The Pilot Money Guys

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Folks, we’re going to be talking about 401ks today. I know you’re all disappointed we’re not talking about taxes again, tax donut holes, and all that good stuff, but we’re going to be talking 401ks. Before that lets get into a little airline news.

As we’re writing this this, it appears that language is currently getting debated on roughly how much of a dollar amount is making its way into the budget reconciliation that big $1.9 trillion economic relief package.

It does appear that payroll support for airline workers is likely to make it in. It is not official, but it looks as if some of the folks that are up on Capitol Hill are advocating for this industry to keep its head above water, that would hopefully keep everybody onboard through September of this year.

Again, it’s a kicking of the can, I’m not here to debate whether how good or bad some of this is, but from the government spending perspective, but I think keeping everybody on board is definitely a positive.

While I was at the gym getting buffed this morning, or I should say not getting fat, I saw that United was working with Archer aviation to accelerate production of advanced short haul electric aircraft.

How cool is that it says a workout with air mobility company. Archer is part of the airlines broader effort to invest in emerging technologies that decarbonized air travel, whatever they just want to save money. We know that, but anyway, rather than relying on traditional combustion engines, archers electric, vertical takeoff and landing aircraft are designed to use electric motors and have the potential future for air taxi and urban markets. I think its amazing.

Let’s get into our financial topic.

What is a Roth 401k and how does it differentiate itself from a traditional 401k.

Roth and traditional?

Think about it this way. Uncle Sam is going to get their money on the front end or the backend.

So you get to choose which one, which end it is so to speak.

Roth, you’re going to pay the taxes on the front end – Uncle Sam’s getting the money on the front end. You pay taxes and then the money goes into the 401k and then the money is to never be taxed again.

Never is a strong word in the financial industry and some people may question, whether that truly will never be taxed again, we can’t make those types of guarantees, but that’s what the rules and the regulations say at this point. You put money in, that’s been taxed, it grows tax-free and then you withdraw in retirement tax rate.

That’s the Roth.

The pretax or non-Roth is the exact opposite. It’s deducted from your paycheck. Let’s say you make a, just to keep the numbers easy a $100,000. You put $20,000 into a pre-tax, non-Roth 401(k). That essentially is the equivalent of making $80,000, a hundred thousand dollars, less than 20 that you put in the 401k.

So therefore, You pay less taxes. However, when you pull that money out of the 401k in retirement, you will then pay tax on that amount.

How does that grow? How does the Roth earning get taxed, if you paid your tax upfront for a Roth 401k.

All the growth in both of those options are a tax-free growth. Maybe some people say tax deferred growth, maybe more technical way to say that. If you went online and did a calculator and said compare an investment that grows tax-free versus one that is taxed, you’re going to get faster growth over time in a tax deferred growth vehicle, like your 401k, like your IRA.

Later today, we’re going to help people create, essentially tax-free growth in a taxable account. I’m being vague there because you can’t exactly do it like you can in a 401k, but you can invest tax efficiently.

So we’ve got this tax-free growth, a Roth 401k. What are the limits? Can we contribute as much as we want? Or what, how much is the amount we can actually contribute to a Roth 401k through our employer.

You do get a catch-up if you’re over 50, and that is an extra $6,500 now. So if you’re 50 or over you get the catch up. Here’s something that’s important: A lot of people ask us this, “Hey, I’m contributing to my 401k right now. It’s February. And but I turn 50 in December. Do I need to do anything to my 401k?”

Your company will make that automatic adjustment for you and they know when your birthday is, even if it was December 31st. You don’t have to worry about that not getting the catch-up.

The only thing you need to make sure though, is that you’re contributing the right percentage based on how much you’re making. Just make sure that your percentage is adequate to get $27,000 in there.

Now, some people ask “Can you contribute to both a Roth IRA and a Roth 401k?”

Roth IRA and Roth 401k, the answer is yes. And I’m going to go ahead and expound on that a little bit. One of the major misunderstandings that I’ve been surprised at is that a lot of people think because they make over a certain amount of money, they cannot contribute to an IRA.

That is false. Anyone at any income level can contribute to an IRA. It has to be a non-deductible IRA. Essentially a nondeductible traditional IRA. You can do that at any income. I don’t care if you make a million more dollars. So that’s the first thing that I think everybody should know.

Now whether you should be doing that or not is a different question, but back to your question, yes, you can absolutely contribute to your 401k, whether that be Roth and or Non-Roth, and you can contribute to an IRA. Okay. Those are separate things once through an employer and one is through you personally. You can always still contribute to an after-tax non-deductible IRA.

So you can still contribute to a Roth IRA, even if you were contributing to a Roth 401k, and then what if I make too much to contribute directly to my Roth IRA? Can I still contribute to my Roth 401k, even though I’m making pretty good money as a captain of a major legacy airline?

You are going to be limited by your income on contributing directly to a Roth IRA. You are not limited by your income on contributing to a Roth 401k. So that is very important distinction there.

So the other advantage in using Roth assets is that they don’t have required minimum distributions for the most part. I guess if we get technical about it, a Roth 401k, if you keep them with your company after you retired, then they would be subject to required minimum distributions RMDs.

What do you have to say about RMDs and Roth IRAs in particular? Is that something you recommend?

The Roth is such a great tool that and the Roth 401k, obviously too. It’s not a panacea because you’re paying taxes right now. These are generalities and each person’s situation is different, but we were talking to a single captain. He’s making good money, probably in one of the higher income brackets. So, it may not make sense for him to use a Roth at this point, Roth 401k at this point, cause he’s paying taxes right now. So there’s some pros and cons you, you gotta think about.

As far as the RMDs are concerned, it’s a great tool. It’s awesome to not have a requirement of a distribution. Envision yourself at 72 years old, and the government says, “Hey, you have to take this money out and you have to pay taxes on it.”

We have clients that are in that situation, and they’re not happy about it. It makes people mad and. Especially for our retired military people because they’ve got this military pension and they might not need to take that much money out. They, they’d probably rather let it stay invested and maybe pass it on to their children, then to be forced to take that RMD out and pay taxes. It is not a pleasant situation.

We can plan for that. We can plan for that way in advance. In fact, if you don’t plan for it in advance, there’s nothing you can do about it if you don’t get ahead of that curve.

 

The last thing I’ll say here, is that it’s really a great estate planning tool because of the secure act that was passed.

They got rid of the stretch IRA and we knew that was coming for a long time. The stretch IRA said if I inherited an IRA, I could stretch that out the rest of my life and take very small chunks out every year. Essentially it may just continue to grow in perpetuity.

However, they got rid of that. They shrunk it down to 10 years. So now envision you or your children inheriting your taxable 401k or taxable IRA. They are forced to take that out over 10 years which means they’re going to be in a higher tax bracket and that tax burden is on them.

Sometimes that may make sense. Sometimes it may not, but with a Roth there’s no worry about taking something out over 10 years because there’s no tax anyway. So that’s a really nice estate planning tool.

How about, how does the backdoor Roth IRA work?

This is a term that gets thrown around a lot, but some people say “that sounds illegal”.

It’s not illegal. Thankfully, because we do it a lot.

Here’s how it works. There’s a lot of moving parts here, so I’ll try to start with the most basic.

The most basic is let’s say that you have no other IRAs. You subsequently within contribute to an after-tax traditional IRA, because let’s say your income limit is too high or your income is too high over the Roth contribution limit. So, you contribute to that after-tax, non-deductible IRA. Then you subsequently you probably want to invest that. At some point down the road, it makes sense to then convert those funds to Roth IRA.

Now here’s the rule. Anyone, regardless of income can convert a traditional IRA to Roth IRA. That rule was changed in 2010.

The other rule that’s important to remember is that if you’ve contributed to an after-tax IRA, you’ve already paid tax on that money. So that particular money, when converted, will not be taxed twice. So only the money that, let’s say you invested and that investment grew, let’s say it grew by a $500. That $500 will then be taxable at your ordinary income tax rate.

That’s the basic thing to remember about the Roth conversion, but in practice, they’re very simple to execute. Just be very careful on your tax return to make sure that sequence of events gets documented correctly. The key IRS form there is the form 8606. If you do not document this correctly, you probably will get a letter or a call from the IRS and that’s not fun.

So, people who might be saying I’ve got a Roth 401k. I have to pay an RMD when I hit 72. Not, if you transfer it over to a Roth IRA, convert it to a Roth IRA. Then it’s not, you don’t have any RMDs. Just be aware of the timing there because if you don’t have a Roth IRA opened within five years, you could potentially run into some penalties there.

So, you want to open that before you’re going to use that money, with enough time that five years has passed. Buts soon as you transfer that money over from the Roth 401k into the Roth IRA, it inherits whatever time the Roth IRA has already had. So, if you had a Roth IRA open for three years, you transfer your Roth 401k money into it only has to sit there for two more years before you can touch it for that.

What other vehicles, other than the Roth 401k and Roth IRA, might we use for our money? And it brings up the health savings account.

Since we’re using three letter acronyms, we’ll talk about the HSA.

I like to say the the two, three letter agencies I don’t want to get a phone call from are the IRS and the FAA.

Health savings account. I think there’s a little bit of a potential misnomer with a way that you can actually use an HAS. It’s more of a health investment account, which I recently started using an HSA. So, we’ll talk a little bit about some of the pros and cons of going this route.

The first is the biggest and it’s a con. You have to have a high deductible Insurance plan which for many people, is not going to fit for their current family’s situation with how they consume healthcare coverage. You’re going to be paying a lower premium. But you’re going to have a lot more out of pocket expenses when, depending on your family situation, if you consume lots of healthcare.

So that is the biggest hurdle to overcome with adopting an HSA. Secondly, and this is a little bit more nuanced, but it might require a higher cashflow position because you’re going to be able to save money and you’re going to be spending more money up front.

You’re going to be spending more cash for any healthcare that you do consume over the course of a year. That might just put more of a burden on your cashflow scenario. So those two things are a couple big hurdles to overcome for some people. And for many, it doesn’t make sense to go this route.

A health insurance plan, a PPO provided by their employer makes the most amount of sense for them. There’s lots of scenarios, and I’m not suggesting everyone should do an HAS, it does make a lot of sense. I think people that fall into the category of maybe they’re younger, they’re healthier. They’re not consuming lots of healthcare currently, and they find themselves in a position where they can afford the extra cashflow bourdon and invest efficiently into their future.

Here’s why: Charlie was just talking about the differences between a traditional and Roth for both an IRA and a 401k. You get to make a choice whether Uncle Sam takes his share upfront or when you take the money out? The great thing about the HSA is this is the most efficient investment vehicle because you can take whatever you contribute is tax free just like a traditional 401k. You can invest this money through your insurance provider, who will set up an HSA account for you.

There’s lots of flexibility in how you invest it. And that will grow tax-free over a time. Then when you go to spend it in the future, as long as it’s on qualifying health-related expenses, that money is going to be treated tax-free as well.

One of the reasons why this makes a lot of sense is that the majority of the healthcare that we consume over the course of our life happens in the last few years of us being on this planet. It can make sense to take that money for healthcare and invest it in your known future healthcare expenses instead of paying higher premiums now for.

Again, there are some hurdles for some people in order to do it, but that triple taxed advantage is a very efficient way to grow and invest for your future healthcare consumption.

One of the statistics I read was the average couple in 2020 would spend almost $300,000 on medical costs during retirement. So, investing in an HSA is great, tax-free contributions, tax free growth, and then if it qualifies tax-free withdrawals, that’s great.

If you’re looking at $300,000, you’re going to want some kind of vehicle to help you with that. I also think that’s really important, if by participating in one of these, you defer consuming beneficial care, than it is not a good fit for you.

A lot of our audience are retired military folks that are going to have Tri-Care when they get older. That throws a different part in the equation, because you’re not going to pay near as much on healthcare as someone who doesn’t have that.

I’ve been injured on it before, as you all probably know, I got on the health savings plan and then I broke my neck. I did it, but I did have to pay out of pocket.

Here’s a couple of quick things I get excited about. Besides just the tax advantages, which are awesome, you can actually treat it like a 401k.

What I mean by that is you put your money in there and you’ve got to keep some cash. In fact, Optum bank requires $2,000 minimum. But then you can invest on top of that.

What I did and what some people do is, if my daughter is sick and we go to the 24 hour clinic, I pay $100-$150 bucks out of pocket, and I don’t touch my health savings account. I’ll leave it alone. Now if there’s an expense that starts to make me uncomfortable with my daily budget, then I’ll pull out of my health savings account. But I like to let that go as much as possible. And I keep the receipts, keep all the receipts because there’s no timeline essentially on reimbursing yourself.

So, in other words, I could: Go to the clinic. Pay out of pocket. Keep my receipt and then five years down the road, I could reimburse myself.

When I had my accident, I didn’t have any money in the health savings account because I just started. I paid out of pocket. Then later on in the year, when I was able to accumulate enough, I literally sent myself money from Optum bank to my personal bank account. I reimbursed myself.

The other thing that I’ll say is that at age 65, it basically turns into an IRA. If at 65 I’ve got a hundred grand in my HSA, I’m going to go buy me a new car and pay tax on the withdrawal.

The money is taxable but that’s after age 65. Prior to that, if you spend it on a car, you are going to incur significant penalties. 20%, if I’m not mistaken and taxes.

it’s not a “use it or lose it”. It’s your money. You always have access to it.

Depending on your situation, a Taxable Brokerage account might be a great way to accumulate wealth as well. A lot of people say, “Oh but you don’t have the tax advantages” which is true, however, it’s not without some merits.

There’s no contribution limits. So, like we’re talking about with the Roth 401k, $19,500, if you’re under age 50 and then $6,000 for an IRA. But there’s no contribution limits with a brokerage account. It also doesn’t matter how much you make. You can always put it in there. You can still contribute to your brokerage account with no penalties for an early withdrawal.

A lot of these programs we just talked about, have certain rules. If you withdraw too early, then you’re going to have a penalty. Brokerage account, there’s no such thing. So you’re not going to get a penalty for withdrawing too early, nor will you have required minimum distributions.

If you’re looking at you accounts in an overview, you might want to have a taxable brokerage account because you can get to it quicker than you can a 401k or IRA.

If you hold a security longer than a year, it becomes long-term capital gains. It’s going to be taxed at a long-term capital gain rate versus a marginal tax rate.

I came up with a little example, try to bear with me here, but for example, let’s say you’re retired and you need $80,000 to live on.

Let’s say you only have two accounts. You got a traditional 401k and a brokerage account. Now the traditional 401k will have required minimum distributions and will be taxed at your income rate, your marginal tax rate.

In 2021. If you’re married, filing jointly, you’re going to be taxed on that money at 12% on the $80,000.

Conversely, the brokerage account, you have no RMDs. And if you held your security investment for over a year it’s long-term capital gains. The long-term capital gains under $80,800 right now is 0%. So, if you pull your funds out from the taxable account, you’re not going to be taxed on that.

This is where it gets interesting too, because it’s a taxable income of 80,000 or less,

what does that mean for your gross income? That means your gross income is $80,000 plus at least the standard deduction. If you’re married filing jointly, which is where the 80,000 were comes from, then that means your gross income is over a hundred thousand depending on the standard deduction and the inflation adjustment.

That’s a pretty healthy income and still you’re able to get a 0% capital gains tax rate, which is really pretty cool. If you get the math right, you could potentially get a better tax rate.

Even if you don’t get the 0% tax rate, it’s just really nice to have. This tax diversification is really what we’re looking for, between the Roth non-Roth health savings account, if it fits your medical situation. And then finally the brokerage, you’re just really getting some great tax diversification. You really have a lot of flexibility in retirement to, to significantly reduce the taxes you pay in retirement. It’s just opportunities there.

I’m glad you brought that up, Charlie, because something that kind of came to mind while you’re saying that is when you reduce your overall tax rate.

That also helps you for other, I’m thinking about social security here, your social security, right? Although it may be, not that much for some people, it might be a lot for others. If you’re reducing that, that taxable income, that’s going to lower how much tax you’re paying on that social security income as well. Social security is taxed percentages based on different factors, but overall lowering tax in retirement has a multiplier effect, if you will.

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this Podcast will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any information or any corresponding discussions serves as the receipt of, or as a substitute for, personalized investment advice from Leading Edge Financial Planning personnel. The opinions expressed are those of Leading Edge Financial Planning as of 03/31/2021 and are subject to change at any time due to the changes in market or economic conditions.

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