401(k): Which should you pick Traditional or Roth? You will be surprised

The debate rages on when it comes to saving for retirement within a Employer Retirement Savings Plan, should an investor choose a Traditional 401(k), which allows pre-taxed dollars from wages to be invested before being taxed or should a Roth 401(k), which uses after tax dollars from wages, be used.

In order to fully understand the ramifications of each investment type along with how your tax obligation and your health costs will be affected here is a simple case study:

It is strongly advised that before making any investment choices about your retirement you consult with a financial professional who understands not just the wealth management aspect, but also, the rules and regulations of Medicare and Social Security.

What needs to be defined in order to reach a conclusion:

 

  • Each investor is 30 years of age and will invest until age 70.
  • Income will remain at $75,000 or $6,250 a month (pre-tax) throughout employment.
  • Tax rate before retiring is calculated using 2013 tax rates and can be found at Bank Rate.com.
  • The investment rate of return will be 5% throughout this example.
  • Each investor will use 2014’s 401(k) investment maximum of $17,500.
  • Medicare premiums:

o    Equal $4,000 that inflate at the current rate of 7.5% – source Jester Financial Technologies Scepter Pro software.

o   The income penalty Medicare (IRMAA) assesses will inflate at 2.5%.

  • Social Security:
  • o   COLA will equal 2.8% throughout retirement.

    o   The benefit will reflect the amount that is currently taxable (85%)

  • Tax rate in retirement will be same as 2013 tax brackets (calculated at Bank Rate.com).
  •  

    While working

     Traditional 401(k) option

    Person A decides to invest the maximum amount into their Employer Sponsored Plan on a monthly basis which equals $1,458 using a Traditional 401(k).

    Due to the pre-tax advantage their taxable income will equal $4,792 ($6,250 – $1,458) per month which also drives down their tax bracket to 13.57%.This results in Person A having a lower tax obligation while working on the Federal level ($650.42 a month) leaving them with income of $4,141.58 a month ($4,792 – $650.42).

     Roth 401(k) option

    Person B, who decides to invest using a Roth 401(k), will decide to invest less and opt to pay the tax from the possible investment in order to still receive $4,141.58 in take home pay.

    The taxable income is $6,250 a month with a tax obligation equaling $1,014.92 a month which places Person B in a 16.24% Federal income tax rate.

    The investable amount equals: $1,093.50 a month ($5,235.08 – $4,141.58) or $13,122 annually

    By the time each investor reaches age 70 their investments, which grew at 5%, equals:

     

    Person A – Traditional 401(k) $2,237,196.00
    Person B – Roth 401(k) $1,677,513.37

    The difference between the two is $599,682.48 in favor of Person A.

    The taxes paid:

    Person A – Traditional 401(k) $234,151.20
    Person B – Roth 401(k) $365,371.20

    The difference in taxes between the two is $131,220 in favor of Person A.

     

    In retirement:

    Person A:

    By age 70.5, per federal regulations, the required minimum distribution (RMD) will be taken at an amount of $81,649.49 which, unfortunately, will count as income by both the IRS and also by Medicare.

    Their Social Security benefit, which equals $28,596, will also add to the taxable income amount (85% of that amount of benefit will) thus making their income $105,956.09, but please keep in mind that Medicare uses adjusted gross income PLUS any tax exempt income as well.

    At age 70 the income that Person A generates places them in the 3rd Medicare IRMAA bracket that increases their Medicare premiums by $1,404.00 totaling their Medicare premiums at $5,402.36.

    At age 70.5
    Taxable Income $105,956.09
    Tax obligation on income $20,161.00
    Medicare premiums $3,998.36
    Medicare surcharge $1,404.00
    Overall tax obligation $21,565.00
    After tax & Medicare income $85,437.41.00
    Remaining Balance on investment $2,329,959.00

    In 10 years, at age 80, thanks to the RMD and the Social Security COLA, their income will reach $125,367.72 as their original investment, even with the RMD’s, grew to $2,329,959, thus placing them in the next Medicare IRMAA bracket which will inflate their Medicare premiums even higher to the total of $11,544.13.

    At age 80
    Taxable Income $125,367.72
    Tax obligation on income $34,566.00
    Medicare premiums $7,261.16
    Medicare surcharge $4,848.23
    Overall tax obligation $39,414.23
    After tax & Medicare income $116,383.22
    Remaining Balance on investment $2,329,959

    By age 81, due to their RMD’s, their overall investment will now start to decline while, unfortunately, the RMD will force them to withdraw even more income going forward too.

    At age 90, the RMD will equal $167,544 with their Social Security being $49,678 making their income totaling $217,233.10 not only will this will force them into the highest Medicare IRMAA bracket, the tax obligation on just income will equal: $50,143.00.

    Their Medicare premiums, which have been inflating at this time, now equal $17,059.37 and the IRMAA penalty will add an extra $5,616.34 for a total of $22,675.71

    At age 90
    Taxable Income $217,233.10
    Tax obligation on income $34,566.00
    Medicare premiums $13,577.54
    Medicare surcharge $15,108.88
    Overall tax obligation $49,674.88
    After tax & Medicare income $138,393.69
    Remaining Balance on investment $1,829,588.19

    Age 100, things a look a bit different, but what are the odds of living this long?

    Income due to the RMD being $144,566.50 with Social Security growing to $65,478.50 is now $210,045. The tax obligation is now $46,906 and Medicare costs equal $35,190.59 with the surcharge totaling $7,189.39.

    Their account value, due to the RMD, has now dropped to $804,512.57

    At age 100
    Taxable Income $210,045
    Tax obligation on income $46,906.
    Medicare premiums $25,779.42
    Medicare surcharge $24,780.51
    Overall tax obligation $71,686.51
    After tax & Medicare income $112,579.07
    Remaining Balance on investment $804,512.57

    The Traditional 401(k), that was used to mitigate taxes now, resulted in:

    Throughout  Retirement
    Total Tax obligation on income $1,243,180
    Total in Medicare premiums $360,208.65
    Total in Medicare surcharges $337,297.70
    Overall Medicare payments $697,506.36
    Overall tax obligation $1,580,477.70
    Total After Tax & Medicare Income $3,833,951.68
    Amount transferred to beneficiary $804,512.57

     

    Person B:

    Even with a lower account balance to start, Person B has a much different retirement when it comes to Medicare and taxes, though their income, with a 3.25 withdrawal rate, will be as close as possible to the amount of income from the Traditional 401(k) example.

    At age 70, due to no RMD requirement, even though their account value equals $1,677,513.37, their reportable income for both the IRS and Medicare is just their Social Security benefit of $28,596 which only 85% is taxable.

    At age 70
    Taxable Income $24,306.60
    Tax obligation on income $1,700
    Medicare premiums $3,998.36
    Medicare surcharge $0
    Overall tax obligation $1,700
    Total After Tax & Medicare Income $77,416.82
    Remaining Balance on investment $1,677,513.37

     

    By age 80 the breakdown is as follows:

    At age 80
    Taxable Income $32,037.26
    Tax obligation on income $2,859
    Medicare premiums $7,261.16
    Medicare surcharge $0
    Overall tax obligation $2,859.00
    Total After Tax & Medicare Income $77,399.18
    Remaining Balance on investment $1,995,309

     

    At age 90:

    At age 90
    Taxable Income $32,037.26
    Tax obligation on income $4,215.00
    Medicare premiums $13,577.54
    Medicare surcharge $0
    Overall tax obligation $4,215.00
    Total After Tax & Medicare Income $105,363.58
    Remaining Balance on investment $2,373,309.34

     

    At age 100:

    At age 100
    Taxable Income $55,656.73
    Tax obligation on income $7,343.00
    Medicare premiums $25,779.42
    Medicare surcharge $0
    Overall tax obligation $7,343.00
    Total After Tax & Medicare Income $114,720.49
    Remaining Balance on investment $2,822,919.72

     

    Result for a Roth 401(k) investment:

    Throughout Retirement
    Total Tax obligation on income $109,952.00
    Total in Medicare premiums $360,208.65
    Total in Medicare surcharges $0
    Overall Medicare payments $360,208.65
    Overall tax obligation $109,952.00
    Total After Tax & Medicare Income $3,115,741.26
    Amount transferred to beneficiary $2,822,919.72

     

    Summary:

    The Traditional IRA created a benefit of paying fewer taxes while working with the added benefit of being able to invest more. The result, which is in a huge favor for the Traditional 401(k) totaled $730,902.

    In retirement the Traditional 401(k) owner, Person A, though they had more in investments and they took home slightly more income than Person B, Roth 401(k), they paid an extremely higher amount of taxes due to income and that Medicare surcharge.

    The difference in taxes, including that Medicare surcharge in retirement was:

    Taxes
    Person A -Traditional 401(k) $1,580,477.70
    Person B – (Roth 401(k) $109,952.00
    Difference $1,470,525.70

     

    The transfer of wealth to possible beneficiaries also differed between the two and favored, very heavily, Person B, who opted for a Roth 401(k):

    Remaining Balance
    Person A (Traditional 401(k) $804,512.57
    Person B (Roth 401(k) $2,822,919.72
    Difference $2,018,407.15

     

    From these results it can be concluded that a person who is looking to pay less in taxes over the long haul, while controlling their health costs and still being able to transfer some wealth to their next of kin or children, should look towards investing in a Roth 401(k) if available.

    Even though less was invested in the Roth 401(k) than the Traditional 401(k) the required minimum distribution does nothing but increase taxes liabilities while also driving up Medicare costs, to the tune of an extra $360,000 and there will not be one added benefit or coverage for that too.

    As stated previously: when it comes to planning for retirement it is highly recommended that you seek the advice of a financial professional that understands all aspects of retirement and not just the wealth management, because what you don’t know about retirement will hurt you!

    For more information on how the high costs of health will impact you in retirement please see www.yourretirementcosts.org for a free report.

    For the spreadsheet please see my Linked In profile for contact information at: www.linkedin.com/in/danmcgrathhealthcostretirement/

     

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    The debate rages on when it comes to saving for retirement within a Employer Retirement Savings Plan, should an investor choose a Traditional 401(k), which allows pre-taxed dollars from wages to be invested before being taxed or should a Roth 401(k), which uses after tax dollars from wages, be used.

    In order to fully understand the ramifications of each investment type along with how your tax obligation and your health costs will be affected here is a simple case study:

    While you are looking at Obamacare, something else just happened to your retirement

    The debate rages on when it comes to saving for retirement within a Employer Retirement Savings Plan, should an investor choose a Traditional 401(k), which allows pre-taxed dollars from wages to be invested before being taxed or should a Roth 401(k), which uses after tax dollars from wages, be used.

    In order to fully understand the ramifications of each investment type along with how your tax obligation and your health costs will be affected here is a simple case study:

    Mind Share: How Fidelity created it by marketing to its own competition

    The debate rages on when it comes to saving for retirement within a Employer Retirement Savings Plan, should an investor choose a Traditional 401(k), which allows pre-taxed dollars from wages to be invested before being taxed or should a Roth 401(k), which uses after tax dollars from wages, be used.

    In order to fully understand the ramifications of each investment type along with how your tax obligation and your health costs will be affected here is a simple case study:

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