Wouldn’t retirement planning be ever so much easier if each of us could see ahead into our individual futures? That’s a loaded question! Of course it would be. And if that were the case, I, for one, would also be out of a job. However, that is not the reality that we live in.
Therefore, we need to be a bit more analytical, especially when making a decision between a traditional and Roth 401(k). It is necessary to examine if the 401(k) vehicle that you choose is going to build wealth for you and your family or if it will simply line the pockets of the Internal Revenue Service.
Betting on the Future
As we begin this conversation, I would like to educate you on the realities of both vehicles. Let’s first consider the details surrounding contributions to a traditional 401(k):
- Pre-tax contributions are deductible from taxable income.
- The 401(k) grows on a tax-deferred basis.
- The 401(k) is subject to required minimum distributions when the participant reaches the age of 70.5 years.
- Withdrawals on both contributions and earnings are fully taxable.
- A traditional 401(k) must be rolled over first to a traditional IRA, and then it may be converted to a Roth IRA. This process requires a tax payment.
Now, let’s do the same for a Roth 401(k):
- Contributions are subject to federal and state income taxes during the taxable year.
- There is no age requirement for receiving minimum distributions.
- Withdrawals of accumulated contributions and earnings aren’t subject to income taxes at retirement.
- Funds can be rolled over directly to a Roth IRA with no tax payment, a feature that is not available with a traditional 401(k) account.
Both the traditional and Roth 401(k) come with a maximum contribution, which was $18,000 in 2016. Those individuals who are 50 years of age or older can make additional “catchup” contributions of up to $6,000 for a total contribution of $24,000, which is definitely more generous than IRA vehicles. However, there are downsides that must be discussed.
Traditional 401(k) vehicles offer immediate tax benefits in exchange for future taxable income. A Roth 401(K) offers the opposite, as tax-free retirement income is provided in exchange for taxes today. Therefore, deciding between them comes down to understanding how your future income tax rates will compare with current rates—and which offers a bigger benefit.
“You must understand what after-tax cashflow means and make decisions with this in mind,” said Brad McKeiver, CPA, MBA, principal at LBA Haynes Strand, PLLC, in Charlotte, NC. “We like to make sure that clients work closely with a financial advisor so that their planning doesn’t exist in a vacuum and incorporates feedback from their core team—their attorney, CPA, and financial advisor.”
Current and Projected Tax Brackets
Instead of being fixated on hypothetical situations in the future, let’s focus on what the reality of the present actually is. Start by figuring out your current tax bracket.
If you are in the early stages of your dental career, it’s likely that you are in a low tax bracket (20% range or lower). In this regard, a Roth 401(k) is a wise choice as it is likely that your expected tax bracket in retirement will be higher.
In retirement, you will be claiming Social Security, taking distributions from retirement accounts, possibly realizing capital gains, receiving deferred compensation, collecting dividends, and more. This will push you into a higher tax bracket, and all of your retirement planning could feel like it has been done to simply pay a tax bill.
On the flip side, if your current tax bracket is higher than your expected tax bracket in retirement, then choosing the traditional, pre-tax 401(k) could be the right move for you. This might be especially true for investors who are at or near their lifetime earning peak. Physicians and dentists in their peak earning years are usually going to be better off deferring taxes whenever possible.
I will typically advise my clients to contribute to a traditional 401(k) in the years leading up to retirement because it makes more sense to pay taxes during retirement than it does during high-earning years immediately preceding it.
Ensuring Tax Diversification
Diversification mitigates tax risks—it’s a fact. Tax diversification means not having all of your assets be subject to the same tax effects, particularly when withdrawing in retirement. It is possible to blend your vehicles so that you are making both Roth and traditional contributions.
I’m not necessarily endorsing an even split. That’s something that has to be determined by examining your own financial situation, comfort level, and goals. However, it is wise to have access to tax-free money, tax-deferred money, and some taxable money in retirement. Not only does this strategy protect against the possibility of severe tax bracket changes, but an investor who follows this line of thinking also will be better able to control tax bills in retirement.
Actionable Tips
“You must understand your rates today and the difference between pre-tax and after-tax contributions, as well as the impact of the tax savings today versus the ability to withdraw tax-free in later years,” said McKeiver. “This is something we talk with our clients about regularly.”
Finally, I have put together some actionable tips that are specifically targeted at dentists:
- As a resident, max out your Roth 401(k). Remember that the upfront tax break offered with a traditional 401(k) isn’t worth that much at this point in your life.
- If you get disabled, take a sabbatical, become a stay-at-home parent, retire early, or have lower income (for whatever reason) during one year, think about doing some Roth conversions. Converting tax-deferred assets to Roth assets will not only give you tax diversification, but will also reduce the minimum distributions you are required to pay after you turn 70 years old. This is also a great way to minimize state income tax.
- Save, save, save. If you are regularly maxing out your 401(k), also consider a Roth IRA for additional savings opportunities. After this, consider investing in a taxable account.
- Use a health savings account (HSA). In this regard, you can spend money in your checking account on healthcare expenses and let the HSA grow until you are in retirement. Then, you will get the upfront tax break, decades of tax-free growth, and tax-free withdrawals!
Of course, every person’s financial situation is different, and there is no “one-size-fits-all” approach. To discover the options that are best for you, partner with a financial planner who understands the medical and dental industry, acknowledges your goals and objectives, and can accurately and effectively use retirement calculators to plot your course.
Victor Holloway, MBA, is a founding partner of the Medicus Group, a financial planning and wealth management firm exclusively servicing physicians and dentists. Based in Charlotte, NC, the Medicus Group addresses the needs of clients nationwide. He can be reached at (980) 235-7885 or mymedicusgroup.com.
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