The Ticking Tax Time Bomb in Your Retirement Account
How much you will have to spend in retirement may be determined by Congress
Most Americans are not aware of the ticking tax time bomb in their retirement accounts*. At least that’s how IRA guru, Mr. Ed Slott, describes it as most retirement accounts are tax-deferred—you don’t pay taxes now, but elect to pay taxes later when you withdraw the money in retirement. Consequently, a portion of your retirement account actually isn’t yours, but rather Uncle Sam’s. Just how much of your account is owned by the government will depend on what the tax rates will be in the future. By only having tax-deferred retirement funds, you are trusting that politicians won’t raise taxes in the future. While we can’t predict what taxes will be years or even decades from now, I can think of $28 trillion reasons and counting (the current US deficit) why they could very well be much, much higher. Please see the Us Debt Clock link at the bottom of this article.
A Note Regarding the Deficit: Please note that references to the deficit, and taxes needed to pay the deficit, are not an endorsement or criticism of one political party over another. In the last 70 years we’ve had many different administrations from both political parties, and in those last 70 years we’ve had a balanced budget just 4 times. You read that right, in just 4 years out of 70, America spent less money than it took in. So clearly overspending is not a partisan issue but rather a bipartisan one.
Taxes have never been lower
Taxes in 2021 are at historic lows**, and yet deficit spending these past few years (and in the year to come) has never been higher. As I write this blogpost, literally trillions upon trillions are being spent. Income tax rates are already scheduled to re-set higher in 2025, but will likely go even higher in the future to pay for this spending. (Source: https://www.cbo.gov/budget-options/54787)
Therefore, you would be wise to consider strategies to pay taxes when it’s to your advantage. In retirement individuals may fall into lower tax brackets. However, there is far too much risk in leaving what you will have to spend to future tax rates. Essentially, you have two options: (1) hope your taxes will be lower in the future; or (2) implement a plan that uses strategies to pay taxes when it is to your advantage. I would not recommend the former, but I can help you with the latter.
Here are some of the strategies to consider to pay taxes when it is to your advantage.
Tax Advantages
Every strategy proposed is perfectly legal. As I have heard it said, “Every one must pay taxes, but no one says you have to leave a tip”.
Roth IRA – First, I will begin with the simplest option. You can contribute $6000/year if you are eligible (please see below). If you are 50 years of age or older, you can contribute $7,000.
• Single filers whose income (Modified Adjusted Gross Income, or MAGI) is less than $124,000.00 can contribute the full amount. Those with incomes up to $139,000.00 can contribute a reduced amount; and
• Married Filing Jointly whose income (MAGI) is less than $196,000.00 can contribute the full amount. Those with incomes up $206,000.00 can contribute a reduced amount.
Roth 401k – These have greatly expanded the eligibility for those who can contribute to a Roth, as there are no income limitations. Additionally, because of the higher contribution limits ($19,500 for those under 50; $26,000 for those 50 years of age and older), participants in these plans can save a great deal more after-tax retirement funds. However, there are a number of factors you need to consider. It is thereby recommended that you speak with a Certified Financial Planner™ or tax professional to see if it makes sense for you.
Backdoor Roth/Mega Backdoor Roth — If you are not eligible to contribute to a Roth IRA or don’t have access to a Roth 401k, there may be another option. Some employer plans (401k/403b/457) allow for non-deductible contributions. Because these are after-tax contributions you can immediately transfer them to a Roth IRA. However, if you wait until later, you will have to pay taxes on any gains.
Some employer plans allow for significantly large non-deductible contributions (you can contribute over $30,000) which can then be transferred to a Roth IRA account. Due to the large amounts that can be contributed these are called Mega Backdoor Roths.
However, the benefits of Backdoor Roths can be negated by other rollover IRA accounts that you might have. There are potential work arounds, but it gets complicated which is why it is strongly recommended you speak with a Certified Financial Planner™ or tax professional before pursuing this strategy.
Roth Conversions
Our final strategy can be one of the most powerful ways to reduce your future taxes. They work just as they sound: you convert portions of your pre-tax accounts to a Roth. There are no income limitations on these conversions, but any transfer is “realized” as income in your current year. Consequently, these could make sense in years when your income is lower, such as the years between your retirement and before you begin taking your Required Minimum Distributions (RMDs).
It should be noted that the money is transferred directly from your IRA to your Roth IRA, and you cannot use any portion of the transferred money to pay the taxes. You must pay these out-of-pocket instead; and therefore you need to have the money in the bank, or a non-retirement account to offset these tax expenses.
In the hypothetical case below (see chart), the client will have $3.2 million dollars more to spend because of two factors: (1) Order of Distribution and (2) Roth conversions. The order of distribution refers to taking distributions in retirement from taxable accounts first, followed by distributions from tax-deferred accounts (traditional IRAs, 401ks), and final distributions coming from tax free accounts (Roths and Roth 401ks). The reason why a person should have more to spend with this strategy is because your retirement accounts are not taxed every year (tax-deferred). Every time companies you are invested in via stocks, ETFs, or mutual funds share earnings with you (these are called dividends) you don’t pay taxes. Every time your bond investments pay you income (also referred to as interest) you don’t pay taxes. Or, every time you sell one investment with a gain (capital gains) and invest the proceeds into another these are not taxed. The only time you pay taxes with tax-deferred accounts (traditional IRAs, 401ks) are upon distribution. This is a significant advantage over non-retirement accounts that tax dividends, interest, and capital gains each and every year. See my previous blog for more details: https://www.betterplanningbetterlife.com/blog/see-that-all-things-are-done-in-order.
Roth conversions are the second reason why this hypothetical client should have more money to spend in the future. By converting not yet taxed retirement funds (Traditional IRAs/401ks) into tax free retirement funds (Roths), this money can continue to grow and compound tax free for many years and decades to come. And with more time, remarkable things can happen. See my previous blog entitled “The Strongest Force in the Universe” for an explanation: https://www.betterplanningbetterlife.com/blog/the-strongest-force-in-the-universe
For clients I initiate Roth conversions during periods when their income is lower, so the taxes on these conversions should also be lower. This often occurs in the years just after retirement and before pensions and required distributions begin, but it can also occur anytime throughout your working life (semi-retirements, sabbaticals, etc).
It’s Not How Much You Have, But How Much of It You Get to Keep
As I mentioned in the beginning, many people review their 401k balances thinking they have the entire amount to spend in retirement. However, they really only have between 60-85% of that to spend due to income taxes they still owe.
Going into retirement you want to ensure you don’t just have taxable and pre-tax investments available to you. It’s to your advantage to be tax-diversified. The image from my financial planning software RightCapital below shows the three types of accounts. Taxable (non-retirement) accounts are in red, tax-deferred accounts (traditional IRAs, 401ks) are in orange, and tax-Free accounts (Roths/Roth 401ks) are in blue.
Here’s an explanation why it may be to your benefit to be tax diversified in retirement. There may be moments during your retirement where you will need a large sum of money. Hopefully it’s so you can take your family on a cruise, buy an RV, or cross a few items off your bucket list. Sometimes it could be for health care expenses. If you had to take a large distribution from your tax-deferred account (traditional IRA, 401k) to pay for this expense, that could result in a significant tax bill since you have to pay taxes on the distribution. For example, if a client wanted $100,000 to purchase a boat or RV, they’d also need to withdraw tens of thousands more to cover the taxes on the distribution. With a tax-free bucket of money, you can access funds with no taxable implications.
When Not to Consider a Roth Conversion
As great as I think Roth conversions are, here are three reasons why you may not want to consider one:
(1) You don’t have the money to pay the taxes on the conversion
(2) You could be in a lower tax bracket when you retire (although there is no certainty on what tax rates will be in the future)
(3) Your child is applying to college and seeking financial aid. This will show higher income for you and may make your child ineligible.
Finally, Mr. Slott has a great name for Roths. He calls them tax insurance. Why? Because insurance is there in case something bad happens. As Mr. Slott says, “It doesn’t matter how much they raise tax rates; your tax rate will be zero.*”
Thank you for taking the time to read my blog. I do hope you found it helpful. If you would like to discuss the strategies I have outlined further, please feel free to schedule an appointment here: https://go.oncehub.com/bookjonny
Resources:
*https://www.forbes.com/advisor/retirement/ed-slott-interview-roth-ira/
** https://bradfordtaxinstitute.com/Free_Resources/Federal-Income-Tax-Rates.aspx
Ed Slott is not affiliated with, nor endorsed by, LPL Financial.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
