Afford Anything - Your Dream Retirement Might Hinge on This One Choice, featuring Katie Gatti Tassin, host of Money with Katie

Episode Date: September 18, 2024

#541: Ever wondered if you're making the right choice between a Traditional and Roth 401(k)? You're not alone.  In this episode, Katie Gatti Tassin, host of MorningBrew’s Money with Katie podcast, joins us to tackle this common retirement savings dilemma. We deep-dive into the debate between using Traditional vs. Roth 401(k) accounts for retirement savings, in the context of: Future tax rates  Tax complexities for small business owners and high earners Social Security uncertainty Stock-based compensation  Incentives for business owners vs. employees Katie explains her strategy for maximizing retirement savings while minimizing taxes. She suggests that for some people in higher tax brackets, maxing out a traditional 401(k) and then investing the tax savings elsewhere might be the way to go.  But as we dig deeper, it becomes clear that there's no one-size-fits-all answer. We explore the Traditional vs Roth question, discussing how your current income and expected retirement spending can affect your choices.  It's not just about the math, though. The unpredictability of future tax rates and policies adds another layer of complexity to the decision. Social Security plays a major role, as well. We discuss its current funding situation and the challenges it might face in the future.  This leads to a fascinating discussion about how AI might impact future costs and lifestyles. Could things actually get cheaper in the future?  Taxes for high earners and small business owners is another focus. We break down some misconceptions about who falls into high tax brackets. It's not always as simple as it seems. Stock-based compensation is another hot topic. We discuss how it affects corporate decision-making and the wider economy. This leads to an interesting comparison of the incentives for business owners versus employees. Throughout the episode, we keep coming back to one key point: no matter which type of account you choose, the most important thing is to contribute as much as you can.  Your contribution amount has a bigger impact on your retirement savings than the type of account you use. By the end of this interview, you'll have a better understanding of the factors that go into choosing between a Traditional and Roth 401(k). More importantly, you'll see how this decision fits into the bigger picture of retirement planning and overall financial health. Timestamps: Note: Timestamps will vary on individual listening devices based on dynamic advertising run times. Here are the condensed timestamps and descriptions: 0:00 Introduction 1:46 Katie explains strategy for maximizing retirement savings 3:19 Discuss assumptions behind traditional vs Roth 401(k) decisions 5:54 Compare scenarios of traditional and Roth contributions 8:54 Explore how income affects retirement account choice 13:51 Talk about media's impact on financial perceptions 15:20 Discuss unpredictability of future tax policies 18:03 Explain current state of Social Security funding 21:05 Explore AI's potential impact on future costs 24:41 Discuss how location influences spending habits 28:16 Examine tax implications for high earners 31:12 Talk about effects of stock-based compensation 33:55 Compare incentives for business owners vs employees 36:06 Emphasize importance of contribution amounts For more information, visit the show notes at https://affordanything.com/episode541 Learn more about your ad choices. Visit podcastchoices.com/adchoices

Once a week, Paula Pan of the Afford Anything Podcast answers voicemail questions that listeners like you said in. Here's one now. Hi, Paula. I'd be curious to get your take on a stance that money with Katie has put out there that the traditional 401K is almost always far superior to the wrath for the vast majority of people. Her argument is that for the traditional 401K because you're not taking the rest of the majority of people, her argument is that for the traditional 401K, because you're not taking that tax hip hit up front, you end up putting far more into investments and that amount compounds over time and that amount will be far larger than what you'll end up saving in taxes down the line with the Roth. Her argument is even if taxes do increase over time

that the math plays out to favor the traditional 401K, as long as you invest the difference in terms of what you are saving in terms of not paying the taxes up front. I'd be curious to get your thoughts on this stance. Jesse, we have a treat for you. In order to answer that question, we brought Katie on the show, Katie from Money with Katie. Welcome.

Thank you so much, Paula. I'm so excited to be here. Jesse's calling us with a question about your show. You should join us for the answer. Yeah, why not? Hi, Jesse. Thanks for listening to my show. And thanks for doing your due diligence.

Thanks for going to Paula and being like, she's saying this. Can we confirm? Maybe you're not really getting what you wanted because you're just hearing for me again. But, you know. Well, this could be interesting. So you and I have not talked in advance

about how we're going to answer this question. Right. So I'm curious to hear, how would you approach addressing Jesse's concern? Yeah. To ground us in that context of just the general strategy and how it works, generally speaking, I like to look at how can we get both the biggest bang for our buck and the lowest lifetime tax bill. That's the calculus that I'm running.

And so there are a ton of different assumptions that have to be layered in in order for my conclusion to be true. The conclusion is, if you are in the 22% tax bracket or above, so, you know, 10 and 12%, I think you're running a different calculation. The risk reward calculus is going to change a little bit. 22% and above and or high state taxes and above. You're probably going to be better off by maxing out your traditional retirement plan, probably 401K, 4.03B, what have you, depending on your employer and your employment situation. and then taking the tax savings that you generate from that one decision and investing those tax savings in a Roth IRA or a taxable brokerage account. Roth IRA would be preferable

because then you're getting both pre-tax and Roth exposure, but some people, if they don't feel like doing a back-door Roth IRA or for some reason they want more flexibility, they might go taxable brokerage account. And that over time, in the different planning scenarios that I've run and with the CFPs that I've worked through this with, that generally you're going to, going to see more money later as a result of that simply because you're just investing more money now. So the combination of those two different investments ends up with more than offsets the tax liability of when you're taking disbursements, if you will, from that 401K plan, the pre-tax money later and paying taxes on it. Part of the reason that I think that's true is because within this

strategy and kind of these assumptions that I'm alluding to, you are being smart and strategic. about how you are withdrawing from these accounts later in life. So, ideally, you are structuring your drawdown such that you're getting pre-tax Roth and taxable dollars, and you're not just taking humongous withdrawals from the pre-tax account and basically paying the same tax rate that you would have paid had you made the contributions to Roth anyway. So it kind of takes advantage of arbitrage on both ends, but I feel pretty confident after having gone through this with multiple CFPs and multiple planning software,

is that even when you take into consideration, things like required minimum distributions or wanting to pass down inheritances, like even then with the right strategy, you can really pull off a pretty big coup on the government. It's just, yeah, there are a lot of assumptions baked in. And I think that's the operative phrase here is it really is going to depend on all of the assumptions that you're baking in. So fundamentally, one of the things that you're talking about is contributing more money than you otherwise would. So scenario A, person A, contributes the maximum amount to a traditional 401k and then uses their tax savings to contribute even more money into investments.

Yep. Right. Which means that scenario A, person A is contributing maximum trad 401K plus tax savings. The models that you run, Katie, scenario B, you're comparing that against a person who maxes out their Roth 401k, but then has no additional contributions above and beyond that. Right, because they're using that money to pay their taxes. Exactly. Between scenario A and scenario B, the person in scenario A is making greater contributions. Right. Now, in this particular case, the reason that they're making greater contributions is because they've saved,

on the tax bill. But saving on your tax bill is just an iteration of finding that money in your budget somewhere. So the way that I look at it is that money could come out of your budget in any number of places. That could be money that you decide to buy a used car instead of a new one. It could be money you'd delete Uber Eats and DoorDash off of your phone. If you simply think of the tax savings as money that comes out of your budget somewhere and you run the scenarios in which person A and person B are making exactly the same monetary amount of contributions. Then under that set of scenarios, person B who's making all of those contributions into Roth accounts is going to do better than person A.

So the math only works if person A, the person making the traditional 401K contribution, is contributing more money than person B. Yes. I would say I have two caveats that yes, I think that that is true. And so sometimes people will be like, well, I'm already contributing the maximum Roth to both. Is that a problem? Of course that's not a problem. If you already can afford to do that and that works with your budget, that's great. What I like about the strategy that I outlined is that, yes, if we think about all of this as like a finite amount of money that we have to work with, in scenario A, you're investing more money by paying the government less.

And in scenario B, you're investing more money by paying yourself less. And so you are going to spend less in scenario B than you can in scenario A. Like you have net less income to spend on whatever you want. Right. And for some folks, that's fine because they want to prioritize that complete ultimate certainty of, I know that I'm going to pay zero percent on all this growth later. And that's the most important thing to me. I think the other caveat that I want to throw out there is I think it also really depends

on how much you earn now and how much you intend to spend in retirement. Or put another way, I live in California and I'm in the 37% federal tax bracket. If my tax rate in retirement, when I'm just spending, I don't know, $100 or $150,000 a year, and not only am I in the 22 or 24% marginal rate, but like I also will have 0% capital gains taxes, there are all these different ways that I can cobble together. this income to get my effective tax rate really low, I might not be paying that much in tax on those pre-tax withdrawals later either. That's where the Roth contributions, you might really be

paying a premium to make Roth contributions early in life that you wouldn't need to if you are in an excessive tax bracket now and you know that you won't be later. And I think that that's only true if you are kind of in that fire mentality of you earn a lot now and you're really working hard now to save a lot, but you're not going to be spending a ton of money in retirement, or you won't have other sources of income, basically. All the income you have is going to be your investment withdrawals. In that case, that's another thing that I would consider with the Roth. I could make fully Roth contributions, and I don't because I want that tax break. I am confident that my tax rate in retirement will be lower than the effective tax rate that I pay now.

That's another good assumption that we should probably highlight because when I think about my retirement, I'm fairly confident that in my retirement, assuming that the current tax rate stays consistent for infinity years ahead of us, even keeping that consistent, I am still confident that my tax rate in retirement will be probably about the same as what it is now. Interesting. And is that because you know that you will have continuous sources of income? Exactly. Plus investment income. Exactly. So a lot of people in the fire community who have rental properties have their own tax breaks,

Right. But people who have rental properties, people who have residual income. Yes. That come in from royalties or software businesses where they're a passive owner, there are all of these sources of income that can put your tax rate in retirement to be pretty similar to your tax rate pre-retirement. Honestly, that's the goal. I'm not going to plan for it, but I would not be mad if I had a bunch of residuals coming in. I'd be like, cool. Well, that worked out for me. The other part of it is, of course, the unanswerable question of what will tax rates be in the year 2034, 2044, 2054, that's an unanswerable question because we have no idea what the government is going to do. We don't know who the government is going to be and therefore we don't know what they're going to do at that time. Right. And it's also one of those things where the more that I've thought about it, what premium am I willing to pay now for certainty? Because you are making a

bet on what is going to happen by going the pre-tax and invest the tax savings route for sure. You are kind of making a gamble. And in my case, I feel good about the gamble. But I think it's a question worth asking. And the thing is, like, the tax rates don't stay consistent for long. So the chances are the tax rates are even going to change like between now and then and then by the time you're retired and then probably during your retirement, things are going to shift. I think my hope, based on what I've observed in the last couple years, is that it seems like, for whatever reason, $400,000 is kind of the level beyond which a lot of these tax conversations are happening.

You've probably heard that in the news. Like, we're not going to raise taxes on anyone who makes less than 400K. Yeah. So I think if that holds steady or if there's still that focus on like the 30 to 35, 37 and raising taxes at that level, but not beneath it, it could be a moot point for a lot of people. My concern is what's going to happen to the standard deduction. And if that is going to stay high, because a lot of my strategy does depend on the standard deduction being a get out a tax-free card bucket that's big enough to allow healthy Roth conversions every year. If you're talking a $30,000

standard deduction for married people, that's a huge tax break. That if that gets cut in half or worse, that's thousands of more dollars in taxes that you're suddenly going to owe. So the standard deduction is the thing that I'm a little more nervous about rather than if the 37% is going to go back up to 39 or if 35 is going to bump up to 37. Like that I'm kind of not as concerned about. Right. I'm glad you brought up the standard deduction because we've seen some changes in recent.

years that 10 years ago, I never would have thought possible, it underscores the unpredictability of how that tax code is going to change. And therefore, anytime that you're making a bet in which you decided that you're going to defer the tax bill until later, you are necessarily making a bet that incorporates a greater degree of volatility. Good point. Because you don't know what the conditions are later. Yes. It's super true. Speaking of the uncertainty of the future, I know that people will often bring up things like health care and how expensive that becomes. If you retire before you hit Medicare age, but you don't have health care from an employer anymore, that's obviously a huge expense. And so when we start talking about tax rates changing, the optimistic part of me goes,

well, maybe they're changing because we're going to get universal health care. Or maybe they're changing because they're going to do something really good with it. I'm like, well, in 29 years, I don't know that I've seen a lot of proof that that's what happens when tax rates go up. But as far uncertainty goes, if we can kind of get our act together, there are some things that might end up being cheaper in the future than they are now. So, I don't know, there could be some cause for optimism too. Right. Everything you say makes me think of something else. Such a great point about that is that what we have seen is that there are certain categories of expenses that are inflationary, like groceries. There are other categories of expenses that are deflationary like technology. Yes. So if you

think about the amount that it cost to have one gigabyte of storage in 1985, the average person could not afford a home computer in 1985. And so technology is one of those very obvious class of consumables in which this is a deflationary market. And technology every year gets better and better for cheaper and cheaper. Now, what's going to happen when AI permeates every facet of our lives? And when I say our lives, I don't necessarily mean in ways that we can see. But AI permeates the supply chain. AI permeates manufacturing and operations and logistics. Yeah, such a good point. How does that change pricing? It probably feels crazy, too, at this point, to be optimistic about things like that because we're coming off the heels of such a rapid increase in the cost of things.

But I think you're spot on. Like, it's not outside the realm of possibility that we could see a lot of efficiencies be generated that drive down costs. And we all might be vastly overestimating the amount of money that we will need in the future to sustain our same lifestyles. Like I said, that sounds nuts right now because of what we've just seen. But I think, well, you're right. When you look at the broad scope of history, we go through periods.

like these where there is rapid change. And sometimes there are changes that are going to benefit you. Right. Yeah. Recency bias. Reecency bias leads us to think in terms of inflation. Yeah. The other part that we haven't discussed is Social Security. I actually just did an episode on this. And I think it's fascinating because I didn't understand what people meant when they said that. Right. And I also didn't understand that Social Security is like a giant pyramid scheme. Right. Exactly. It is current, like the money that we are paying into Social Security now, It's not like that's getting like set aside with our name on it for later. They're paying that out in benefits right now to people.

And so the people that are going to be funding our Social Security benefits haven't been born yet. Or like they're, you know, they're three in daycare. They haven't started working yet. And so I think that that's interesting because I think when you think about it in that respect kind of start to go, oh, okay, so all of society is a pyramid scheme. That's great. Love that for us. But also there is an element of what.

can we expect to happen if that trust runs out? And with population trends, what do we think we're going to get? And I don't know what you've seen, Paula, the estimates that I've seen put it at like 70 to 80 percent of estimated benefits will be able to be paid out in the future because there are going to be fewer workers supporting the retired population. I've seen that same stat about 70 percent. And I just looked up the year. My guess was 23. I was two years off. It's 2035. So it's 2035 unless Congress takes action at some point prior to 2035. There's also the open question of the Supreme Court Chevron decision. And how is that going to impact Social Security? Because the Chevron decision applies to governmental agencies. Yeah.

And the Social Security Administration is one of the largest governmental agency. So Chevron is going to have an impact in Social Security. some manner that we cannot yet predict. Hadn't thought about that. God, that's such a good point. Just downstream impacts of Supreme Court decisions that you like don't even think of. Yeah, I think when I looked into this for that episode, A, yeah, there are things that they could do right away. Because, I mean, if you think about the cap on your Social Security wages,

so much of the wage growth in the last 20 years has happened above the $160,000 mark, which is where we currently cap Social Security. So if you're only taxing people up to that point, but the vast majority of wage gains in your economy have been realized above that point, you're not really capturing the benefits and the upside of those wage gains. There's so much support for Social Security. People have paid into it for their entire lives. For sure.

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All of this has stemmed from the question of contribute to a trad versus a Roth 401K. I love it. And the fact that our conversation has steered over here underscores the fundamental question of Trad 401K versus Roth 401K is the question of what do you think the future will look like in 20 years, 30 years, 40 years, 50 years. And that is so unknowable and so subject to the influences of things that go far beyond being in a 35% versus a 37% tax rate. Well, I did want to circle back, Katie, to something that you said earlier when you were talking about how $400,000 is the typically the amount of money that we hear about right now. And this is one thing that I want to clarify for the audience. When we talk about $400,000 as personal income, oftentimes the people who are quote unquote making $400,000 are not W2 wage earners who just have unseemly large paychecks. Oftentimes people who are, who quote unquote make 400,000 are people, small business owners who have LLCs or S corporations, both of which are pass-through entities. And so if you are a plumber or a podcaster with an LLC or with an S corporation and your business makes, let's say, a million dollars and you spend 500,000 of it on business operations and you decide that you want to set aside the other 500,000, you're not ready to reinvest it right away because maybe you want to have a bigger runway,

like maybe you want to have cash reserves such that you know that you have six months of payroll saved so that even if your projects dry up, you can still keep your employees on payroll for the next six months, right? Maybe you decide you want to build those cash reserves for your company. Or maybe you decide that you want to build out a warehouse space or a studio space and you don't want to take out a loan for it, so you want to save up enough money to make a cash outlay. Those would all be reasons why the owner of a relatively small business, again, a plumber or a landscaper or a podcaster, ask me how I know, might have on paper taxable income that is $500,000, $600,000. But on paper, is taxed as personal income. But in reality, it's actually business revenue that just hasn't been spent

in that calendar year. Yeah. And does that, I guess then you would realize a tax break later if you spent it in a following calendar year? If you spend it in a following calendar year, it depends on whether you're spending it on capital expenditures, CAPX, or if you're spending it on something that could be an immediate right offer deduction. Gotcha.

Going back to the warehouse analogy, let's say that you buy a forklift for your warehouse. Yeah. That forklift you can't write off entirely in year one. You would have to depreciate that over a period of X number of years. Gosh, I see what you mean. Yeah. Okay, yeah. Because I was to say, I feel like there's got to be some way to like capture that later such that you're not just paying taxes on it as though it's income when really it's just going to end up as an expense.

So it sounds like at some point you can write it off. But the accounting of all of this means that in your current year, you look as though you are quote unquote richer than you are. Exactly. Because you're really doing some business accounting and some business planning. And it's not just like personal income that you're taking home and going on a vacation to Turks and Kegos. Yeah, exactly. So I think that gets lost oftentimes in the discussion around like quote unquote people or taxpayers who make more than $400,000 a year. A lot of those are small business owners.

Oh, yeah. I agree. I feel the same way. I think the 400K is something that I look at and go, yeah, that's probably not going to apply to most people. but to your point, if you're a business owner, there are other scenarios too where I would look at our tax system currently and say, I pay the same marginal tax rate as someone who makes $100 million a year. And actually, that person probably pays less because a lot of that's probably carried interest exemption or capital gains or something that's getting text at 20%, not 37.

And so when I see the focus on 400 and above, I'm like, wait, wait, wait, can we bump that up a little bit? because I don't actually think that this is like people that are making 400K, whether through a business or through a W2 income, they're paying a lot of money in taxes already. Yeah. Multiple seven figure and the finance jobs and the things where you are private equity hedge funds, the way that that compensation works, a lot of those people's top marginal tax rate is 20%. Anyone who's getting stock compensation is not paying the same thing that a business owner who's making 400K is paying.

Yeah. I wish that was where we were focusing the conversation. and focusing more on how you're getting that income, how it's being taxed. Yeah. We just did an episode on stock-based compensation, and it's... Ah, good. It's largely due to the structure of the tax code that stock-based compensation became so popular.

Oh, yeah, because they want to be able to take the lower tax rate. Mm-hmm. Right, exactly. So stock-based compensation ended up becoming a bigger and bigger part of compensation packages due to the tax efficiency around it, which again, I guess just goes to show that... Talk about incentives. Yeah, that any time you make a change to policies or codes, it often has these downstream effects that were unanticipated at the time of passage.

I don't think anyone really thought stock-based compensation will take off as a result of passing X or Y or Z bill. And I do not envy policymakers because that is extremely like third order consequences of things are incredibly complicated. I do not envy those people. I think one of the things that we've seen also as a result of that is that if you have people whose primary compensation is coming through stock, talking CEOs, CFOs of publicly traded companies, that also impacts the way that these businesses are doing business and like whether they're spending their money on stock buybacks to juice returns or investing in R&D. And I feel like Boeing is kind of the quintessential example that everybody uses for this of like, You're spending a ton of money on financialization of your firm and not on like your core engineering product and how stock-based compensation can really like change the economy more broadly and like the productivity of firms. We've seen such an increase in financialization as a result of

that, maybe not because, you know, wholly as a result of that or only because of that. But it seems pretty obvious that they're connected. Exactly. When you set up an incentive structure such that people are rewarded in quarterly increments. There's no incentive to make decisions that are best for the company in 10 years out, because you might not even be there 10 years out. Yeah. And again, that's where we go back to my advocacy for small business owners, because if you are a small business owner, you broadly speaking, you anticipate that 10 years down the road, you're still going to own that same business. Yeah. That plumbing company, that landscaping company, that is yours and it's going to be yours 10 years.

down the road, 20 years down the road. And so you might spend a few years amassing cash reserves, investing in major capital expenditures, investing in heavy machinery, depending on what industry you're in, making those big long-term investments. Totally. And unfortunately, a lot of small business owners are then put into a very bad tax situation as a result of that because of the fact that on paper, they appear to be making $500,000. Mm-hmm. When in fact, what they're really doing is their long-term planning for the 10-year trajectory of their business.

Yeah. Wow. All of which is to go back. When I said earlier that I anticipate having a tax bracket in my retirement that is comparable to my current tax bracket today, part of that is because I identify as a small business owner, and I anticipate retaining ownership of the business forever. Yeah. Even if I'm not the one running it on a day-to-day basis.

And so there would be some type of payout that comes from that. I can see you having the same thing, too, Katie. Well, fingers crossed. We'll see. I think right now I am a W-2 employee, technically, because I sold my brand. I think that that's where the incentives are interesting, right? this whole conversation highlights how ownership changes the way that you think about the work that you're doing and the investments that you're making compared to in general, if you're a W-2 employee,

your incentives are really like if you're only being paid wages and you have no equity ownership stake long term in the business that you're in, you are rationally incentivized because there's no other incentive structure that makes sense for you. You want to get as much out of it as you can while you're there because you might not be there forever. And you being there might not be under your control. It's kind of why people who have expense accounts traveling for business are like, I'm going to go to the fancy restaurant because it's not my money. Small business owners, they might be taking advantage of that tax break when they go out to eat, but they know ultimately it's still their revenue that this is being counted against. So they're not probably going to be

swiping the card as though it's like a blank check. Right. And I don't know. I think about that a lot, how your incentive structure changes and to your point about retirement, like, ultimately, it would behoove me longer term to own and operate and own the intellectual property and own everything that I'm doing. And I probably would make different decisions if that were my situation, just because that would be more economically rational. Wow. So, Jesse. I don't know how we got here, Paula. We have gone to Mars and back. Yes. So Jesse, there's the answer to your question. Yeah. Clear as mud. They're like, wait, I don't think they answer. I know, right? Jessie's like, so do I invest in a traditional or a Roth?

Yeah, looking at her watch, like, it's been 35 minutes, and we're somehow talking about incentives for business owners. The answer is, do whatever feels right. Because as long as you're investing the most that you can, either path, is probably going to be good for you. Yeah. So for people that are like really stressed about it, I'm like, okay, if this stresses you out, just pick one and go full force at it and don't stress yourself out. Like if you value certainty, just go Roth and don't worry about it. Yeah.

And at the end of the day, your contributions are the single biggest determinant of your investment success. Yep. At the end of the day, what matters are the contributions that you make? Everything else. That's the 80 of the 80-20. Yep. Amen.

Or is it the 20 of the 80? It's the 20. You know, because it's 20% of your effort yields 80% of results. Yes. So is it the 20 of the 80, 20? It's whatever. Yeah, it's the 20% of your effort. Yes.

That's going to yield 80% of your results. It's just making those maximum contributions. So it's the 20 of your 80-20. Mm-hmm. Perfect. Well, Katie, thank you for joining us to answer this question. Thanks for having me. That was a blast.

That was so much fun.