Today, on the Market Call Show, we're uncovering three powerful yet underutilized strategies that could revolutionize your retirement savings approach.
We dive deep into the world of the mega backdoor Roth IRA, revealing how high-income earners can bypass traditional contribution limits and potentially save thousands in taxes over time.
Next, we explore the often-overlooked realm of self-directed investment options within 401(k) plans. Using examples from industry giants like Fidelity and Charles Schwab, we illustrate how these tools can dramatically expand your investment choices and potentially boost returns.
Drawing from years of experience in wealth management, I share insights on the critical importance of asset location. We discuss how strategic placement of investments across various account types can significantly reduce your tax burden and enhance overall portfolio performance.
As we navigate through these complex strategies, we emphasize the value of holistic financial planning. Whether you're a seasoned investor or just starting to take control of your retirement savings, these techniques offer a roadmap that focuses on wealth accumulation.
SHOW HIGHLIGHTS
- I discussed the concept of a "mega backdoor Roth IRA," which allows for substantial after-tax contributions to a Roth IRA, even for high-income earners.
- Explained the different types of 401k contributions: pre-tax or traditional, Roth, and after-tax, emphasizing the importance of checking if your plan supports after-tax contributions.
- Detailed the steps required to maximize contributions using the mega backdoor Roth IRA strategy, including the need to max out regular 401k contributions and then contribute additional after-tax dollars.
- Highlighted the overall 401k contribution limits for 2024, which are $66,000 for those under 50 and $73,500 for those over 50, including all sources of contributions.
- Outlined the advantages of the mega backdoor Roth IRA strategy, such as high Roth contributions, tax-free growth, bypassing income restrictions, and avoiding required minimum distributions (RMDs).
- Discussed the potential disadvantages of the mega backdoor Roth IRA strategy, including plan limitations, tax complexity, contribution limits, and immediate taxes on gains if not converted promptly.
- Introduced the concept of a self-directed 401k investment strategy, which allows for greater investment flexibility and the potential for higher returns through options like Fidelity Brokerage Link or Charles Schwab PCRA.
- Emphasized the importance of checking plan eligibility for self-directed investment options and the benefits of utilizing investment advisors for managing these accounts.
- Explained the concept of asset location, stressing the importance of placing tax-inefficient investments in tax-deferred or tax-free accounts to optimize tax management and overall returns.
- Highlighted the use of technology and advisory expertise to integrate retirement accounts into a comprehensive financial plan, improve tax efficiency, and optimize rebalancing strategies.
PLUS: Whenever you're ready... here are three ways I can help you prepare for retirement:
1. Listen to the Market Call Show Podcast or Watch on Youtube
One of my favorite things to do is to talk with smart people about investing, financial planning, and how to live a full life. I share this on my podcast the Market Call Show. To watch on Youtube – Click here
2. Read the Financial Freedom Blueprint: 7 Steps to Accelerate Your Path to Prosperity
If you’re ready to accelerate your path to prosperity, the Financial Freedom Blueprint lays out a proven system for planning and investing to secure your financial independence. You can get a personalized signed hardcover copy – Click here
3. Work with me one-on-one
If you would like to talk with me about planning and investing for your future. – Click here
TRANSCRIPT
(AI transcript provided as supporting material and may contain errors)
Louis: Welcome to the Market Call Show, where we discuss investing wisely and living well. Tune in every Thursday to Apple Podcasts, Spotify, Google Play or subscribe on YouTube.
Hi there and welcome to the Market Call Show. This is Louis Llanes. Today, I'm going to ask you a question: Are you leaving money on the table? Are you leaving money on the table when it comes to your retirement accounts? This is one of the things that I've found to be very common. A lot of people don't understand some of the strategies they could be doing that could increase their wealth, lower their tax bill and, overall, make their financial plans much better, in particular, for those people who have high income and are really in a situation where they're trying to maximize their retirement accounts.
So let me just kind of set the stage about what I'm talking about here. There's really three less known strategies with your retirement accounts that can significantly help you build more wealth, create more income for longer and save on taxes. And basically what's happening is most people who have built capital in their 401k and now it's grown to a significant amount of their net worth, they really become to rely and will need to rely on these funds for future income.
So typically these people are high income earners and they have high income taxes, and one of the things that's concerning now is many people are concerned that taxes could increase, especially since the sunset rules may be ending, you know, so that we may see that the tax rates will be bumped up automatically. And also inflation has been raising income brackets for a lot of people. So this is not talked a lot about, but it's really happening and I see it every day when we're working with clients where their incomes are going higher because of inflation.
Just to stay even, incomes have to go up, but the tax rate brackets stay the same, so the cutoffs, the amount of income that you need for each tax bracket, doesn't really change. So in essence, everybody's tax rates go up because as you make more income, the tax rates go up, so that that creep in an income tax rate increase is also affecting many people. We have a lot of uncertainty in capital gains tax and income taxes. Next year there's a lot of election uncertainty and that's also leading me to want to get this out there and hopefully this can help you.
You know, when you have money in your retirement account, one of the basic things that I'm sure you understand. Most people do understand that all of the money that you take out from your retirement accounts when you retire is taxable as income. It's taxed to your income tax bracket. That bracket may be higher than the capital gains tax rate, depending on how things turn out.
So I want to talk about these three strategies. You may have heard of them, you may not have, but I want to make sure that we cover them because they can mean a lot of money in your pocket.
The first one some people call it the mega backdoor Roth IRA. This is an advanced retirement strategy. It allows you, as an income earner, to contribute substantial amount of after-tax dollars into a Roth IRA, even if you exceed the typical income limits for a Roth contribution. So here's a breakdown of how this concept works and its pros and cons.
The first thing is a 401k contribution has different types. You can contribute into a 401k into three different ways. First is pre-tax or traditional contributions. The second is going to be a Roth or after-tax contribution. And then there's after-tax. It's different from Roth. It's not common in all plans, so you have to check to see if in your plan you can do an after-tax contribution as well. Most big plans that we see, or sizable plans, do allow for this, so you'll have to check to see if that is available to you.
So the second thing is the mega backdoor. Roth has a few steps that you have to take in order to maximize your contributions and get the most tax benefit. The first step is you max out your regular 401k contributions. So, for example, in 2024, this is $23,000 per year if you're under 50. If you're over 50, it's $30,000. And your employee contributions, whether pre-tax or Roth, that is your maximum contribution you can put in.
But the second step is really important. You can contribute additional after-tax dollars in your plan. So some employers allow for after-tax contributions above that standard $23,000 or $30,000 limit. The overall 401k contribution limit in 2024 is $66,000. That's if you sum them up and that's if you're under 50. If you're over 50, it's $73,500 in 2024. So this includes all sources your employee contribution, your employer match and any after-tax contributions.
So a lot of people think that limit is only $23,000 to $30,000. For many plans, if you add it up to the total contribution limit, including after-tax contributions, you could get that number to be significantly more. In fact it's over double the amount. So that's important to understand and over time you can significantly increase your tax savings.
So now here's the other thing. The third step here that I want to talk about really is the kicker. If you perform an in-plan Roth conversion or roll the after-tax contributions into your Roth IRA, this allows these contributions and their earnings to grow tax-free.
So let's just use an example: Assume in 2024, you contributed the maximum $23,000 in pre-tax contributions to your 401k and then your employer contributed another, let's say, $10,000 in a match. That leaves you with room to contribute another $33,000 in after-tax dollars and that would give you that total of $66,000. You can then convert these after-tax contribution to a Roth or a Roth 401k and if you do that immediately, you will not have a gain problem. It's very important to understand that.
So let's talk about who can do this. First of all, the employer plan must be compatible. Not all 401k plans allow after-tax contributions but I must say many, many do. So it's important to check. Some don't offer in-plan Roth conversions, so you'll need to check with your plan to make sure they have these features. But if they do, that could be a goldmine for you.
Second is the income limit income limits. The backdoor strategy bypasses those income limits that normally restrict Roth IRA contributions. Anyone can use this strategy, regardless of your income level, as long as your 401k plan permits it. So that's a big boon because there's many high income earners who can't put money in a Roth IRA. This will allow you to get more money in a Roth IRA which is tax-free, and tax-free is a big deal, especially if tax rates go up.
So let's talk about what the advantages are. Obviously, high Roth contributions. It allows contributions far above that regular Roth IRA limit, which is only $6,500 in 2024 and $7,500 if you're over 50. So that's the first advantage. Second is it's tax-free growth. So once you convert that money to your Roth IRA, both of the contributions and future earnings growth are tax-free, and that can compound significantly over time.
Number three you bypass income restrictions, so high income earners who normally can't contribute to a Roth IRA due to income limits can use this mega backdoor Roth strategy to fund Roth accounts. Fourth, your Roth IRA advantages. Roth IRAs do not have required minimum distributions, also known as RMDs. This gives you flexibility for retirement withdrawals. Many people are stuck and they have to take those withdrawals. I look at our clients that are retired and you know, when we pull that plan up, we just know we're going to be paying taxes on those RMDs no matter what, and this gives you some flexibility so that you don't have to take those RMDs out.
So there are, however, disadvantages: First, plan limitations. Not all 401ks allow for you to have that tax contribution. You know you may not be able to use this strategy if it doesn't offer it. And second is there's tax complexity on after-tax contributions before conversion which may be subject to tax. So it's important that you do these conversions at the right time, the right amounts, so that you can avoid paying extra taxes.
Also, you have the contribution limits. You still may be limited to your overall amounts and you have to make sure that that includes your employer match. So the strategy only works for those who can afford to contribute significant amounts of after-tax dollars. So this is for high-income earners typically.
So fourth, immediate taxes on gains. Any gains on that after-tax contribution before you convert may be taxable when you roll those funds into that Roth IRA. So it's important to roll it quickly so that you don't have those gains. If you wait a long time and you have a big move up in your value, then that could be taxed. That's not good, so you want to avoid that.
So now we talked about the 2024 limits on the employer-employee. We've also talked about that. You can get a lot more money in, so this is a significant strategy. This is the first strategy I wanted to mention. If you're not doing this and you qualify for it, your plan qualifies. I'd check it out and see if that's something you want to do. So in summary, that's great for high earners and to get more money tax free.
Now I want to talk about the second strategy. This is one that we bump into a lot, so a lot of the larger plans. They allow you to do what's called a self-directed investment strategy in your 401k money. So typically, when you put money into your 401k or your retirement account, they give you a list of funds that you could choose from and they're many times rather limited and they generally are invested in just your core type of investments like large cap, mid cap, small cap, all United States stock. There might be like a Barclays global bond or maybe just a domestic Barclays bond index, and typically there's money funds or other types of secure, guaranteed return type investments that pay lower yields but have no ability and have stability in the value. In fact, a lot of times they're called stable value funds.
You might have some international developed and a lot of times you're seeing them being indexed. You might have emerging markets in there and if you're lucky you might have some real estate and gold and things like that, but that's typically not in many plans, so you have some limitations with most 401K plans. So you have some limitations with most 401k plans, but if you check in the fine print, you might have the ability to do a self-directed IRA.
Now I'm just going to mention two of the major brokerage firms that you typically see with these. Typically, if your retirement plan is at Fidelity, they have what's called a brokerage link and with a brokerage link account you basically are opening up a regular brokerage account that you can invest in a broad range of mutual funds stocks, bonds, ETFs you know, really like a brokerage account, because it is a brokerage account but it's still linked to your 401k. So it is a 401k account but you have self-control to be able to, or self-direction to be able to invest those funds in a much better way.
Now you can also use investment advisors, like we managed PCRA accounts or brokerage link accounts as well. So Charles Schwab's version of this is called a PCRA. They have some differences in how they're put together, but they're basically the same thing.
So let me tell you a little bit about how this works. In a self-directed account, when you opt into that brokerage link, for example, a portion or all of your retirement assets are moved into a self-directed brokerage account within Fidelity or Schwab, if it's a PCRA, and then you get expanded investment choices so you can now invest in, like I said, stocks, bonds, ETFs across the board. You can get much more diversification and, on the account management side, you can manage this account yourself or you can have an investment advisor or a money manager help you manage that and that you know that would really take a load off of you for the buying and selling decisions, decisions, rebalancing, and you can get your account more suitable for your particular situation.
Because, depending on what your assets are outside of the 401k you might it might be better for you to have a different allocation than is available to you. If you just did a normal 401k, if you didn't have self-directed, you wouldn't have the ability to customize and make that allocation excuse me, make that allocation right for you. So that's the big advantage. You have greater investment flexibility. You have potentially higher returns, especially if you have expertise or if you have advisors who have the expertise to help you construct a better portfolio for you. And you get better diversification because your asset classes that you can invest in the sectors the security selection is much wider.
So what's the downside to this? Well, there's more complexity. You know self-directed investments add complexity. You have to monitor and manage these investments. That's why using an investment advisor or money manager to help you can be very helpful. If you like to do it yourself, then it could be good for you as well, but it could be time consuming and require a strong understanding of the financial markets.
So if you don't have the time or inclination to do that, obviously you could use an advisor to help you with that, but it also can increase your risk. If you do it on your own and maybe you're not up to speed about what the risks are of all these investments, there's the danger that you don't do well with it because your portfolio is not managed in a way that's sound. So it's important that when you invest in individual stocks or sectors or other funds, that you know how to construct a good portfolio and it's cohesive with your financial plan.
There could be some additional fees. Some investments may have trading fees or they may have management fees that are associated with them. So you have to see what those fees are. Now when you look at the brokerage for the two I mentioned, Fidelity and Schwab, they tend to have very reasonable fees and if you do security selection correctly, you know typically there's not a commission per se on the like an explicit commission on buying stocks and bonds, and many of the exchange traded funds don't have commissions and they have very low fees. So you can really get around a lot of the fee issues.
So who should use a brokerage link? I would say it's either experienced investors who are more suitable for it. If it represents a big part of your portfolio, like if you've been putting a lot of money there away, there that becomes an important part of your plan. That could also really give you a strong case to use a brokerage link because you want to take better care of those assets. And it's also good if you have advisors that can help you seek customization so you can build a tailored portfolio that your standard employer plan just can't give you and the benefits and features are much more broad.
So how would you access a brokerage link? The first thing you'd need to do is you need to or PCRA, by the way. First thing you need to do is you need to check your plan eligibility right. Not all employers offer it. Then you would open up a brokerage link account and then you would fund, you would transfer those money and you would fund it over and then you could invest it. So that's a good way to go. Look at, look for the see if your plan has those self-directed plans, particularly with Fidelity Brokerage Link or Personal Choice Retirement Account, PCRA for Charles Schwab. Those are, those are a good thing and not underutilized benefit that you may benefit significantly from.
Okay, so now let's move on to the last strategy that I wanted to mention to you and that actually has to do with wait for it Asset location, all right. So one of the most important things to understand is that and you probably already understand this, I'm beating a dead horse, but I have to say it taxes are so important to your returns. There's lots of studies out there trying to estimate how much of your return is dragged down, pulled down by taxes, and on average, you see the number estimated to be anywhere from one to 3% of your returns. So it could be a lot and some people go well, that's not that big of a deal. Well, over time, that adds up to a lot of money.
So managing taxes is really important and in doing that, it's important to be able to have strategies. There's many different ways for managing taxes and this is not a tax strategy only podcast, so I want to talk about it in particular, with the 401k, and we've already talked about conversions, right, converting to the Roth. Now I want to talk more about asset location.
So there are certain investments that are better suited to be in a tax deferred account or tax free account, and that has to do with how much taxation those investments spin up. So if you have. You know when you look at your total portfolio, if you have a balanced portfolio that is invested properly, with good diversification, you're going to have some investments that spin off more taxes than others. For example, high dividend yield paying stocks tend to spin off more taxes because those dividends are taxed. Taxable bonds that generate interest, that will be more taxable, that will cause more taxes. Or if you have investments like, say, private credit, which is a good asset class to consider, where you can get higher yields than traditional bonds, and then you can access those in the private markets, have them in your investments and then you could put those tax free so that you're not paying taxes on all that interest. So those are just a few examples of the types of investments that you would want to or consider having located in your retirement accounts.
So when you look at your total picture and it's really related to how much you have outside of your, how much investments you have outside of your qualified plans, your retirement accounts, and you know what your balance is. Do you have rental real estate? So it requires a holistic view of your situation.
Now one of the most powerful things that you can do is there is technology now where you can analyze your total picture, including your investments inside your retirement accounts and outside, and make some asset allocation decisions to optimize your taxes and optimize your returns. So typically, if you combined this type of technology which allows you to look inside. For example, we as investment managers, we have access to these tools we can look inside any of these plans and see what are the options that are available. You have a list of options. Okay, what are those options? And we can look at the holdings-based analysis down to the holdings level. What does that portfolio look like if we structured it in different ways?
And if you look at that, you can really tailor your investment portfolio of your retirement accounts to your whole picture. So instead of just isolating each investment, it's better and more sound to look at the whole picture. So it gives you better tax management, gives you better integration into your total financial plan and gives you a comprehensive look. So this is probably the biggest advantage of using technology to look at that. And also, with this technology, you can also get the advisory expertise. You can also get fund selection that's more detailed and you get portfolio rebalancing.
So one of the biggest advantages to having a well-run strategy is having a system on how you're going to rebalance your investments. There are different ways to rebalance. You have time-based, where you just do it based on the calendar. You know every quarter, for example, or every year, you you know if stocks went up versus bonds and you sell off some stocks and buy some bonds or vice versa. You can do it based on time or the calendar, or you can do it based on volatility. So if you have a target allocation and it moves a certain percentage above or below what your target is, then that would be a triggering event that would cause a rebalance. There's some studies that show that that can be advantageous relative to calendar based, because it's based more on, you know, changes in the risk return profile of the overall portfolio. So having that rebalancing capability is really important.
So this is really more about a technology, strategic way of thinking about and managing your retirement account in the context of your overall portfolio and also you can optimize that to your specific goals and risk tolerance. Risk tolerance is a big part of it and your retirement timeline. So with the retirement timeline, what you're you know, everybody's situation is different. So you may it may be optimal for you to first start taking income from your taxable accounts or from it may make more sense to take some from Social Security first or from an annuity first or from a pension first. There's a lot of different variables for different people.
Maybe you should take it from your tax-deferred account first as a default that's not the best way to go usually. Or it may be better for you to take a ratio income that's prorated over certain accounts and that requires full financial planning to understand what's optimal for you because everybody's different. But getting that tax and investment efficiency, getting the ongoing monitoring and rebalancing, improving your risk management that is the biggest benefit of using these types of technologies.
So I want to summarize here. These are three of the what I would consider least utilized, most important things that a lot of people can do where you're leaving money on the table with your retirement accounts. First is the contribution and conversion strategies that I mentioned. That allows you to put more money away. Perhaps that makes sense for you. The other would be self-directed either a PCRA, a brokerage link or anything like that, and utilizing expertise to get that done correctly. And then also tax location, using a holistic investment allocation that can lower your tax bill and give you longer term investment results.
So that is pretty much it for this podcast today. I guess my suggestion to you is to check these things out and see if they can work for you and if you want any assistance on that. As always, you can always reach out to us and we'd be happy to answer any questions for you as to how you can best get this done for your situation. That's all for now. Thanks for tuning in and we'll talk to you later.