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★ Your 401K is a Waste of Time
★ How to Earn 20% a Year in Your Roth IRA
★ Backdoor Roth IRA – How Does It Work?
★ Have an Old 401k? Should You Rollover to an IRA?
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What Is a 401(k) Plan?
A 401(k) plan is a tax-advantaged, defined-contribution retirement account offered by many employers to their employees. It is named after a section of the U.S. Internal Revenue Code. Workers can make contributions to their 401(k) accounts through automatic payroll withholding, and their employers can match some or all of those contributions. The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money, typically after retirement. In a Roth 401(k) plan, withdrawals can be tax-free.
How 401(k) Plans Work
There are two basic types of 401(k) accounts: traditional 401(k)s and Roth 401(k)s, sometimes referred to as a “designated Roth account.” The two are similar in many respects, but they are taxed in different ways. A worker can have either type of account or both types.
Contributing to a 401(k) Plan
A 401(k) is what’s known as a defined-contribution plan. The employee and employer can make contributions to the account, up to the dollar limits set by the Internal Revenue Service (IRS). By contrast, traditional pensions [not to be confused with traditional 401(k)s] are referred to as defined-benefit plans—the employer is responsible for providing a specific amount of money to the employee upon retirement.3
In recent decades, 401(k) plans have become more plentiful, and traditional pensions increasingly rare, as employers have shifted the responsibility and risk of saving for retirement to their employees.
Employees are also responsible for choosing the specific investments within their 401(k) accounts, from the selection their employer offers. Those offerings typically include an assortment of stock and bond mutual funds as well as target-date funds that hold a mixture of stocks and bonds appropriate in terms of risk for when that person expects to retire. They may also include guaranteed investment contracts (GICs) issued by insurance companies and sometimes the employer’s own stock.
Contribution Limits
The maximum amount that an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation. As of 2020 and in 2021, the basic limits on employee contributions are $19,500 per year for workers under age 50 and $26,000 for those 50 and up (including the $6,500 catch-up contribution).
If the employer also contributes—or if the employee elects to make additional, non-deductible after-tax contributions to their traditional 401(k) account (if allowed by their plan)—the total employee/employer contribution for workers under 50 for 2021 is capped at $58,000, or 100% of employee compensation, whichever is lower. For those 50 and over, again for 2021, the limit is $64,500.
Employer Matching
Employers who match their employee contributions use different formulas to calculate that match. A common example might be 50 cents or $1 for every dollar the employee contributes up to a certain percentage of salary. Financial advisors often recommend that employees try to contribute at least enough money to their 401(k) plans each to get the full employer match.
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#401K #401KProblem #Retirement
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This video is for entertainment purposes only. I am not a legal or financial expert or have any authority to give legal or financial advice. While all the information in this video is believed to be accurate at the time of its recording, realize this channel and its author makes no express warranty as to the completeness or accuracy, nor can it accept responsibility for errors appearing in this video.
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The Biggest Lie About Traditional 401Ks and IRAs
When it comes to retirement savings, traditional 401Ks and Individual Retirement Accounts (IRAs) are often touted as the golden standard. Financial experts and institutions promote them as the ideal way to build a nest egg for the future. However, behind this glossy facade lies a significant lie that many people fail to notice: the promised tax savings.
The primary appeal of traditional 401Ks and IRAs is the promise of tax-deferred contributions. This means that the money you contribute to these retirement accounts is deducted from your income, reducing your current taxable income. Many individuals are enticed by the idea that they can lower their tax bills in the present, assuming it will lead to substantial savings in the long run.
But here’s the cold, hard truth: taxes never really disappear with traditional 401Ks and IRAs. They are merely deferred until retirement. When you start withdrawing money from your retirement accounts, you will have to pay taxes on both your contributions and the earnings accrued over the years. In fact, the entire amount withdrawn is treated as taxable income in retirement. This means that you may end up paying higher taxes in the future than you would have if you had saved your money elsewhere.
The lie propagated by financial institutions is that you will be in a lower tax bracket during retirement. Many people believe they will have lower expenses and a reduced income once they retire, resulting in a lower tax liability. However, the reality can be quite different. Retirement can bring unexpected expenses, such as healthcare costs, home repairs, or even supporting grown children who face financial difficulties. Moreover, if you have a considerable amount of saved money, required minimum distributions (RMDs) imposed by the government can push you into a higher tax bracket.
Considering these factors, traditional 401Ks and IRAs might not be the tax-efficient tools they are made out to be. This is not to say that these retirement accounts are entirely useless; they still offer valuable advantages such as employer matching contributions and tax-free growth during the accumulation phase. However, it is crucial to be aware of the truth behind the promised tax savings.
So, what alternatives should individuals consider when planning for retirement? One option is the Roth 401K or Roth IRA. Unlike traditional accounts, Roth contributions are not tax-deductible. However, the withdrawals in retirement are entirely tax-free, including the earnings. By paying taxes upfront, individuals can avoid the potential tax burden during retirement and enjoy the benefits of tax-free growth.
Additionally, individuals should explore other investment avenues, such as taxable brokerage accounts or real estate investments, that can provide more flexibility regarding tax implications. Diversifying one’s retirement portfolio and considering different tax strategies can be key to mitigating future tax burdens.
In conclusion, the biggest lie about traditional 401Ks and IRAs is the promise of significant tax savings. While they do offer certain advantages, the taxes are not eliminated but postponed, potentially resulting in higher tax liabilities during retirement. Individuals must be aware of this and consider alternative retirement savings options that better align with their financial goals and long-term tax strategies.
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This makes perfect sense to me. Love your videos, Jake.
Your videos on this subject opened my eyes and convinced me to pursue this method. Thanks! Wish you'd go back to going finance-related videos.
I never thought about the fact that a taxable brokerage account would be the same as a roth account if your income stays in the 0% threshold. That being said, a lot of people would probably still fall in the 15% tax bracket in retirement, so folks should be careful not to assume they will have 0% tax on long term capital gains.
Also, while I understand the point that people invest a certain dollar amount in retirement accounts, you can't ignore the tax savings someone would have with a traditional 401K. Maybe people would just spend the extra cash and not save it, but even then you should account for the increased quality of life the tax savings provides. I think of Roth accounts like forced additional saving vs traditional. I'm all about the Roth 401K, but I don't think you can just ignore the tax savings today, and the fact that you need more income to invest the equivalent amount of money in a Roth vs Traditional 401K.
You really shouldn't use statements like 'always' in finance. Someone who contributed to Roth IRA doesn't always pay less tax than someone who contributed to Traditional. If their withdrawal in retirement from a Traditional IRA is up to the top of the standard deduction, and lets say they use capital gains or dividends beyond that income level, then they will have tax-free income the same as someone who contributed to Roth while working.
Actually, they end up ahead by contributing to Traditional…. Because they reduced their tax burden while working, allowed their money to grow tax-deferred for years, and then withdraw in retirement within the standard deduction at a 0% tax rate.
Totally makes sense for most people. It also makes a difference whether you expect to be in a higher tax bracket after retirement, vs a lower tax bracket after retirement. If you make a lot of money one year and little money the next year, it might make sense to go the Traditional IRA route during the high income years, and draw down the retirement account slowly when you are in a lower tax bracket. Also, I think it's likely we (U.S. American's) will have higher taxes in a few decades (to pay for the deferred maintenance of infrastructure and climate change mitigations). Roth option has a lot of benefits.
Can a person just open up a Roth and max it at 6k? For the year then move the rest of saved money elsewhere for spending etc. savings. Whatever?
You make good points but there are scenarios where the traditional IRA is a better deal. I am a CPA in a rural area where most people don't earn the kind of income Carlos is talking about. One thing Carlos left out of his argument is that if this hypothetical 'super saver' person were to invest the 33.3% tax savings each year in an after tax brokerage account he would have an additional $1 million or so at the end of 35 years. But realistically no one does that. These projections rely on a lot of assumptions without taking into account the reality of financial setbacks during working years–outsized medical bills, college tuition or loss of a job. I have a difficult time getting people to fully fund their IRA's in their late 20s through mid 40s as there is always something more pressing. The tax savings on the traditional IRA is an incentive to get them to put money away. I agree with Travis below and suggest people have both a traditional and Roth IRA and fund each according to their circumstances that year. Since many of my clients get a late start on retirement saving my rule of thumb is that a married couple should take the tax savings with a traditional IRA until they are on a path to about $500k by retirement age. When it looks like you are going to hit that number in their 60s they should start funding the Roth. They won't pay much tax on the $40000 or so taxable withdrawal and will have saved a lot of tax dollars along the way. (I often use 20%-15% fed and 5% state when estimating tax savings). Just imagine if you actually saved the $1200 or so every year.
However, if somebody is contributing to a Roth IRA or a Roth 401k, and when they retire if their only income is social security they would be paying very little in income taxes, and hence would be saving money paid to taxes – isn't that an accurate statement?
Do you believe the tax rate will change significantly between contribution time and withdrawal time? How long will it have to sit and collect? If you're 59 and pulling out the same money the next year at 60 a lower income bracken, traditional would be better. Traditional could win in cases where you are 'behind' – low total savings and near the age you'll withdraw.
Love all your videos but I respectfully disagree. I've been contributing 15% Traditional of my paycheck for a while now and have a tight budget. I'm switching to Roth for tax diversification and will be changing my contributions to 33% to account for this. Seems pretty normal that people would account for this.
Doing 100% traditional has been huge for me to get the stimulus checks over the past few years, along with other tax credits that are income dependent.
I certainly understand value of Roth and starting to do that as well now
Very good information…thanks
Hi Jake,
What about a tax drag in the brockerage acct from qualified dividends being taxed every year? 15% of 2% is 0.3% of the account value. That's not pocket Change.
I do agree that roth IRA or Roth 401K can be very beneficial when one day we retire and have millions in the accounts. But if you are in the high income bracket, consider contribute to traditional based on your own situation. Let's say if the household income is $320K per year and file married jointly with two incomes. If we do roth 401K, we pay almost $10K (based on 2022 401K limit) more on the tax (in Texas with 24% bracket). That's your $10K annual opportunity cost which you could invest to your brokerage account. It could be very close to $1.8m in your brokerage account with 10% market return after 30 years. Not to mention your income will continue grow, the 401K limit will continue increase, etc. There's always different calculations with different scenarios but in this example, you can see having that $5K less in your bank account could make impact. If you just started your career and in the lower tax bracket, do roth 401K, because your wealth will have longer time to build and your future tax rate most likely will be higher due to income increase. If you are at the high point of your income, IMO, I would suggest to do traditional.
In a Fidelity taxable brokerage account, which do you prefer for an S & P index fund, VOO or FXIAX, or do you have better option? I appreciate your feedback. 🙂
Carlos is comparing Red Apples vs Green Grapes. It's not like an Apple could be Green; or that a Grape could be Red.
$19k is the 401k (Grapes) contribution limit. $12.5k is the IRA (Apples) contribution limit.
Traditional (Green) is one type of 401k or IRA, Roth (Red) is an alternative.
Unless the video Carlos was commenting on was specifically Traditional 401k vs Roth IRA, but even then you can have Apples and Grapes.
"your version of facts" haha!
Great clarification. Also love the point on no age requirements on a brokerage account, allowing early retirement – yes!!!
The behavioral argument is lame…why can't you just compare like with like? Plus, you never even mentioned the high likelihood that in retirement your living expenses and thus 401K withdrawals will be less than current income (due to mortgage and kids college paid off, kids out of home, downsized home etc..) and thus, the deferred tax will be at a lower marginal rate than if you had paid it upfront (ie before contributing to your brokerage). You really think someone making $250K a year with 4 kids, a big mortgage etc.. will need the same amount of money in retirement without all those expenses? Have to say that I found this video pretty disingenuous. In most cases, Roth is better than a 401K but to say a regular brokerage account is better than a 401K is just silly.
ROTH IRA is the way to go if you can afford to max it out, but if you cannot then that is when the deferred accounts have the advantage. It is a lot easier to max out traditional ira or 401k than roth when you consider taxes could hamper one's ability to contribute higher amounts.
I agree with you Jake. For the main reason that you actually have access to your ordinary brokerage account any time you want. It’s a big deal then just a few percentage of taxes. Math doesn’t account for what curveballs life throw at you or opportunities for you and family. In Roth you “kinda” have access to your contributions before 59 and half, and 401k and traditional has pretty much no access unless you pay penalty or borrow against it.
You do not understand the tax brackets. The 24%is marginal. The last money you earn will be taxed at 24%. If it goes into the traditional you save (get) a 24% immediate federal tax break. That is a 24% return with no risk.
Also, You assume the tax savings will be spent as opposed to applied to additional wealth accumulation and retirement savings. This money invested long term in growth and value equities can be huge.
Also, you will have no ordinary income when you quit active employment. Your Traditional retirement withdrawals will replace that ordinary income at a rate you can manage as you decide and plan how much you want to withdraw prior to RMD's.
Your analysis is shallow and incomplete.
I can not afford to max out a Roth 401k, but I can max out a traditional 401k. I have student loans and a mortgage and kids now that I won’t have as financial obligations in retirement. I make 78,000. You seem to be speaking only to high earners. Average household makes 60K.
Roth, for me, is going to be way less stressful in retirement. Taxes…Oh that thing I already took care of. Whether I want to pull out 10k or 10 million my taxes won’t change.
I agree with your logic… Carlos’ example is mathematically accurate (though it’s close to a wash after taxation at withdrawal); however, if you are a) maxing out contributions (hitting a dollar cap), or b) contributing a fixed percentage without regard to the up-front tax effect, the Roth will always have a lot more spendable money at the end.
Wow this is so bad. You will always put into a Roth at your marginal tax rate. For the sake of easy math lets just make up a 20% marginal tax rate. It costs you $7500 to save $6000 in a Roth. For the same $7500 you could put $6000 in an IRA, BUT you have $1500 left, at the same 20% marginal tax rate you could ALSO put $1200 in a Roth. When you go to withdraw your money you will pay taxes at your effective rate, not your marginal rate.
So you’re saying tax savings don’t matter now but tax savings do matter in retirement.
Several good points made.
But let's back away from the trees enough to see the forest.
Given the mentality of the average person, or the average commenter, is it possible that these two videos may have completely discouraged many people from saving for retirement at all?
I max out my 401k pre-tax, I max out my 401k after tax, I max out my T-IRA. , I also keep converting both after tax contributions to Roth immediately.
It's mostly about tax rate now and in the future. The CA example is good for CA residence. I am not living there and have no plan to live there ever.
Roth is like having a paid off house, it may or may not be best bottom line but it sure is nice to know things are already paid.
Jake, It would be helpful if you broke the example with math on the screen showing the pre and post-tax differences at various stages. You started to do this but then never fully took it home. I think this would help us see what point you are arguing.
So what if student is in college and the Traditional helps with Financial aid as it lowers your income?
Maybe I'm strange because I'm a tax preparer, but I literally calculate my tax savings from the deductible contribution and I put that into my personal brokerage account. I have a significant tax savings between Fed and CA tax and I feel I will come out ahead in the end. I'll take the tax savings today and invest it over the tax free earnings in the future. Its different for everyone, but for me this works. Also I have a self directed with Charles Schwab so I am not limited to what I can invest in with my 401K.
I agree with those disagreeing here. I would NOT contribute the same amount to a Roth account as I would to a pre-tax one. Another thing is that Roth IRAs have low limits. That 19k for the 401k listed here is the top of the 401k contribution limit, but a single person can only contribute 6k to a Roth IRA (Roth 401ks have the same limit as a Traditional one). Yes if you are in the lower two brackets, you might be better off with the Roth. But, most middle class people will be in that 22% or higher bracket (like I am). I live in NC with a 5.25% state tax, so that is another tax savings there.
In retirement, one thing you need to consider is that pre-tax accounts are only taxed on the amount you pull out for that tax year. Technically, you could just pull 24k per year (married jointly) from a 401k during retirement (and nothing else) to get 0% fed taxes due to the standard deduction. Another thing is that most 401ks have a employer match (and it's rare for a Roth match). I am blessed to have a 125% match for my 6% contribution to a traditional 401k. Many companies will do a 100% (or 50%) match between 3 and 6%. That's free money compounding on top of those tax savings. Basically I'm saying that the numbers are not as black and white as you make it out to be. Carlos is oversimplifying as well.
Knocked it right outta the park
Jake, I respect your analysis. But you couldn't be more wrong in the Roth VS Traditional comparison. Hear me out:
People contributing $6000 to traditional, why they have to pay tax at withdraw? Because they get tax savings on contributing, you cannot simply ignore that.
If traditional IRA has no tax saving on contribution and still have to pay tax at withdraw, of course Roth wins.
We need to use Traditional amount + tax saving to compare with Roth amount.
There becomes a good time for an Each, honestly. Tools for advantage ing your investment of Time. #taxation
Thumbs up for the strategy thought but nah, maxing my 401k with smart Roth Conversions annually is going to save a ton of taxes. I agree going into retirement with only a large 401k at age 65 plus would be a mistake. Also, I can afford to max my 401k but not a Roth 401k. So it's true after tax will be less.
I was contributing 15% to a traditional 401k but had to lower it to 12% with a Roth to receive the same take-home pay!
I was saving 15% in a traditional 401k… I swapped over to a Roth 401k and noticed my bi-weekly checks were slightly less than the traditional 401k…
I'm still contributing to a Roth 401K but now only 12%!
So yeah people do notice a difference!