The Wealthy Don’t Pile Money Into a 401(k) — They Do This Instead, Says Preston Seo

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Most personal finance experts agree that maximizing 401(k) contributions is an excellent strategy to prepare for retirement. A 401(k) allows employees to contribute pretax income to an account that can grow tax-free over time. In some cases, employers match some amount of contributions, essentially doubling some of the employees’ money. However, the downside of a 401(k) is that you must pay taxes on your withdrawals based on your income bracket in retirement.

To make the most of your savings, it’s vital to have an exit strategy for your 401(k). Preston Seo, an expert investor and financial influencer, gave some great advice in a recent Instagram post. Here’s how wealthy people pay less in taxes on their 401(k) plans.

Step 1: Contribute To Your 401(k)

Employees who participate in their company’s 401(k) have a portion of each paycheck automatically withheld and transferred into the account. You can choose from a variety of investments, including stocks, bonds, mutual funds and ETFs. Your money grows over time without the disruption of capital gains tax.

Seo pointed out that this is a big upfront tax break for the years you’re earning a sizable amount. For example, if you earn $150,000 annually and send the maximum $23,500 to your 401(k), your taxable income drops from $150,000 to $126,500. While your income remains in the same tax bracket of 24%, the amount you pay in taxes for the year drops from $36,000 to $30,360. If you take no further action, you may pay less taxes on those contributions if you fall into a lower tax bracket in retirement.

Step 2: Roll Your 401(k) Money Into a Traditional IRA

Many miss the next step that wealthy people take, which is rolling the funds from their 401(k) into a traditional IRA once they leave a job or retire. Because traditional IRAs and 401(k) plans both allow you to defer taxes on your contributions while they grow in your account, many may see this action as unnecessary. However, Seo pointed out that traditional IRAs give you much more control over your investments and have lower fees.

While 401(k) plans allow you to choose how you’ll invest your money, you’re limited to the investment options of your employer’s plan. With a traditional IRA, you have complete control over how you grow your money, meaning you have access to many more investment options. You should be aware 401(k) plans also have an expense ratio, which is several management fees you must pay the provider annually. Traditional IRAs may also charge fees, but you can opt for a provider with very low or no fees, saving you money year after year.

It’s important to note that even though contribution limits for a traditional IRA are $7,000 to $8,000 per year, depending on your age, they don’t apply to rollover funds.

Step 3: Every Year, Convert IRA Funds to a Roth IRA

Seo explained that the final step in the process is transferring your money again, this time to a Roth IRA. Roth IRAs function differently from 401(k) plans and traditional IRAs in that they’re not tax-deferred retirement accounts. Instead, you make contributions with money you’ve already paid taxes on. Once you put contributions into your account, the money can grow through investments tax-free, similar to the other retirement accounts. However, with a Roth IRA, you don’t need to pay taxes on these funds when you withdraw the money in retirement. 

Seo recommended converting money over many years to take advantage of timing, such as making decisions based on low-income years. You must pay taxes on the money you transfer as regular income once you withdraw it from your traditional IRA, so that should be considered when planning when to convert. The reason Seo believes this is still a good idea is that you can continue to grow your money in the Roth IRA over time without worrying about future taxes.

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