WHAT WAS COVERED
0:12 – Podcast starts
1:34 – The basics of a 401k.
3:56 – What actually happens in Korea?
6:37 – Building financial independence for the sake of a “work optional” lifestyle.
11:44 – Do you know what the tax rate is for retirement?
14:06 – How to calculate the tax liability.
16:08 – How much money should we keep in our core?
20:08 – How much should you put into a Roth vs. a 401k?
22:27 – Understanding taxable tax deferred and tax deferred.
25:26 – How to plan for a lower tax bracket in retirement?
[Tweet “Math is best used with planning as a relative comparison to the potential outputs of two different strategies being tested against one another. #YourBusinessYourWealth”]
[Tweet “Make no mistake that investing in 401k, a traditional one, is making a bet on tax rates. #YourBusinessYourWealth”] [Tweet “The higher percentage of your assets are in a tax-deferred account, the harder it is to engineer yourself into a lower bracket in retirement because all of that money is going to come out taxable pushing you back up the bracket. #YourBusinessYourWealth”]
Curious what you can accomplish with our help? Schedule a free 15-minute meeting with us! sfgwa.com/scheduling
Sound Financial Group’s Website for a Financial Inquiry Call – [email protected] (Inquiry in the subject)
SHARE THE SHOW
Did you enjoy the show? We would love it if you subscribed today and left us a 5-star review!
Click this link – Your Business Your Wealth
Click on the ‘Subscribe’ button below the artwork
Go to the ‘Ratings and Reviews’ section
Click on ‘Write a Review’
——————————————————————————————————————————- 0:12 0:31 0:38 0:44 0:51 1:50 3:30 4:04 4:07 4:29 4:40 6:13 6:37 8:03 8:55 10:55 11:16 13:15 13:43 13:52 14:08 14:42 14:52 15:56 16:13 17:21 17:34 17:39 17:52 22:27 23:53 25:27 25:46 27:18 27:31 This Material is Intended for General Public Use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation. Sound Financial Inc. dba Sound Financial Group is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance. Insurance products and services are offered and sold through Sound Financial Inc. dba Sound Financial Group and individually licensed and appointed agents in all appropriate jurisdictions. This podcast is meant for general informational purposes and is not to be construed as tax, legal, or investment advice. You should consult a financial professional regarding your individual situation. Guest speakers are not affiliated with Sound Financial Inc. dba Sound Financial Group unless otherwise stated, and their opinions are their own. Opinions, estimates, forecasts, and statements of financial market trends are based on current market conditions and are subject to change without notice. Past performance is not a guarantee of future results. Each week, the Your Business Your Wealth podcast helps you Design and Build a Good Life™. No one has a Good Life by default, only by design. Visit us here for more details: yourbusinessyourwealth.com © 2020 Sound Financial Inc. yourbusinessyourwealth.com ———————————————————————————————————————————
Full Episode Transcription
Hello and welcome to sound financial group podcast now no longer called your business your wealth because we have decided to connect the brand of the podcast to the ever powerful brand of sound financial group joined by Mr. Corey, the brand Shepherd, thank you for being here.
I thought it keeps, we gotta stop saying the old one, right, that’s called the brand that shall not be named.
Oh, we can do like, like Prince, like the artist formerly known as your business, your wealth podcast. And
no, I was thinking more like Harry Potter. You know, it’s like, the brand that shall not be named because we need to,
we’re now we’re now the new brand that is not the old brand. And welcome all of you for still following us. And we have a treat today where we are going to talk about what is the difference between your traditional 401k and your Roth 401 k. Now, Roth 401k rolled out sometime in the early 2000 10s, I think 14 or 12, in a case that Roth 401 K is now instituted across nearly every 401k that we run into, it used to be that only like one out of 10 employers had it. And now it seems to be the opposite. 90% of employers have it, one out of 10 doesn’t. So you probably even if you don’t know it, have a Roth 401 K and Cory and I are gonna show you the differences between the traditional side and the Roth side. So that you get the opportunity to make an informed decision as to what you want your future to look like based upon the decisions you’re making today. So Cory, would you kick off, maybe just walking people through the basics of a 401k and how it works?
Sure. So 401k is a paycheck deduction from your employer, you usually work with HR, or whoever’s doing your payroll to say how much you want taken out. And the traditional 401k was like a time machine on your paycheck, they take some of that paycheck, and instead of giving it to you put it into the time machine called the 401k. And then it moves it forward into time. And whenever you take it out in the future, you would then pay taxes on it. So you defer the paying of the taxes to sometime in the future whenever they Time Machine resurfaces. So in the short term, you get a deduction for that amount of money that’s put into your paycheck, or pulled out of your paycheck. And your employer usually matches some amount of that contribution into the 401k as well. Up to a percentage of your total income. Something like three to 6% on the high end is not uncommon. 6% is a little less common than the three side but we see it plenty. So as long as you’re putting in at least three to 6% of your paycheck, you’re getting as much as your employer would match for you. And the Max goes up every single year, this year 22,500. If you’re under 50. They add another 70 7500. Yeah, yeah, that’s right. That’s right, let another 7500. On top of that, if you’re over 50 as a catch up contribution.
And if you take it early, 10% penalty before it’s 15 and a half. And when it’s 401k, you might not be able to take it early. There are loan provisions that some employers allow in the plan. But if you are not terminated from your employer, you don’t get the opportunity to just touch your 401k may have the ability to for some hardship withdrawal reasons. But if like you needed 100 grand the former case, probably not going to handle that distribution for you. So kind of now that we understand the basic rules. Let’s look at what actually happens. Cory, I’m going to need you to keep your calculator handy if you wouldn’t mind.
Oh, mine. Oh, yeah. Okay. Yeah.
So you know how well we prepare for this ahead of time, folks. Well, I should say I prepare I don’t prepare Cory. Cory just walks in and, and like the Magnavox commercial, the older is that Magnavox where they put the cassette in and the guys blows the guy’s hair back. That’s how I forget. I think memory. I don’t know. Now we gotta go there.
All was did you want to HB 12? B A, ti 82. Which one,
you can use reverse Polish notation or not Cory, it’s totally up to you. And we’ll need that calculator here in just a couple minutes. So what we’re doing here is we’re looking at a person and what we’re going to do for the sake of this conversation, and for those of you listening on the podcast, this will still totally make sense but if you want to see the visuals, jump over to YouTube when you get a chance, but we are looking at it Individual age 40. So we’re looking at the ability for them to contribute to a retirement plan every year $22,500 each year, and what does that accumulate to now we think they should be able to put more money in each year over time. Because the 401k contributions are indexed, though, right now, we’re just going to look at his $22,500 year why math should not be used as a predictor like to predict how your future is going to turn out. Math is best used with planning as a relative comparison to the potential outputs of two different strategies being tested against one another, like we’re doing here. So we put in $22,500. Here, and Cory, this is what we end up with at a 7% return, we have $1,522,721. Now for the sake of this conversation, I’m going to make an assumption that this person is in the same tax rate when they put it in 30% tax rate. And when they take the money out, because it’s fully taxable, when we take it out, they’re also in a 30%. tax rate on distribution. So far, so good.
So far, so good. I was just gonna say one quick planning assumption we can, can make, as you know, let’s say it is 1.5 million give or take, that’s probably not enough to be the only place that you’re putting money for the rest of your life. So just Amen. Yeah, this is a segment of somebody’s finances. A segment. It’s never, this is the only thing you should be doing anyway.
Yeah. Which, incidentally, we’re going to talk about tax rates here in a moment, and we’re talking about retiring the exact same tax rate. Now, the reason we’re illustrating it that way, is the clients that we work with, are not working with us, because they want to have less money, income opportunity, ability to experience life in their old age, they want to still be able to fully experience life like they do now with more free time in their old age, which is why we call it building financial independence for the sake of a work optional lifestyle. Because it’s not that we wouldn’t work at all, but we want to have the option. But if that’s the case, and we’re in the exact same tax rate, that’s the math we’re doing here. But for many of you, at age 41, you probably put a bunch of money in the 401k. When you were in a 20% tax bracket back when you had two little kids and weren’t making much money and had a big mortgage payment, and you put money in it 20% Back then, and you’re gonna have to take it out 30% In the future, that is reverse tax planning, that is the IRS getting to benefit from all of your diligence, and trying to invest your money well, but because they’re partnered with you, and they get unilateral opportunity to change their interest in this partnership. When you take money out in your old age, or anytime, if you had a good income year, but had to invade your IRA or 401 K for some reason, you’re going to be paying a higher tax rate, because you already had a high income this year, and it’s going to stack on top. So
you just said something really important that I would I don’t want anyone to miss on I say it slower again, which is Yeah. A partnership with the IRS, where they’re setting the interest rate in the future. No different partnership interest rate. Yeah, yeah. It’s, it’s similar to if you had a mortgage where the bank said, don’t worry about the interest rate now, in 30 years, we’ll tell you what the bill is, or your mortgage? Yeah, it’s a little bit like. So there’s a lot of different things at play, you’re getting a match from an employer, like that’s a useful thing. But make no mistake that investing in 401k, a traditional is making a bet on tax rates. But that’s a really simple way to summarize how this account works, you’re making a bet on future tax rates. And you’re
making that bet, whether you realize you’re betting or not. Because you’re not only making the decision to defer the taxes on the 22,500 that went in, because we don’t have to pay taxes on that. But we’re also deferring the calculation. So in deferring the calculation, let me click over here, see if I can grab this chart really quick for us quarry. US income tax chart. So this hang on history of US tax that’s going to tell me how to calculate somebody’s taxes. Let’s get the tax history. There we go. And so you can see that we have had tax rates in this country. When I first saw this chart, by the way, I was blown away. I had been in the business just three or four years, of course, being told everybody should put all the money in their 401k first thing they do. They’re in your early 20s Get started your 401 K. And then I was told about the fact that we had windows of time in the United States here. When tax rates were over 90%. Now, the tax rules were different than there were the ability to produce all kinds of crazy write offs. But it doesn’t change the fact that Ronald Reagan, if you read his autobiography, or the one Nancy did, but in any case, like the movies, bedtime for Bonzo, one was made them bedtime for Bonzo, two and the delayed bedtime for Bonzo. Three that was the one with the monkey. Because they were waiting till the next year for tax reasons the monkey died. So Jack Nicklaus was playing the PGA Tour. By May or so of every year, he was already paying 90% income tax. And same thing with Elvis Presley. There’s a plaque in the basement of Graceland that says that the reason Elvis Presley had so much unreleased material at his death was because they were holding it back waiting for the next tax year,
just to get an enough out under the tax bracket. So imagine if you’re not Elvis, but you’re just a person with money in an IRA or a 401k, how you might be trying to hold some back each year to stay under a certain tax brackets same kind of thing ends up happening to folks in retirement.
Exactly right. And the mere fact that you can see, this is when Reagan was making movies as an actor. This is when he came in and said he would reduce taxes. Now that’s about 50%, which is pretty good. By comparison, these tax rates surely had to make like 100 grand a year to pay this. And so what we see is that over time, they keep trying to adjust the tax rates to try to stimulate the economy and yet taxed on tax capital. But there are trillions of dollars in these retirement accounts. And it is a source the IRS can pull on. We just want people to be aware, doing the calculation ahead of time, because what most people say to themselves, is when I retire, I will be in a what Cory, lower tax bracket, lower tax bracket we hear from people all the time. But the trouble is that it’s almost been picked up like a euphemism very successful people with high levels of income. were under the impression that there is a different tax rate after age 65, or different tax rate after I take Social Security, no difference. It’s just Were you successful enough that you’re still have enough income to pay a higher tax rate? Or did you fail financially, and if you failed financially, and you were in a 35% tax rate, all through your working years, and then you retire in a 20% tax rate, good job, your 401k worked well, except you retired poor and your life sucks. i That sounds so harsh, guys. But if where you were at was making $600,000, you’re at a 35% tax rate. And that’s what you were putting in your 401 K. And then you’re retiring 20%. That means somewhere in the area of $150,000. Here, there is nobody listening this podcast making $600,000 here that wouldn’t think that trying to live off of 100 or so would not suck. Now, it’s different for each one of you. I know I’m using really strong languaging Corey has discovered. But
no, here’s what I’m thinking about Paul is like, here’s another way of saying that there might be someone who was making 600 living off of 200 and paying taxes and investing off of correct rest. Correct. And if that was the case, they could have themselves in a lower bracket. But number one, they had to be putting money in a lot of other places in a 401k because you’re not putting 22,500 A year
enough to replace 600 in a 401 K, you’re exactly what higher income people cannot rely on their 401k Even if it maxes out every year, that’s a great point
and more that you have in the 401k like the higher percentage of your assets are in a tax deferred account, the harder it is to engineer yourself into a lower bracket in retirement because all of that money is going to come out taxable pushing you back up the bracket. So the 22
Exactly. So now let’s look at this person. Again. We talked about how tax rates probably when you look at like I don’t know foreign wars, the collective liability of Social Security, Medicare, Medicaid, probably they’re gonna have to raise taxes, but we’re gonna say they just stay the same for the sake of this conversation. 30% tax now Cory, what I’d like you to do is take this 1.5227 to one, put that in your calculator and multiply it by 70%. Don’t tell me the number yet. And I want you to multiply by point seven zero so those of you watching can play along at home. And I hope
you remember how to do it on a slide rule. Let me see I know opposite my abacus handy. So I got the abacus backup.
There you go. So we have that 1522 Now if we’re in the same tax rate that means we own 70% you count that’s the partnership split interest So we own 70% and Cory I am going to do like the great Carnac from Johnny Carson, back in the day. And I’m gonna say does the envelope say $1,065,904? Does? Okay, 70 cents? Yeah, and 70 cents? Yeah. So the reason for those of you watching what I did earlier, is I took 70%, that’s the amount that’s left after taxes, if I invested it myself, I paid my taxes invested myself, I didn’t put it in the 401 K, I would be left with $15,750 a year. I’m 50. Now, that is our assertion, that that is what is your part of the 401k. It is the part that you didn’t pay taxes on because you didn’t save any taxes, the IRS, you just put the IRS as money co invested with yours, because somebody told you being a lower tax rate when you retire.
And by the way, man, any intellectually accurate 401k statement would split the balance into two parts, what’s yours and the current estimate of tax liability in the future? So folks really thought about the amount of money that was theirs to keep inside of their
core? You’re exactly right. I think it’s one of the biggest, I would just call it a subtle lie to the American public, is that every time you get your 401k, it just casually says like Corey Shepard, interest of sound finance group 401k. Now that means it looks like oh, I own it. No, you don’t, that trust owns it. And that trust has a legal obligation to make sure that the IRS knows what you took out of that account so they can get their pound of money. So if what we have is this future date in which we are going to be assessed as to whether or not we make enough money, or if we’re paying enough taxes, odds are the IRS is going to always want to get their chunk meaning. We only have in the plan, the amount of money I’m just trying to get to where you guys see my screen again, the amount of money that was after tax, if we were to just pay tax, and that’s if tax rates remain the same, meaning you know, $22,500 you can put into the plan, but only 15,007 50 that is yours in a 3% tax rate.
In other words, Henry David Thoreau has a famous quote where he said most people live lives of quiet desperation. The most 401 K’s live lives of quiet obfuscation, like, oh,
yeah, watch that quarry man, he’ll drop some philosophical stuff on us. So we make our
catchphrase like, like, oh, we need an easy button. But it’s the blue button on an online store.
All I can think about is the scene at the beginning of Wolf of Wall Street when Matthew McConaughey goes, which I’ve just recently, totally, totally improvised. That was like really going to the director being like, Hey, I’m gonna try something a little crazy. I think it’s gonna work. And it created a character in the movie. So let’s jump back in and look at our alternative option. Okay. Now what we just finished explaining is it’s like when you put $22,500 into a 401k, it’s like you put in $15,750. And the IRS put in the $6,750. That makes up the remainder of the 22,500. Because that is what you saved in taxes when you put the money into the 401k. Now, that money grows, we got to pay taxes on it when we distribute, distribute it and split it with the IRS. But here’s the fundamental problem. The window we have is 22,500. That window is the same whether we share it with the IRS, or we keep it all to ourselves and Roth we’ll discuss in a moment. So stick with me here. When you go on an aircraft and let’s say you’re sitting in your seat and you’re waiting for the next person to come down. Here’s the thing and for the Browns linebackers that listen to this podcast is not meant to be offensive. When somebody the size of a Browns linebacker comes sauntering down that aisle, you think to yourself, I hope they don’t sit next to me, because I’m gonna get no armrest. That $22,500 like sharing the armrest with the IRS. They right now you get 70 they get 30. But later in the flight, they could scoot over and take 40 versus the Roth IRA is us getting to sit by ourselves in that row. And we still put in the $22,500 Just like before, but the difference is on the back end. With this one. We have no taxes as long as we take it out past age 15 and a half all that our distributions in retirement are not taxable which means we have 1,000,005 earned $22,721. Cory? How much of that do we have to give to the IRS? Like, what’s the math? What percentage? So we get 100%. Right? So we get 100% of that money. Meaning if we just compare these two strategies, y’all and let’s say all you had cashflow wise, was the 15,007 50. Instead of putting it in the 401k, let’s say this is all the money you had. And you said, Well, I want to put that into Roth. If that had gone into Roth, the output would have been 1,065,000, the same as your output from the 401k. If you retire in the same tax rate as when you put it in. Here’s our point, guys, you didn’t save any money putting money in a 401k. You delayed the tax only in delaying that tax is not a problem. But we have to be aware of as the IRS has the opportunity to change tax rates on people or you have the opportunity to have been more financially successful than you currently anticipate, and therefore have higher taxes. So this is our recommendation we want to leave you with today, as we have discussed what is a traditional 401k. What is a Roth 401 K. Part three is, what in the heck should I do with this information, Paula Cory just gave me was a little bit easy to rest on number one, most of the time your employer’s matching your 401 k is going to be pre tax anyway. Now you have the opportunity to convert it to Roth inside of most plans, we won’t get into that today. So no matter what you’re going to have, even if you did 100%, Roth contributions, all of your match is going to be before tax. Second, as you listen to this podcast, if you’re about this 40 year old that we’re talking about here, you probably have some other IRA money you’ve saved up over time, that’s all pre tax, meaning it hasn’t been taxed yet it will be taxed in your old age or when you die. So what we want to do is help people not just asset allocate, not just make sure their money is in the right buckets for the timing of its use. But we also need to have tax allocation. Cory talked earlier about if you had all your money to 401k, you get no tools to be able to choose when I take some money on pay taxes versus if I take another path. So Cory, can you walk everybody through just a little bit of kind of how setting up the three different types of buckets really makes a difference on distributions.
And yes, we’ve got taxable tax free and tax deferred. Those are the three different kinds of buckets, your savings account, your checking account, our taxable accounts, that you may not be earning enough interest to even notice that there’s tax due but you are fully taxable on the interest you earn in those accounts every year brokerage accounts are taxable. So the idea is, if you can, if you can have the right balance amongst taxable tax free and tax deferred, then you can pull some levers to engineer the tax rate that you want to be in retirement, because you want a certain amount of taxable income every year, because you want to make sure you can at least maximize your standard deduction. Like if you had 100% of your money in Roth, and protect me leaving Social Security off the table for a second. But if all you had was 100% tax free income, well, you actually would have paid too much tax along the way in getting it into the Roth so much as you want to, you don’t get to, you would have no you get don’t get to like carry over that, that standard deduction, you just don’t get to use it. So you want to be able to in the right situations to pull the trigger, generate some taxable income on purpose to make sure you can then use what’s in the tax code to your best advantage.
And the flip side, just while we’re looking at this simple graphic of the three buckets taxable tax deferred and tax free, in tax free, you might have things like life insurance, cash values and tax deferred, it could be everything from an old annuity, Somebody sold us to our 401 K and IRA, what we might do in a given year is let’s say we had something that created a large taxable event, like we sold a piece of property or something, and it’s going to cause our tax deferred accounts to be extra tax this year, we might just take a very small amount from that one. But then maybe we would say well, we’ll take a little more from the tax free bucket this year because of that taxable event. And that this with your coach and advisor you can work out each year, where’s the most effective place to pull money from but if all your advisor has you doing is just IRAs or all Roth or all life insurance for that matter. If they’re not coordinating the different types of assets that you have to try to maximize the retirement and cashflow output, which by the way, is the only score that matters in this game is were we successful. Did we keep the implicit promise to our children that we would not be obligated to have to live with them in our old age. Like that? What makes the difference, it won’t matter that we maxed out our 401 K or not, we actually have to have a strategy to build assets up in different types of accounts that are coordinated together in a way that both their accumulation and distribution is as efficient as we can get. And this is just one more entree into that knowing the difference between the traditional 401 K and a Roth 401. K, and how you can orchestrate the best performance of those assets. coriolus the last word
on more? Yeah, one more example. Because you said, people talk about being in a lower tax bracket in retirement, the real question is lower than what? When you’re 20? Maybe not, when you’re 50 or 6065, maybe. So. remember liking say,
Yeah, I want to I want to sit on that just a little more, I want to make sure people didn’t miss it. Because thank you so much for bringing it up, I forgotten that you might hit your peak earning years, say 50 to 60. Now, let’s say that after you work with your advisor, or for your advisor, do the math and be like, Well, looks like I’ll have $200,000 a year of income for the rest of my life. That’s, that’s less than the 350 I make now. I mean, it’s plenty, I’m happy with the 200, the client says, but I’m gonna be great. Let’s put as much as we can in tax deductible savings, because now we’re in that five or 10 year window, where we actually can sort a steer the plane in and land it the way we want. And make it far enough to 40 year loan speculation is ridiculous. But like the last five years of my career, when I’m making the most money possible, like we had a client that was in the C suite for a fortune 500 company, before he retired and for years and years, he listened to my advice, and we didn’t put money into tax deductible 401k After he became a client in about the year 2002 Guess there’s been a client for a little over 20 years. When he moved to the C suite role, it was like crank the deferred comp, crank everything because we knew he’s making millions a year, those last years. And we knew that he was going to have about a million a year of income on the back end. So we could put as much as we want to tax deductible accounts, we knew that we wouldn’t at least be doing reverse tax planning.
And so at that first conversation when you were like, Hey, we got to he was probably Paul, what are you taught? I thought I thought these were bad, right? And, and keep in mind,
I’m I am 44 years old. 21 years ago, I was 23. And I’m squaring off with this executive for a fortune 500 company. And he did exactly that. It was challenging to him to accept it. And you know what it took math, because the math works. And it wouldn’t matter if I was 10 years old, giving him the idea. If the math works, then you have to seriously consider a new direction and strategy and he did. And now the guy has millions of dollars of Roth, most all of his qualified accounts have been converted or spend down so that when he passes, He will not leave any of those fully taxable dollars to his family. And it’s all because we built it as a strategy. Instead of following the path of the zealot that says the sun never sets on 401k 401k always the best 401k First thing you always do. can’t employ y’all enough, get help get good advice, get a good coach and get the best chance you have of designing and building a good life. See you guys next week.
This Material is Intended for General Public Use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation.
Sound Financial Inc. dba Sound Financial Group is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance. Insurance products and services are offered and sold through Sound Financial Inc. dba Sound Financial Group and individually licensed and appointed agents in all appropriate jurisdictions.
This podcast is meant for general informational purposes and is not to be construed as tax, legal, or investment advice. You should consult a financial professional regarding your individual situation. Guest speakers are not affiliated with Sound Financial Inc. dba Sound Financial Group unless otherwise stated, and their opinions are their own. Opinions, estimates, forecasts, and statements of financial market trends are based on current market conditions and are subject to change without notice. Past performance is not a guarantee of future results.
Each week, the Your Business Your Wealth podcast helps you Design and Build a Good Life™. No one has a Good Life by default, only by design. Visit us here for more details:
© 2020 Sound Financial Inc. yourbusinessyourwealth.com
Podcast production and show notes by Greater North Productions LLC