what, if you truly retire it in your 40s, that’s probably what I would do, take the tax deduction now, and then start converting like crazy when you retire between then until age 60 or even 70.

Joe: Very logical advice or very logical spitball there, Big Al.

Al: Yeah, yeah.

Joe: But I would do- I would go Roth all the way. You’re not going to miss the tax deduction. The guy makes $700,000, $600,000 a year. He saves $280,000 bucks. That’s a ton of cash. I would much rather have $80,000 each year compounding for me tax-free at age 35. Because by the time I’m 45 and 50, I’m going to go back to my younger self and say, damn-

Al: Good job.

Joe: -You are the smartest guy in the world. Look at all this cash I have, 100% tax-free sheltered from the IRS. Who knows what the hell tax rates are going to be? I don’t know. Everything might be free at that point and there’s no tax or tax rates could be at 90%. You’re taking the uncertainty of future taxes off the table.

Al: Yeah, and there is logic in that approach too.

Joe: Brent the Fan. Go Roth. All right. We got to take a break. Or is that it?

Andi: That’s it. We’re done.

Joe: That’s it. All right. Thank you all for another wonderful week. We will see you again next week. The show is called Your Money, Your Wealth®.

Andi: Besides plenty of drinks in the Derails, along with Keegan the Irish setter and his plant, so stick around. Help new listeners find YMYW by leaving your honest reviews and ratings for Your Money, Your Wealth in Apple Podcasts, and any other podcast app that accepts them.

The Derails

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