In my life, I have learned that conventional wisdom is either not valid or it has changed. For instance, many of you know I am interested in health and wellness. So much of what we have been told about diet and exercise is untrue. It makes our health worse and contributes to diabetes and obesity.
At Harford Financial Group, as a leader, I want our organization to make good fact-based decisions based on valid research compared to opinions, feelings, or loosely based research. Additionally, sometimes the circumstances change. In a football game, the coach goes in with a game plan to run the ball, but the other team stacks the line, so they have to change their game plan.
In the financial world, we have this situation. The conventional wisdom I was told when I entered the workforce was to optimize and max out my pre-tax accounts within my 401k. The assumption was that I would get a tax deduction when I contributed, and later in retirement, I would be in a lower tax bracket. By and large, this was good advice. When I started contributing to 401ks in the early 90s, the U.S. debt to GDP was approximately 40%, the government spending was more controlled, and the assumptions were likely to be true that I would pay less in taxes in retirement. Fast forward to 2023, and our debt to GDP has skyrocketed to over 100%, which is very dangerous in the long term. Our national debt is $30 trillion, and we have deficits where there is little meaningful effort to control spending. As I have outlined in other blog posts, the U.S. credit card will come due at some point, and to pay for these debts and deficits, both spending will need to go down and taxes will need to go up. We do not know definitively when this will happen, but it will likely occur within the next 10 to 20 years. Therefore, the assumption that I will pay less taxes in retirement than while working is less likely to be true. What is a person to do? Here are three pieces of advice:
(1) If you are still working, consider switching all or a portion of your contributions to Roth 401k, 403b, or TSP - About 10 to 15 years ago, retirement plans started offering a Roth feature. Roth is the complete opposite of traditional pre-tax 401k. You do not get tax deductions when you put money in, but when you retire and start taking the money out, the distributions are tax-free (as long as you meet the requirements). Everyone can contribute up to $22,500 in their 401k, so if your employer offers a Roth option, you can put up to $22,500 into a Roth 401(k) regardless of your income. Additionally, once you are in the year you turn age 50 and beyond, you can contribute an additional catch-up contribution of $7500 for a total of $30,000 per year.
(2) If you are retired or close to retirement, consider doing Roth IRA conversions - As you see in the graphic, we are discussing moving money from the pre-tax funnel to the tax-advantaged funnel. This requires careful and detailed analysis and should be done sparingly. We do extensive Roth analysis and work collaboratively with our client's tax professionals and CPAs. The reality is that it will likely cause your taxes to rise in the short term. However, you would do it for the lifetime tax benefits if taxes were to go up dramatically. It is not unrealistic that your effective tax rate could double if the U.S. debt situation becomes critical.
(3) Encourage your younger children, grandchildren, and young people you love entering the workforce to contribute to a Roth instead of pre-tax. I feel very strongly about this and tell the younger members of our team that they should contribute to Roth IRAs (if they are eligible) and Roth 401k's. They are most likely to be in the workforce when taxes are likely to go up. We want them to be proactive and avoid creating a long-term problem.
I like to tell clients that I do not have all the answers. As some of you read this, you have heard the conventional wisdom that we should max out the pre-tax portion of 401k. I respect that point of view. The world has changed, particularly the financial situation of the U.S. In the future, taxes will likely go up significantly and possibly double. Using the Roth IRA or Roth 401(k) is a way to be proactive and mitigate the effects.