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Personal Finance For Women

A CFP Poked Holes in My Traditional vs. Roth Strategy—Does It Still Hold Up?

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November 8, 2023

Financial Independence, Investing & Taxes

Listen & follow The Money with Katie Show: Apple Podcasts | Spotify

If you’re a regular listener, you probably know that we already did an “ultimate” Traditional vs. Roth 401(k) episode this year. “Katie,” you might be saying, “Do you mean to tell me that the ultimate was…*gasp* wrong?”

We put my strategy to the test with Eric Jones, CFP® with the Hook Jones Group at Baird Private Wealth Management, to find out.

Our show is a production of Morning Brew and is produced by Henah Velez and Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is our Chief Content Officer and additional fact checking comes from Kate Brandt.

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Mentioned in the Episode

Katie:

Welcome back to the Money with Katie Show, Rich Girls and Boys. I’m your host, Katie Gatti Tassin, and this week we are reopening my favorite can of worms. Now, I pride myself on a commitment to challenging assumptions about personal finance best practices and taking a closer look at the options we normies have available to us to build wealth. There’s always been something about financial strategies and tax strategies in particular that feels like an irresistible puzzle to me. How can we fit all of the pieces together to generate the best results?

Part of the inherent challenge with something like traditional versus Roth decisions is the number of assumptions we have to make in order for something to be true. There are a dozen variables that determine what’s technically best in any given situation, a reality made more unwieldy when you consider that those variables can change at any time.

Here’s just a portion of what comprehensive financial planning considers: your income and how that’ll change over time, your lifestyle and how that’s going to change over your lifetime, the age you estimate you want to retire, and, are you sensing a theme, how that might change over time, the way tax rates may change between now and then, referring to the progressive systems brackets, the way tax laws may change between now and then. So think things like the standard deduction or how capital gains are treated. There’s when you’re going to die, which is a super fun component of this, future rates of return, which are virtually unknowable, though history gives us a decent approximation. Future rates of inflation, which same, and sequence of returns risk, which refers to the way bad timing or a few bad years in a row can alter your long-term outcomes. For example, the way someone who retired in 2007 with formerly rosy prospects would find themselves facing down a financial calamity that decimated their retirement savings and took several years to rebuild.

That was, counting fingers, nine variables that when changed can make the difference between dying with millions and running out of money when you’re 70. No pressure. So as personal finance nerds, we try to layer certainty on top of our best guesstimate and pick a path, any path, and start making progress, but there is a disquieting sense in the back of our minds that ultimately a lot of what we treat as fact is built on some shaky foundations. Oftentimes the salve for this uncertainty is, quote, working with a professional, and it’s true that professionals have access to highly sophisticated projection software that can mathematically calculate all of these variables and spit out the likelihoods of alternate realities, which can then be transformed into a plan of action.

But I think the best professionals are the ones that are just as willing to admit that they also don’t know when you’re going to die or what the president in 2050 is going to think about the 0% capital gains tax bracket, unless that president is Katie Gatti Tassin, in which case, 0% capital gains tax for everyone.

So one such example that epitomizes how shifting variables can radically change outcomes is this traditional versus Roth 401k debate. Now a few months ago, I released my ultimate traditional versus Roth strategy episode, which aimed to take a closer look at the advice we often hear when strolling down Main Street in personal finance town, that all Roth is always better. Now, the episode was an hour long back and forth where Henah and I addressed point by point the reasons why pretax contributions often get short shrift and why contributing the maximum to a traditional 401k to generate a lump of tax savings that can then be invested in a Roth IRA creates both tax diversity and net more investible dollars.

But there are a few assumptions on which that analysis rests, first and foremost that the individual in question is going to retire before they are 59 and a half. It’s also true that traditional tends to be more effective for high earners, as well as people who have high save rates. Still, after all was said and done in our original 28 page analysis, I felt pretty confident that a traditional 401k was the way to go in most scenarios.

And after the episode went live, I received a thoughtful email from a CFP professional named Eric, who wrote, “I listened to your traditional versus Roth 401k podcast the other week and I wanted to respond because I think there are finer details that make this comparison even more interesting.” We’ll get into it after a quick break.

So Eric and I met one Wednesday over Google Meet to hash out those details. Hi Eric, can you hear me?

Eric:

Yeah. Hi, Katie. Nice to meet you.

Katie:

Yeah, you too. So the email you sent me, I thought it was really interesting and it underscored this fundamental assumption that we have to make when we’re planning that rests a lot on the 4% safe withdrawal rate and assuming that it’s true, that it’s going to work. And I used the 4% rule in my analysis because I figured, well, you can’t really draw down on what’s not there.

So if you tell me how much you’re saving, I can tell you what’s a reasonable amount to expect you’re going to be able to spend later and therefore guesstimate your effective tax rate in retirement. So I guess I’m just curious, when you’re working with real clients, how are you arriving at their retirement budget?

Eric:

Right. Yeah, and it’s almost impossible to know because every situation’s going to be a little bit different.

Katie:

Eric told me it’s common practice in financial planning software to compute retirement income a little bit differently. Rather than projecting what someone is likely to have and then taking 4% of that number, he works with them to determine a retirement budget, often $100,000 in today’s dollars. Then he calculates an approximation for what they can expect to get every year from Social Security or other income sources and he calculates the difference between those two numbers.

For example, if you are set to receive $50,000 per year from Social Security, he would calculate that your nest egg needs to supply the other 50k. We discussed this a bit in our previous traditional versus Roth episode when we talked about replacement income, or the income you’re likely to want to live off in retirement. And as a quick recap, a Fidelity study mentioned 75% of your previous salary as a reasonable number for income replacement, based on the fact that your retirement income isn’t subject to employment taxes and you also don’t have to account for the portion of your paycheck that you were contributing to your 401k. Now, recommendations on what number to assume you’ll be using as income in retirement can vary broadly and there’s no perfect substitute for a weekend of binge budgeting your retirement numbers.

Okay, so that’s interesting. In my analysis, I assumed that if someone had maxed out a 401k for 25 years and then they could retire on that, but you’re saying that that might not be a realistic assumption. It sounds like you’re thinking of retirement income a little bit differently.

Eric:

Right. So when I looked at your analysis, I noted that you took this notion of a 4% rate of withdrawal and just ran with it, and obviously that shows a nice consistent rate of income, consistent rate of taxation, but it also assumed that this couple who had been living on an income sufficient to max out a 401k and still be taxed at the 24% marginal tax rate, meaning their household income was somewhere around 250,000 or higher, that that couple would suddenly retire and live off of an income of, I think you calculated like $48,000 in today’s dollars before taxes.

I think you’d acknowledge that there were other sources of income that could help boost that to a more realistic number, but I felt like the analysis stopped short of making the connection between that extra income and how that would affect the tax rates that this couple would be paying in retirement.

Katie:

Okay, so that makes sense. I totally see what you mean. And also, I feel like it’s important to really double down on the intent and maybe the spirit of the strategy in this discussion and maybe clarify further who our analysis was really intended for, that one, across all income brackets, not just the 24%, that a person who contributes the max to their traditional 401k and then invest those tax savings in the Roth IRA does create more net investible income now, that this isn’t exclusive to higher earners, it just creates a greater tax impact for them, right?

But number two, that it nestles within this broader strategy that we’ve talked about on the show before, and maybe my fire roots are showing a little bit, but that we’re achieving that tax-free drawdown later, where you’re coupling your standard deduction sized pretax withdrawals with taxable withdrawals up to the 0% capital gains limit, and maybe you’re supplementing with Roth withdrawals really to your heart’s content, which today, Roth aside, would be around 89,000 in tax-free capital gains, and then, what, like 27,000 in tax-free, tax deferred income for married couples. So we’re talking roughly $117,000 in tax-free income per year.

So I don’t know, maybe I did a bad job of making the implicit explicit here, that you’re not just investing $22,500 in a 401k and then spending the other 180,000 of your $250,000 income, that you kind of have to be investing that in a taxable account because you can’t enact a strategy like that later if you’re only investing 22,000 a year. I don’t know, I guess unless you work for 60 years, right?

Eric:

Right. And that’s fair, and I think you’re right that there’s a lot of tax strategies that could be employed if you retired early enough and had the right balance of pre and after tax investment accounts. But I wanted to take your overall question, which is tax saving strategies during our working years, which one leads to a better outcome.

And we can dig into what outcome it is that we’re measuring later and just evaluate that, accounting for all of the issues that financial advisors like myself typically spend a lot of time planning around, which are things like Social Security, like required minimum distributions, taxation. And typically we have some complex financial projection software to do the heavy lifting, but I wanted some quick tool that I could put together so we could really pull a lot of these levers and just get an assessment across a variety of situations to see if this strategy really holds up in all cases.

Katie:

So you’re like me, you like to play around in the spreadsheet and be like, let me see this directly.

Eric:

It’s my go-to, and it probably comes from 20 years of engineering before this. It makes me a bit obsessed with columns and rows.

Katie:

Eric sent me several iterations of this spreadsheet tool as he added various elements to it and on a later call we discussed other things that we wanted to look at.

Oh my gosh. Okay, so I have the spreadsheet in front of me, I’ve just opened it. Okay, this looks really complicated. What am I looking at? What is going on here?

Eric:

Yes, the financial projection software I think does a better job of making this look simple from a user interface standpoint, but taxes are really at the heart of everything and there’s so much that goes into them that it’s rarely just as simple as picking an effective rate and running with it. You leave out just one element and you might miss the entire story. So on the one hand we have this complex interplay of ordinary income and the progressive tax rate brackets that go with that, and capital gains and they have their own set of progressive tax brackets. We’ve got deductions and those can change based on your age and relationship status and even whether you’re blind or not.

But then on the flip side, countering the complexity of that is that we have some tax brackets that are relatively broad, especially in the income ranges that maybe a lot of your audience is in. And once we’re in those big brackets, sometimes we can make some pretty meaningful changes and that doesn’t really shift our tax situation much, just because of how broad those are.

Suffice it to say I just wasn’t that satisfied that an analysis that was banking on some fixed low effective tax rate was going to give us all of those little super granular details that maybe your rich audience thrives on. So I wanted to see how much our more laborious kind of financial planning software type calculations, how many of those that we could stick into this spreadsheet to be able to play with. Like yours, I’m tracking the retirement account balances and that after tax savings account. That’s part of the strategy.

And then at some point in the future, we switch gears from saving and start retiring and now we’ve got to pull funds to generate whatever that retirement income is that our couple needs. Obviously I had to make a few assumptions about where we’re pulling that money from because of the tax implications we talked about earlier. And then at some point you’ve got Social Security as well. So we’ve got this income and we’ve got these expenses, so we’re pulling from Social Security is paying first, then we take from the pretax accounts, which is going to help us in those early years, like you said. Then we pull from the Roth accounts if we run out of pretax money and then we pull from the after-tax investment account if we come up short. And all the while we’re calculating year by year what is the tax situation for that year, with those brackets and that rate.

Katie:

Most of Eric’s concerns had to do with retirement income and taxation pieces that he said were largely out of our control or weren’t fully explored in our analysis. Specifically, he raised three primary concerns, Social Security, RMDs, and inheritance taxes.

So let’s start with Social Security. We made several, say it with me, assumptions in our original analysis. One was that high savers were stockpiling assets in order to retire early. We assumed a person or couple starts saving at age 30 and retires at age 55. Now, this earlier retirement date framework impacts my perspective in two key ways. The first is lessening the impact of RMDs, or required minimum distributions, giving the runway that your younger age provides you to circumvent them more effectively. And the second is lowering the Social Security benefits you’re going to receive.

So let’s talk about how those different elements play a role then more specifically. When it comes to the Social Security piece, and it is a bit of a foregone conclusion in our conversation that we’re having right now, I think, that it will exist in 40 years in the same way that it exists today. There are levers you can pull there too. How are you thinking about Social Security?

Eric:

We could probably spend an entire hour just on Social Security alone, and I’d say that’s a pretty frequent conversation with clients. But suffice it to say we do expect some form of Social Security to be there in the future. I mean, it’s been around for almost 90 years and it’s almost more important now for retirees than it ever has been, as more and more employers have gotten rid of pension plans. How it’ll function when you’ll receive it, what the actual benefit will be, all of that’s subject to change. And we’ve actually changed, I think the Social Security program, I think 17 times in its history. So we’re used to having to make little tweaks along the way. But I think disregarding it entirely makes retirement planning perhaps unnecessarily pessimistic.

But if we take your original couple making a $200,000 plus household income, they’re probably going to expect somewhere in the 60 to $70,000 range as far as annual Social Security benefits are concerned, and that’d be around full retirement age. So on the one hand, that’s great, because it means that assuming that benefit’s there, we can add that to the withdrawals you calculated at 48,500, and now suddenly we’ve got maybe a more realistic retirement income of 110,000. Maybe it doesn’t help us for that age 50 to 65 range, but at least later in retirement that money is there.

But on the other hand, that means we’ve also just added $60,000 of taxable income and that’s obviously going to affect the tax rate and maybe eat into that window that you’d talked about of where we could pull out this money tax-free or at a super low tax rate when we’ve used up a lot of that window with perhaps Social Security income. So that was probably the first place that flew up a red flag for me in the analysis, was just that you’d calculated this 4% withdrawal rate and that led to a 4.74% effective tax rate and who wouldn’t want to sign up for that.

But there’s also this line that was in your episode, and I’ve seen it a lot in online blogs that talk about retirement income, that basically reads to the effect that during your working years, you’re saving at a marginal rate so that you can withdraw retirement at the effective rate. And that usually comes right before they make some incomplete assumptions about marginal rates being high and effective rates in retirement being low. And that’s why pretax is always a no-brainer.

Katie:

See, this pains me. Because I think if you’re assuming that this person is retiring at 50, that still might be true. Someone can’t start taking Social Security until they’re 62 and then could obviously defer beyond that, but regardless, okay, it sounds like you are just not a fan conceptually of making this explicit delineation between marginal rate now and effective rate later.

Eric:

Right. I am convinced that that is an inaccurate way of describing it.

Katie:

Okay, convince me.

Eric:

All right, I’ll try. So when we talk about the working years, we say each marginal dollar contributed is saved at the marginal rate. And that makes sense. We’re deducting that from our pay. We know that each dollar at that end of our pay is being taxed at a marginal rate. So any dollar I take off and put in the pretax account, saved at the marginal rate.

The problem is when we take those same dollars out of an IRA or 401k in retirement, they’re still coming out at a marginal rate. We may not know what that rate’s going to get up to, but every time we take a dollar out, it gets added to our income and eventually that income hits that income tax bracket and we have to say, oh look, I’m now in the 24% tax bracket. Every dollar I take out of my IRA is coming out at 24%. So I just don’t understand how that all marries up with this. We’re just going to calculate an effective tax rate and say the dollars are coming out at that. They feed into one another.

Katie:

You’re saying that it’s not like you can take that effective tax rate and then apply that effective tax rate to whatever income you want to assume.

Eric:

Right. Because every dollar you take out is affecting that effective tax rate and increasing it. So I get it. For small amounts of money, it kind of makes sense if here’s broadly what my effective tax rate is right now. Yeah, if I take a couple hundred dollars out of my IRA, sure, that’s really not going to affect my effective tax rate, but if I’m talking about taking 50,000 out, well now I could be potentially doubling my effective tax rate or at least increasing it significantly.

Katie:

And at that point you’re kind of back where you started, right? It wouldn’t matter if you’re paying the taxes while working or in retirement because your tax burden on that incremental dollar is going to be the same, assuming the rates were the same. So what levers do you recommend people looking at then? How would you counsel someone to determine their best path? What levers can they pull?

Eric:

Sure. So when it comes to Social Security, you don’t have a lot of levers to play with as far as the benefit itself is computed based on your best 35 years of employment. So unless you’re self-employed and can really manipulate how much reportable income you’re bringing in or are willing to-

Katie:

Interesting.

Eric:

… just severely change jobs, such as I really don’t want a big Social Security benefit, so I’m going to take a job that pays me half as much. I mean, probably not going to make that decision. So really for most people, the only levers that you have to move are the timing component. And I think you’ve mentioned probably in the past, and I haven’t listened to all your episodes, sorry, that you can take Social Security-

Katie:

Eric, why not?

Eric:

Well, I’m trying to get caught up. But I think you and I know that Social Security, you can take that as early as 62 and you can delay it until 70. And that’s a decision that each, if we’re talking about a couple, that each person in that couple gets to make independently and they kind of play off one another. So if I can choose any month between 62 and 70 and my spouse can choose any month between 62 and 70, that really gives you something like 9,200 different possible timing accommodations that are going to result in different levels of income coming in. Each year that you delay Social Security leads to about a six to 8% increase in benefits, on top of course the cost of living increases that are happening every year as well.

So we could make the assumption that Social Security wouldn’t be there, but based on your 4% safe withdrawal rate calculation, if we took the Social Security income they expect and said, well, what is that number as a 4% withdrawal of some savings, that would mean our couple would have to have saved something like an extra $1.7 million throughout their working career to replace that Social Security income that we’re assuming isn’t going to be there.

I know a recent study from Fidelity showed that the average 50 to 59-year-old 401k balance is like $175,000. Maybe expecting people to come up with another 1.7 million to make it so we don’t have to account for Social Security is perhaps not realistic. So if you can put together a plan that works without Social Security being there, that’s great, but if you’re somebody who’s trying to put a plan together without accounting for it and it’s not working out for you, I don’t know that I would write off Social Security just yet.

Katie:

You know what this is also making me realize is how it can backfire to make your taxable income look as low as possible. Because if you are trying to make it look as though you’re not earning any money, your Social Security, like if you’re self-employed, to your point, and you can really make it look like you’re not earning much, you could be investing the money yourself elsewhere, but I don’t think that people really think about how that element of their tax strategy as a self-employed person would impact them later, that oh, you actually might just get a lot less in Social sSecurity benefits now.

Eric:

Yeah, it’s interesting because there’s a lot of business owners that I talk to who go to their tax accountant and say, “I want to pay as small amount in taxes as possible.” And I don’t think they realize that by doing that they’re also, yes, they’re saving now, but it is affecting their Social Security benefit down the road.

Katie:

Well, it basically only benefits them if they’re not paying that money in taxes and then turning around and investing it for the future because if they’re just spending it, well, now you’re really up a creek. We will get right back to it after a quick break.

Let’s talk about required minimum distributions for a second because RMDs are basically what happens when the government acknowledges that you have avoided taxes for too long and rewards you for your financial prudence by forcing you to start withdrawing money from your traditional retirement accounts expressly so you can pay those taxes. Now, RMDs were Eric’s biggest concern with our original analysis, and even though forcing you to have more income doesn’t exactly sound like a problem I would be unhappy about, Eric told me that someone who’s been contributing the maximum amount to their 401k for 25 plus years will have RMDs of about $75,000 per year in today’s dollars, starting at age 75. Now, RMDs are currently required to start at age 73, but legislation has that going to 75 in 2033.

I think where the ideal and optimal meets the practical application here, which I guess is really what we’re concerned with, it’s probably the sticking point, what I’m hearing is that we are assuming no other tax planning for RMDs, right? Because if I started contributing the maximum to my 401k at 30 and then I retired after 25 years of maxing it out at 55, could I not take pains then to start converting or drawing down portions of that money immediately and then spend the next 20 years turning that money into something that is more tax efficient via Roth conversions or something else?

Eric:

Of course, at least our current tax code would allow you to do something like that. And I feel like with all the assumptions we’ve made, we need a little disclaimer ticker running across the bottom of the screen, like a CNBC episode or something.

For the couple we’ve been focusing on, I really haven’t done a lot of tax optimizations. As we discussed earlier, it’s hard to know everyone’s individual situation and what it may be and what tax strategies might be available in the future to them. So I had to make some assumptions about how money is pulled out during those pre-social security years and then after. It can help the early retirees for the reasons you mentioned. And it also prioritizes the way I’ve done it, passing along the tax-free assets to heirs, and it might not be right for everyone, but at least gives us a consistent base to compare the other situations against.

Katie:

Yeah, and I guess it’s almost like where do you balance what someone’s actually most likely to do versus what looks best in a model, in a spreadsheet.

Eric:

Right. And in theory, someone retiring that early, to your point, could use the next decade or two taking advantage of every inch of those lower marginal tax brackets to help improve that situation down the road, paying a low marginal tax rate now so that hopefully I don’t have to pay a higher one later.

Some of the common limitations with that are just the difficulty in executing some of those strategies, especially if you’re trying to do it on your own, just given the complex nature of our tax code, although hopefully you’re working with an accountant or financial professional who can help with some of that. The interplay of taxable income on current healthcare plan tax credits and/or Medicare premiums, I think that’s an interesting one that comes up a lot, just because if you’re paying for private health insurance from age 50 to 65 until Medicare kicks in, at least our current healthcare marketplace, those premiums are based on your reportable taxable income. So if you’re doing huge RMD conversions, you might be now suddenly paying thousands of dollars, tens of thousands of dollars more for your health insurance.

Katie:

I love it here.

Eric:

But yes, the earlier you retire, the more flexible your tax situation may be. And if you haven’t looked at those account projections ahead of time or you’re for some reason constrained based on the other things we’ve just talked about, then it might surprise you when you get to RMDH.

Katie:

The other nine things that we’ve talked about.

Eric:

Because RMDs also aren’t withdrawn at a fixed rate. They’re adjusted for age and your account balance every year. So for most of your audience, RMD is probably going to start at around age 75. It’s 73 right now, but going up to 75 over the next decade. And so at age 75, at least with the current life expectancy tables, that works out to your first withdrawal being about 4.07% of whatever your account value was at the end of the year before that.

And those percentages then go up every year and they also can get adjusted from time to time based on changes in life expectancy. So your first RMD is already bigger than the 4% safe withdrawal rate we’ve talked about, and it’s just going to get worse, if taking out more income is worse. By age 85, it’s six and a quarter percent. By age 90, you’re drawing more than 8% out of your account every year. And there’s really not much at that point that you can do about it. That’s the bare minimum you can take out. So if we’re assuming a 7% rate of return, that means our account value for a lot of those years is outpacing the RMD, which means the RMD not only is going up as a percentage, but it’s also going up on a bigger balance every year. And so that just creates these tax constraints through retirement that we can’t really avoid.

Katie:

And at that point, I mean, things start to get a little existential for me, where I’m like, okay, at 90, who really gives a shit? You’re not really concerned about lowering your tax burden by then, I would assume, unless you’re super altruistic and you want to make sure that your kids, your charities get as much as possible, which is obviously a total consideration here, but when we start talking about the problem of having too much money when you’re too old, I’m like, yeah, this is not, at least as a 28-year-old today, not my primary consideration. I’d be okay with that problem. That’s fine.

Eric:

And I completely get that. I was just kind of approaching it from the standpoint of, well, gosh, if we’re going to even waste time trying to optimize taxes, really we should be looking at it for the entire retirement and not just, gosh, what gives us the best first 10 years?

I said there was really nothing we could do about RMDs. I mean, there are some small strategies like [inaudible 00:29:59], God, the financial industry loves its acronym. I’m just saying that if you didn’t plan early enough to do some of those strategies that you had mentioned, then it’s a huge forced income problem. And we see clients who come in, especially later in life to start working with us, who are just surprised when you tell them, “Hey, guess what? Next year you’ve got to take $130,000 distribution out of your IRA.”

Katie:

I’m struck by how, even though I am loath to acknowledge that these are all very excellent plot holes in my analysis, it’s also weirdly hopeful in a way for retirees, like, oh darn, I’m going to have multiple six figures and forced income. What a drag. There’s just this weird optimism that feels worth calling out, too. And that yes, we are obviously both very perhaps irrationally excited by tax avoidance strategies and we have fun trying to figure out what’s the best way to optimize this. But I’m almost relieved by the fact that this is the financial world that we’re existing in right now, where these are considered our most pressing problems. What a great spot to be in, that this is the problem you’re trying to avoid.

The last aspect Eric raised was inheritances, and I stand by the fact that if you receive a substantial inheritance or die with enough money to bestow a substantial inheritance on someone else, a lot of these tax planning hacks at the margins are borderline irrelevant to you. What do you care if you owe an extra 20k if you’re sitting on five million bucks? But still, it’s worth considering. So I asked Eric to talk me through it.

I’ve kind of always ignored inheritances, maybe because I don’t have one, but I’ll admit that that is empirically shoddy on my part. But at a high level, can you make the case for why I should care? Give me CFP spin on why I should be thinking about inheritances as a piece of this puzzle.

Eric:

Sure. So I think the fundamental assumption in this entire analysis from the beginning is that individuals are concerned with minimizing the amount of their wealth going to taxes whenever that happens. But you may have approached it from the viewpoint of which approach creates the highest income flow, but effectively we’re asking the same question.

And this tax minimization question is really the foundation of estate planning, tax planning, investment planning, and if individuals weren’t concerned with taxes that were being paid by those inheritors, then why would we spend so much time and money trying to avoid it through all these complex trusts and lifetime gifting and discussions like the one you and I are having? So I just assume that if minimizing all taxes paid regardless of which side of the dirt I’m on when they get paid is a priority, then we should probably at least consider the inheritance issues and introduce yet a few more assumptions just for fun.

Katie:

We’re up to number 11 now.

Eric:

I’m glad you’re keeping track. But improper planning could lead to the next generation paying perhaps as much as 40% in estate taxes or inheriting an IRA and then paying a 37% or maybe 39.6% of the current tax table sunset. And maybe some of that could have been avoided with different planning ahead of time. So your initial approach was mostly concerned with income, but you were tracking account values. I mean, you know in your spreadsheet how much money that your couple ended life with. So I just thought that before we declare victory on one strategy, we should probably figure out how those end of life values might change as that money moves to the next generation.

Katie:

Fair enough, fair enough.

So yeah, a Katie side note here, a lot of people want to pass down wealth to their children, and in that sense, you’re really trying to play the tax long game because you’re not just concerned with how the nine factors we highlighted at the top of this episode will impact you in your lifetime, but for lifetimes to come. Taxable investment accounts receive a step up in cost basis, effectively making the amount the inheritor receives the new cost basis, so no gains to pay taxes on.

And while Roth accounts and our taxable investment accounts are effectively inherited income tax free, that doesn’t mean they’re exempt from estate taxes. And without getting too deep into bar exam material, an individual today can transfer about $12.9 million to the next generation without having to pay federal estate tax. Or for those of you who are not wearing your calculator watches today, that’s about $25.8 million per couple, thanks to portability or the ability for one spouse’s exemption to be added to the surviving spouse’s.

According to IRS data, fewer than 2% of estates that filed tax returns between 2011 and 2016 owed estate tax. So it’s not really a significant issue for most individuals, though that exemption number is expected to sunset at the end of 2025, reverting back to the pre tax cuts and JOBS Act number, or about half of its current level. Still, you’d have to have a lot of money for this to be a concern. Additionally, 12 states have an estate tax, so you may be subject to that depending on where you live.

As for tax deferred accounts, the inheritance rules used to be much more favorable, but that changed recently and now a non-spousal beneficiary has 10 years to liquidate a traditional IRA. This is less of an issue if it’s not large, but Eric pointed out you may end up with millions in the IRA that you’re passing down, which means your children would basically have 10 years to liquidate it at their marginal tax rate.

Eric:

So I basically ignored estate taxes just because of the high threshold and how few people are actually subject to those, at least at the federal level, and primarily focused on the income taxes that you would pay on a pre-tax retirement account since that’s the one that basically can’t be avoided and everyone’s going to be subject to.

So with some specific exceptions, non-spouses who inherit an IRA have about 10 years to empty that account. So if you pass away with a few million dollars, and in today’s money in a pretax IRA, and suddenly you’re perhaps healthily employed son, daughter, niece, nephew, or favorite financial blogger may suddenly have hundreds of thousands of dollars of additional taxable income, and your hard fought taxed optimized account is now just getting slammed at some obscene marginal tax rate.

Katie:

Oh no, I hate it when I get hundreds of thousands of dollars unexpectedly. Oh no, I kid, I kid. No, you’re right. You’re right. I think that that makes a lot of sense because you’re going through all this painstaking work to try to optimize your situation and then all of a sudden it’s like, well, shoot, I have 10 years to empty this thing. I really don’t have a choice.

Eric:

And we have the same conversation with clients and especially beneficiaries that don’t look a gift horse in the mouth, you’ve got money, but if you’re going to spend 60 years of your life trying to optimize all this stuff, you’d hate for something to go that awry because you just didn’t put a little bit more thought into it ahead of time. And I also just hated the idea of declaring, again, victory, just looking at the inheritance balances without at least acknowledging that Roth dollars in this context are not the same as pretax dollars once they move to the next generation.

Katie:

From that perspective, it’s Roth is definitely the favorable. You would absolutely want to be passing down the Roth dollar. So I guess for the sake of argument, I’m like, well, if we assume all of these things are true, that you’ve got a household in the 24% marginal tax bracket, they take their Social Security, their RMDs, what does their retirement tax situation actually look like then?

Eric:

All right, well, are you ready? Because I had to add a few more assumptions just to make sure that-

Katie:

Oh good.

Eric:

That we got-

Katie:

Just what we needed. I was just thinking we were short a few.

Eric:

Right? There’s a few details that just had to crop up. So we took your couple that was in the 24% tax bracket, but in order for all those dollars to be going in the 24%, we had to give them an income of about $275,000. And I guess I should point out, I’ve got both couples contributing to their 401ks.

Katie:

So 45k.

Eric:

Right.

Katie:

Okay, cool.

Eric:

And then of course you’ve got the standard deduction coming out of that and that’s what gets you kind of to that edge of the 22, 24% tax bracket.

Katie:

Nice.

Eric:

I also just assumed that their employers were matching something and I picked 5% and I assumed that money was going in on a pretax basis. We didn’t account for any other savings. So this 30 year old couple has already, I don’t know, maybe they blew their entire savings account on a down payment in this housing market, but.

Katie:

Sensitive subject.

Eric:

Sorry. Does that hit too close to home?

Katie:

Triggered.

Eric:

Pun intended. And I’m just using standard deduction. I’m not accounting for child tax credits or any other craziness like that. We’re using the same 7% rate of return you had, same 3% rate of inflation. The current tax code with all of its rates and brackets just adjusted for inflation going forward. And then true to your analysis, we did put every tax dollar saved into another account that I’m basically treating as just tax-free growth. I could account for the fact that if they’re invested, they’re getting capital gains or interest in dividend income and blah, blah, blah. But I’m just assuming that it’s all just perfectly invested and they don’t pay a dime in taxes on it until money gets pulled out of it.

And since I wanted a representative kind of retirement period, I just used a life expectancy of 90. And I guess I should point out I didn’t account for any age 50 catch up contributions to the 401k if anyone’s trying to repeat my math here. For the rest of this conversation, let’s just keep numbers in today’s dollars so we don’t have to do the mental inflation math hurdles.

Katie:

Yeah, good call.

Eric:

So our couple who chose to do pretax contributions paid an effective tax rate during their working years of about 15.3%.

Katie:

Nice.

Eric:

And then they paid an effective rate in retirement of about 11.9%.

Katie:

Nice.

Eric:

I mean, really varied between 10 and a half and 13, depending on those different issues that we’ve talked about before as far as RMDs ramping in and whatnot. But they stayed in the 22% marginal tax bracket throughout retirement. So that’s a small win. They were in the 24, now they’re in the 22.

Our couple that chose the Roth path paid an effective tax rate during employment of about 16.7%, so almost a percent and a half higher than our pretax couple, but they paid an effective tax rate in retirement of just 2%.

Katie:

Oh man. Okay. You’re telling me it’s a what, 11.9% for my pretax scenario versus two for Roth? So that sounds like a huge difference. Does this mean my entire analysis is screwed?

Eric:

Drum roll.

Katie:

Okay, yes?

Eric:

It’s actually pretty surprising. The results are staggeringly skewed towards the pretax approach.

Katie:

Woo-hoo. Victory lap for 401k strategy. Should I jump up from my desk and do jumping jacks? How is that possible, though? It seems like if you’ve got a 2% of retirement, that’s pretty substantial. So walk me through that.

Eric:

So let’s put some numbers to it to flesh this out a little bit more. So our pretax couple started retirement with about $3.2 million saved up. So this is age 50, and that’s across all of their various accounts.

Katie:

So they did retire at 50.

Eric:

Right. So they retired at 50, started drawing down on those pretax accounts and after tax savings accounts, and they ended life with about $1.7 million in after tax inheritance.

Katie:

Like they’re giving that, they’re passing that down.

Eric:

Right. So the next generation paid, I assume the 22% inheritance rate on that, and that’s what they ended up with, was 1.7 million.

Katie:

Cool.

Eric:

Our Roth couple who started retirement same age, everything else is the same, but they started retirement with 2.7 million saved up instead of 3.2, so about half a million less, and they were only able to pass on about $900,000 to the next generation.

Katie:

Well that certainly, as someone who’s received no inheritance, that certainly feels like a meaningful difference to me.

Eric:

I think it is. Yeah. That’s a pretty substantial 84% higher benefit for the pretax slash invest tax savings camp, if you’re just comparing the two inheritances. And I tried running this even with the tax code that we would get at the end of 2025 when the current law sunsets.

Katie:

Oh my gosh, you went so above and beyond.

Eric:

I know. And that gap does narrow just a little bit, just because the old tax code that we would go back to has slightly higher rates. Your 12% goes to 15, 22 goes to 25, and the lower standard deductions associated with that. And under that scenario, advantage drops from the 84% to 73, but it’s still substantial. So it just goes to show you, I think, that those extra investment dollars that you’re putting away during your working years compounding for that much time really does outweigh even that substantial change in effective tax rate in retirement that the Roth side gets.

Katie:

Sweet vindication. Well, okay, so let’s leave ideal land, though, for a second and let’s take a jaunt down reality lane instead. Because what happens if you don’t include the investment of the tax savings? Did you run that scenario? What happens then?

Eric:

So we did, and if we don’t include the tax savings being invested, then the tables tilt wildly in Roth’s favor. And I don’t think that that should really surprise any of us.

Katie:

And if you didn’t listen to our original episode, allow me to summarize the ultimate 401k strategy that we had landed on. You contribute as much as you can to your traditional 401k, then you calculate, based on your marginal tax rate, what you saved in taxes by doing so. Or you can use the 2024 Money with Katie wealth planner’s income tax estimate with and without your pretax deferral and it’ll show you the difference in federal and state taxes owed. And then you invest that amount of money in a Roth IRA or perhaps a taxable brokerage account if you’re already maxing out a Roth IRA. But since it’s money you did not have before making the pretax contribution, you are investing net more money with the same income.

I guess the upshot then is if you’re only contributing 22,500 total and your choice is traditional or Roth, it’s obvious that if you’re contributing the exact same amount to both account types and not investing anywhere else, and they grow this same amount, the Roth is going to provide you with more total withdrawal potential. It is only in investing your tax savings from that 22,500 contribution somewhere else, I mean, I say ideally a Roth account, but pick your poison, that you’re going to edge ahead, which I will concede might not be the natural course of action for most people who aren’t intentional about this or don’t listen to the Money with Katie Show.

Eric:

That’s correct, and I think that there’s an interesting aspect of behavioral finance that comes into this in that people tend to do the easiest thing. And I think if you are contributing on to your 401k, that money’s coming out of your paycheck. So it’s easy to avoid that. But once it hits your bank account, then I think it takes a lot of effort and intentionality to say, no, some of that money belongs over here invested, and after 10 years, when I’m looking at my quote unquote a hundred thousand dollars savings account over here, that again is supposed to be earmarked for retirement but doesn’t have maybe any constraints around it, especially if it’s not a Roth IRA or something, maybe there’s that inclination to pull funds from it before you should.

And that doesn’t mean that you shouldn’t. Maybe you live an even greater lifestyle there during your working years. But it does just kind of point to the fact that people who want to make the best of that strategy, the save the pretax money strategy, have to overcome that impulse. They have to work harder to do that. It just goes against our nature.

Katie:

Oh, absolutely. And I get that question all the time where I think it shows maybe where I have not done an excellent job of explaining what I mean because people will say, “How do I know what my tax savings are? If I’m maxing out my 401k, how do I then know what amount of money I need to be turning around and investing somewhere else? What is it creating for me?”

And so I think the real calculation is a little more complicated, but I always just tell people, “Multiply your contribution by your marginal tax rate and then that should be the number you’re striving to invest somewhere else.” That’s the simplest way to, although if you’re right, barely in the 24%, most of it might actually be in the 22, but you get the picture. I mean, that seems pretty extreme, though, the difference in outcomes if you just half-ass the strategy, you don’t do the entire thing.

Eric:

Well, let’s go back one step because I didn’t want to walk away from this. Oh, I didn’t invest the tax savings and had a different outcome without talking about what that outcome was. So if we assume everything else was the same, the amount of money I spent in retirement, et cetera, and I just didn’t have that tax savings account there, our pretax couple actually ran out of money around age 87, while our Roth couple really passed on the same 900,000 because nothing has changed about their situation. So we went from passing on, what was it, 1.7 million to suddenly actually running out of money.

Katie:

Running out of money. Oh my gosh.

Eric:

Three years before that. So it’s something to consider as far as those two strategies. And going back to your original point, if all you can really do is commit to this amount of money is going into my retirement plan, the Roth is actually saving more money, because you’re saving the full amount and not the amount I’m going to pull out later, plus the taxes I have to pay on that.

Katie:

Okay, can we edit our CNBC ticker to say remember please? Because that’s like the crux of the entire thing is that you might think, okay, I’m looking at my income, I can only afford to invest 22,500. It’s like, but in the process of investing that money in the pre-tax account, you are now getting more investible income. You just have to make sure you actually take the investible income.

Yes, you have to actually use the bigger paycheck for more investing. And you can’t just go buy more pairs of Louboutins with it, which is sometimes what I do. So do as I say, not as I do, I guess. So we know what it looked like, I guess though, for the 24% couple. Did you look at the trend for the others? Did you see what happened with the 12% and 32%, like we talked about originally on the show?

Eric:

I did run those. Obviously had to make a bunch of other changes to my assumptions about how much they were putting away and what their expenditures were going to be in retirement to make it scale somewhat. So for our couple, I just assumed they had about a hundred thousand dollars of household income and maybe a $60,000 retirement budget and they’ve just got one person maxing out their 401k and getting let’s say a 3% employer match. So just kind of scale everything down.

And in that case, it made much less difference which approach they used. I’d say the end of life after tax inheritance values between the two was less than a 10% difference. And I’d say given, how many assumptions did you say we’re up to, 13? I’d say given those, a 10% difference is a rounding error at that point.

Katie:

Yeah, that’s totally fair.

Eric:

And then we looked at the 32% couple as well, and really the trends were very, very much in line with the 24%. So there really wasn’t anything drastic there.

Katie:

Victory. So I’m feeling pretty good about the spreadsheet math, given Eric’s far more complicated findings ended up mostly supporting my theory, though he did have me in the first half, I’m not going to lie, I thought I was toast once he started popping off about Social Security.

But we’re not done yet. Remember that my previous assumptions centered around this couple that retired early and had time to stretch out IRA withdrawals, achieve lower RMDs, and have smaller Social Security benefits. I had to know if the results changed if a couple worked into their sixties or seventies, which is a situation that Eric said was very common among his clients.

Can I ask you a couple more questions, though? How did the results change if someone does work until they’re 65? Because when you originally reached out to me, the email that you sent looked at that, and I might be naive, but it seems like someone who’s trying to lock in this strategy early in life and work actively towards something like financial independence probably wouldn’t want to work that long, but maybe you’d end up really loving your job and you do actually want to work for income for that long. I don’t know, things change. So I’m curious how the results would change.

Eric:

That’s a valid question and I think I’ve found in my years of working with people from a range of income and family wealth levels that a lot of people have chosen to continue to work well into their sixties. I think I even have a few clients still working into their seventies and it’s not necessarily because of a financial motivation Sometimes it’s to maintain maybe health insurance through their employer. They’re just not ready to jump ship at 55 and switch plans when they’ve been happy with whatever they’re on. Often it’s just because they enjoy what they’re doing and they’re not ready to stop. And we could spend a ton of time talking about the psychology of retirement. I think it’s fascinating.

But I think for many of the more affluent listeners you have, those jobs tend to be less labor intensive, and so it’s something that they’re really just physically able to keep doing well past age 60 and the thought of retirement just might not be that appealing. They enjoy the work. They’re getting paid well to do it. They don’t want to deal with the hassle of finding private insurance and drawing down retirement funds before they start Medicare and Social Security. It’s not that they can’t do those things, they just choose not to.

Katie:

Yeah, I mean, you’ve got your lucrative fake email job, what’s not to love? Keep it for as long as you can. I can totally understand that.

Eric:

And I can do it from anywhere.

Katie:

And I can do it from anywhere. I know a couple of people in their fifties and sixties, I would say pretty well, that probably could have retired in their forties, because they’ve accumulated that much. They’re still working, they’re doing it by choice, and they’re happy. And I mean, in an ideal world, this is kind of where we come back to the optimism piece or the, isn’t this actually kind of wonderful piece, ideally you’re not rushing to quit your job ASAP. Ideally, we’re all going to find jobs that we love. We’re all going to have high paying fake email jobs that we want to do for a long time to come.

Eric:

And it’s all about satisfaction. If your health is good and your life expectancy is 90 plus, and I realize we use 90, I mean, by the time our generation gets up there, I mean, gosh, just think that if we cured cancer suddenly our life expectancy is-

Katie:

I’m going for a hundred, I don’t know about you, but I’m trying to hit triple digits.

Eric:

The retiring at 50 can be daunting. That’s half your life without employment and spending down your nest egg at the same time. For those who are in the throes of a stressful work life now, maybe that sounds like utopia, but for many, I think their social groups and personal satisfaction are just so intertwined with their contributions to society or an employer or however you want to look at that, that to remove that suddenly creates this real crisis of purpose.

The early retirement years, I think that’s what everyone thinks about when they think about retirement. They just think, oh great, that’s an extended vacation. There’s so much I can do. I’ve got this huge list of bucket list items that I can get taken care of. But I think over time that can wear on you a little bit, and that bucket list starts to shrink and your friends may still be working. They can’t do these activities with you. And if you’re not well connected within your community or engaged in social or philanthropic endeavors, then your list of activities may shrink considerably over the years.

And all the while through that, remember, you’re dealing with that psychological baggage of worrying that your nest egg has to last you another 40 or 50 years. I think that’s something that maybe goes underappreciated, is just how much our brains have trained themselves over 50 years that I put money in, account gets bigger, and making that transition to now I’m going to spend the next 50 years taking money out, account gets smaller. That’s a tough hurdle for some people.

Katie:

It’s hard. It’s hard.

Eric:

And over that period of time, if you think about the markets and what our expectations should be, we expect to have a pretty significant drawdown in the markets multiple times per decade. We expect or should expect at least a decent recession every decade. That’s just what history shows us, which means over 50 years, you’re going to experience that a lot.

So if you go back in your mind and think how did it feel in 2020 with Covid and how did it feel in 2008, 2009 with the Great Financial Crisis, and how did it feel during the dot.com bubble? That’s three major financial situations that have all occurred just in the last 20 years. And you’re going to have to live that two times plus through retirement. So it could be stressful.

Katie:

Yeah, I mean, no kidding. When I pretend to put myself in those shoes today, yeah, I mean you could be totally unemployed and just vibe. If you told me, “Hey, you’ve got $10 million right now, go ahead,” I wouldn’t want that. It honestly sounds scary. This is also partially why we did an episode about sabbaticals not too long ago where we encourage people, if you’re really looking forward to early retirement, you probably shouldn’t try to cram all the work into the first 40 years of your life just so you can coast for the next 60. You should probably just start taking six months to a year sabbaticals now and just work for longer because it’s maybe not all it’s cracked up to be. I’m sure there are wonderful components of it, but to your point, there are also really pretty substantial psychological challenges to face, too.

And if you’re not quite ready for that, you’re right, I think it could be a very real case of expectations not meeting reality. So let’s say someone else is in those shoes, though, maybe they want to retain the option to retire. I think that sounds nice, again, psychologically to know that I could, but also maybe I know myself well enough to say, okay, Katie, you have a hard time going a week without working. The chance that you’re going to completely stop working altogether anytime soon, yeah, that’s not going to happen. But you have to have a contingency plan for working till 60. Does that seriously screw up the numbers or how does that really change things?

Eric:

And keep in mind, it might also not just be that they’re working, maybe they’re a business owner and yeah, they’ve completely stepped away, but they’re still drawing a significant revenue stream from that or-

Katie:

True.

Eric:

Or you own a lot of investment properties. I guess the main point is just what happens in the scenario where we’ve got a substantial income coming in still between age 50 and 65, that again has taken away those tax planning years that we were hoping to use to drop some of this future tax liability. So it turns out that actually does have a huge impact on the numbers themselves.

The overall strategy recommendation I think still remains intact in most cases. Contributing to those pretax dollars, investing in the tax savings still gives an edge, but it has given up a lot of ground. And so if we look at our 24% couple and see how things have changed with another five to 10 years of employment, if you remember, we showed an 84% advantage in those after-tax inheritance assets between our pretax and Roth couple.

If they work until age 60, that lead drops to about 10%. If we have them work until 65, that lead drops to about 3%. Which again, going back to earlier, I think anything in that zero to 10% range is really any small change in tax code or any one of the number of assumptions we’ve talked about could easily make that sort of difference I think disappear. Our 12% couple, however, now shows for the first time a win for the Roth.

Katie:

Oh, okay.

Eric:

And that’s even after accounting for investing the tax savings. And I don’t know that I’d get too hung up on the size of that difference, but just suffice it to say that we’re now playing very sensitively around that significant tax jump from the 12% bracket to the 22. So from the 22 to 24% tax bracket range, that’s a huge income range. And if I pull up my numbers real fast, 22 to 24% covers incomes from 90 to 365,000.

Katie:

Oh, geez.

Eric:

That’s a huge range, with only a 2% tax difference. But if you go from 89,000 to 88,000, well suddenly you’ve dropped from 22 to 12%. So that almost doubling of the tax rate right there means that if they’re really close to that boundary, then working a little bit longer may suddenly mean that their entire retirement’s on the other side of the line instead of the shorter side of the line. So that’s where I think this 12% couple is showing this anomaly.

Katie:

That is such a good distinction. I know typically when people who are pretty solidly in the 12% reach out to me and are really hung up on this, I’m like, “Honestly, just do Roth. It’s fine.” I was like, you know what? At that point I would just like, if it gives you the peace of mind, don’t even bother with it.

All righty, to sum things up, the traditional 401k plus invest the tax saving scenario still held its own and remains the reigning champ in pretty much all scenarios. That said, your effective tax rate will probably be higher than my original estimates if you factor in both Social Security and RMDs. Now, if you lack the discipline to invest your tax savings, let’s be honest with ourselves, if you know that that’s you, choosing Roth will result in more overall retirement savings.

The earlier you plan to retire, the more sensitive you are to these contribution choices. Retiring later removes a lot of the advantage of the pretax plus tax savings approach and begins to tilt the scales toward a purely Roth approach, or at least makes it so close between the various strategies that you probably should not get too hung up.

And finally, getting the most out of this strategy requires playing the tax game in early retirement. Proper tax planning, and we’ll link our fun tax-free retirement episode in the show notes, can really take this to the next level. And of course, all of the assumptions these results are built on can change at any moment for any person for any reason. How’s that for a disclaimer? And while I don’t think it’s necessarily worthwhile to try to predict what tax rates are going to do in 50 years from now, Eric had a different view.

Eric:

There’s reason to argue that we are paying right now the lowest rate of taxes on income that we ever have as a nation. I think when you just look at our current tax rates, tax brackets, the types of credits that are available, we’ve been effectively cutting corporate and personal income tax rates over much of the last, I think it’s like 80 years at both the top and low ends. So everyone’s kind of benefited from that, and I don’t think it’s any secret that the government has a budget deficit problem.

And there was actually a recent study by the Committee for Responsible Federal Budget that looked at our deficit problem, said, okay, well if you wanted to address this over the next 10 years and we weren’t going to touch defense, Social Security, Medicare and veterans spending, which has very broad support, but those are the things that consume a lot of the budget, so if we can’t touch those, then we basically have to cut all other spending by 85% in the next 10 years just to get to a neutral budget.

And so I guess where I’m going with this is we’ve got a low tax revenue because we’ve been dropping rates forever. We’ve got high expenses. One of those things in my mind would have to give. So I’m not typically a gambler, but I guess I’d be willing to bet with my 401k salary deferral election, that tax revenue is proudly going to have to go up in the future, and that’s going to be an easier road than making the sorts of cuts that would have to be made. So tax code, maybe this is as good as the tax code ever gets for us, I guess is the summary.

Katie:

I wish I could deploy my Reagan drop. It’s like trickle down economics, baby. Anyway, yeah, but okay, I mean I hear you, but also these things are cyclical, right? Even if they go up in the next decade, who’s to say that by the time I retire they’re not going to be on a downswing again? And considering how politically unpopular it is to raise taxes and the class of people on whom most tax rate increase discussions are focused, at least from what I see, I feel like usually we’re not talking about the middle class, which in my mind is anyone who earns less than $500,000 in income.

If you want to say [inaudible 01:02:57] that number has to go for the entire country and people that are in SF and New York and whatever, I can’t see them really increasing, going like who should we increase the taxes for, the people that are earning millions of dollars a year or the people that are earning $60,000 a year? It seems like most of the tax increases focus on the higher earners, but I don’t know, is that in what you’ve seen, or from where you’re sitting, do you feel like it’s a widely held belief that those who are currently in that 22 to 24% bracket are going to see their tax rates rise? Should we be worried about that?

Eric:

No, I think I generally agree with you. I think it’s probably more important where your income falls relative to those boundaries themselves, and 22% versus 24, maybe not a big deal. I think when the tax code sunsets, it’ll be 22 versus 25. Maybe that’s more substantial.

But if you can make those changes that are going to move you down from a 22 to a 12% bracket, that’s somebody who’s going to be much more sensitive to little changes in the tax code, where that boundary moves relative to your income. So those are the people that maybe should be paying a little bit more attention to where those conversations go because that could change their strategy then if they suddenly find themselves doubling their tax rate. So maybe the thing that’s more concerning would be to watch out for changes to things like Roth account rules or changes to capital gains rates.

Katie:

I think those are going to get targeted, unfortunately.

Eric:

There’s a lot more room to play there, and maybe people are less sensitive to that, at least politically-

Katie:

Oh yeah, because think about everything-

Eric:

[inaudible 01:04:33] paycheck.

Katie:

Who owns the stock? What is that saying, that 90% of the stock market holdings are owned by the top 10% of Americans? So the vast majority of, like your average American is probably a lot more concerned, I mean, rightfully so, about how their income is being taxed than what they’re going to pay on capital gains taxes.

Eric:

And obviously a big change would be if we saw an elimination of cost basis step up at death, that would obviously change a lot about these calculations, especially depending what that capital gains rate is. If capital gains rates suddenly were the same as our ordinary income rates, well maybe now those two strategies, the save my tax, put my tax savings away, plus the Roth, maybe those two strategies become a lot closer in that scenario, but I don’t want to play this game all afternoon because we could and we could come up with all the fear-

Katie:

You don’t? Why not?

Eric:

… uncertainty, and doubt that we want to.

Katie:

It would be so fun.

Eric:

That’s what we get paid to do, is to predict the way that things can go wrong and do our best to try and plan around it. For me, it’s working with clients and for you, it’s sharing that information so that all of your listeners can be aware of it.

Katie:

At the end of the day, taxes are pretty inevitable, and I’d make an argument that citizens have a duty to contribute to the good of the whole, and taxes help us do that if employed properly, maybe the biggest if that we’ve covered today, but finding ways to pay less of your lifetime income in taxes is a worthwhile charge.

Eric:

Another way of putting it all is if the math and all these assumptions are overwhelming, then maybe it’s just sufficient to ask yourself, how do I feel about paying 22% or 12% or whatever my current marginal rate is today? Whatever rate you’re paying, just ask yourself, am I comfortable with that? If it went up or down, just am I comfortable?

The one thing about going the Roth route is that we can basically throw away a lot of these assumptions. I have locked in, hopefully, assuming no major change to Roth rules, I’ve locked in my taxes on that money. So I don’t care what happens in 20 or 30 years to the tax code because really it shouldn’t affect me.

Katie:

Yeah, you’re limiting your downside.

I hope you enjoyed this spirited discussion, and I would like to give a big thanks to Eric Jones with the Hook Jones Group at Baird Private Wealth Management for joining us today and bringing an actual license to the table, because I just bring the vibes. That is all for this week. We’ll see you next week, same time, same place on the Money with Katie Show.

Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is our chief content officer, and additional fact checking comes from Kate Brandt.

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