Traditional 401(k) verse a Roth 401(k)…when you health is on the line a Roth wins every time
The choice of investing into a Traditional 401(k) or a Roth 401(k) has been a debate since the Roth was designed and consensus tells us that they way to go is with the Traditional 401(k) as that is how many investors have gone.
Unfortunately, when certain legislation concerning health coverage is applied this may not be the case.
When you retire, you must have health insurance, which means you will enroll into Medicare when you are 65 years-old or older and no longer have coverage through a creditable health plan from an employer or spouse’s employer.
The problem arises due to the fact that this health coverage is predicated on how much income you have and the more you have the more you will pay as Medicare implemented the Income Related Monthly Adjustment Amount (IRMAA).
Now, couple this with the fact that income is defined as adjusted gross income PLUS any tax-exempt interest there may be or everything on lines 37 and 8b of the IRS form 1040 and many people in retirement may feel a bit of sting in retirement, especially if healthcare costs maintain their current inflation rate.
To illustrate the issue at hand let’s take two investors who are, currently:
• Both 55 years old.
• Earn $75,000.00 a year each throughout employment.
• Plan on retiring at age of 70.
• Plan on living until age 85.
• Are both in the 25 percent tax bracket.
• Have each saved $200,000 by age 55 in their 401(k)’s.
Also, at retirement age of 70, they will both receive Social Security benefits that, according to Social Security’s Quick Calculator, will start at $54,432.00 a year which is expected to receive a cost of living adjustment (COLA) of 2 percent.
The only difference between the two is that that Person A will invest $9,000 a year into a Traditional 401(k) to get a tax break today and Person B will invest only $6,750 a year into their Roth 401(k) as they will opt to pay the taxes today to be tax free in retirement.
By age 70, Person A is clearly ahead of the game as they will have saved roughly $689,000 by retirement while also saving approximately $36,000 in taxes.
Person B, who will not realize that tax break, will have saved only $636,000.00 at the same time, but once health coverage is factored in the story changes.
At age 70.5 Person A must start distributing income from their retirement savings due to the required minimum distribution (RMD’s) while Person B does not.
For Person A, their RMD will be roughly $25,000 in their first year of retirement which will be added to their Social Security benefit for a total income of $79,432.00 at age 70.5.
Thankfully, Person A is under the threshold that Medicare uses in order to implement a surcharge at this time, but, by age 73, due to that 6 percent investment growth and Social Security’s COLA, they will reach the first Medicare IRMAA surcharge bracket which will increase Part B and D premiums by close to 40 percent.
Unfortunately, for Person A the problem then compounds further and by age 80 their income, from their RMD’s and Social Security benefit, will exceed the second Medicare IRMAA surcharge bracket.
The result will be that Person A will face a surcharge of about 100 percent of that year’s Medicare Part B and D premiums as they are earning over $107,000 a year.
With Medicare premiums expected to have a rate of inflation of over 5.5 percent a year, according to the Medicare Board of Trustees, Person A should expect to pay an extra $82,840 for their health coverage due to these surcharges throughout retirement.
Due to Medicare’s IRMAA surcharge any tax savings realized by Person A in their Traditional 401(k) investment will have been negated and then some.
The other issue that Person A must now also consider is the fact that their Social Security benefit, may be subject to a decrease in realized benefits too.
According to current legislation, Medicare Part B premiums and any surcharges due to income are automatically deducted from any Social Security benefit.
Because of this legislation, Person A is in a position to see their realized Social Security benefit remain stagnant with a distinct possibility of it even decreasing throughout retirement.
With changes to Medicare’s Hold Harmless Act in 2009 any Medicare beneficiary who reaches any IRMAA surcharge will not be afforded the protection of that act, thus their Social Security benefit can actually be reduced year over year.
The good news for Person A is that even with the RMD’s their savings have the potential of growing to about $815,000 by age 85 as long as they receive that 6 percent rate of return. Not too shabby even if it is taxable when withdrawn.
For Person B, well the story is a little bit different since they are not required to make any distributions from their Roth savings and even if they did take a distribution it wouldn’t count as income.
So, for Person B, with having only their Social Security benefit counting as income they will never hit any of Medicare’s IRMAA surcharge brackets, thus saving that $82,840 throughout retirement as well as being in the position to possibly realizing an increase in income from their Social Security benefit.
The other bonus for Person B, since no distributions must be taken and if the account is allowed to grow, by the age of 85 they will have the possibility of saving over $1.5 million, assuming that 6 percent rate of return.
Due to federal regulations dating back to 2003 the advice of investing into a Traditional 401(k) or IRA to maximize tax benefits today may be very costly later, but hey, everyone likes to give more to the federal government…just ask them.