Congratulations, you did it! Your discipline and dedication to automatically investing through paycheck deductions, and regular savings has resulted in being able to reach your goals and retire. Unfortunately, there may be a hidden downside if you have not been careful in where you invested, as you may get a much larger tax bill than expected.
For today’s workers, the most common retirement investment vehicles are qualified plans such as 401(k)s/403(b)s or in Individual Retirement Accounts(IRA)s. When you are in the accumulation phase in preparing for retirement, it is easy to focus more on the savings aspect, and forget not to prepare for the tax consequences of your contributions that will occur in retirement.
Most individuals contribute normal pre-tax contributions to their 401(k) plan resulting in not being taxed today but all of the contributions and gains will be taxed at ordinary income rates upon distribution. For these super savers, this problem accelerates the year they turn age 70 1/2 when the IRS mandates a Required Minimum Distribution (RMD) from all qualified plans such as the 401(k)s, as well as Traditional, or Rollover IRAs.
To help illustrate the intricacies of retirement and tax planning, I would like to share a hypothetical story about a couple, Joe and Jane, who are preparing for retirement. Through this story, I hope that the examples I provide can provide more context around the importance of planning, and how it can make your own retirement all the more successful.
Joe and Jane – Preparing For Retirement
Joe and Jane are a married couple ages 58 and 59 that are each preparing to retire at age 62. They did a great job-saving in their 401(k) plans by living a modest lifestyle and diligently saving. Due to this diligence, they have saved roughly $3 million dollars in their retirement accounts resulting in overfunding their desired retirement lifestyle. This gives them flexibility in spending more at retirement or leaving some as a legacy to their family.
Having a larger than needed nest egg is a good problem to have! However, despite the vast savings, Joe and Jane only made pre-tax contributions to their 401(k) plans resulting in all future distributions in retirement being taxed as ordinary income. Presuming they don’t choose to spend more in their early years of retirement, their portfolio will grow to over $4 million dollars by the time they are both of RMD age. This could result in an RMD amount of $156,585, which pushes them into an effective tax rate of 17% at age 71 which is a jump from prior years.
Because their portfolio is outgrowing their spending lifestyle for retirement, each year the RMD goes up and pushes them into a higher tax bracket and higher effective tax rates for the remainder of retirement. Even if Joe and Jane don’t have our gift of hindsight, there are many ways that they can help unravel future tax concerns (which I’ll address later in this article). That said, first, let’s take a look at what could have been done differently during their accumulation phase.
Consider Roth Contributions Into Retirement Accounts:
A great course of action to take during your accumulation phase is to consider making Roth Contributions or a mix of pre-tax and Roth contributions. Having a mix allows for more flexibility toward your retirement distributions strategy in retirement.
One option you may consider is to max out a Roth IRA. For 2019, this limit is $6,000 ($7,000 if age 50 or older), and if you are married, this comes out to a possible $12,000 (or $14,000) a year. Assuming a married couple contributed the annual shared limit of $12,000 annually over 20 years with a 6% growth, they could see substantial growth of these funds. See future value chart below:
That future value of over $467,000 would now be funds that can be distributed right at retirement tax-free or more likely taken in smaller distributions in those years where more income is needed without creating additional taxable income.
While Roth IRAs are convenient, you may want to review if your 401(k) allows for a Roth Contribution or other special options like a Mega Backdoor Roth Conversion. When trying to decide if you should contribute to a Roth or Pre-tax 401(k), you will want to review what is your current effective tax rate versus your estimated effective tax rate in retirement. This information can help make an educated decision on if you should be making Roth Contributions and paying taxes on contributions today or rather making pre-tax contributions to pay taxes on contributions and earnings in the future.
One thing that is tough to account for is what the tax rates will be in the future. Often a good rule of thumb is to focus on Roth contributions if you are younger due to the likelihood that your income potential is at a lower amount early in your career. As you move 10-20 years into a career, it is likely you can demand a higher income which will result in higher taxation where you may want to favor more pre-tax contributions for their ability to reduce your taxable income today.
Income Too High? Consider Backdoor Roth Contributions
If your employer does not offer a Roth contribution option in your employer plan, you may only have the choice to use a Roth IRA. Unfortunately, one issue that you may fall into is that there are income limits to being able to contribute to a Roth IRA. In short, if you make too much income, you cannot contribute directly to a Roth IRA. However, there is an option to work around this where you contribute to a Traditional IRA, and can then convert these dollars into a Roth IRA. This process is referred to as a Backdoor Roth Contribution and more details can be found in this great article by the Financial Buff outlining how to accomplish this.
Need Other Options? Consider Non-Qualified Accounts
There are also several non-qualified options that are available during the accumulation phase of growing your wealth. Typically, non-qualified accounts do not have the same tax advantages of your retirement accounts but can be a great tool to help build wealth.
First, there is a brokerage account that lets you invest in various mutual funds, ETFs, and other various equity and bond-based investments. A brokerage account does not get the special tax treatment on contributions and earnings that you can get in qualified plans such as 401(k) plans or IRA(s). When ordinary dividends are distributed in the brokerage account (whether reinvested or taken as cash), they will get taxed as ordinary income. There are also some mutual funds that payout qualified dividends and capital gains that will be taxed as Capital Gains with taxation at 0%, 15%, 0r 20% depending on one’s tax bracket. And finally, if you sell anything within a non-qualified account for a profit, you may also have personal capital gains (though these can be offset if you’ve sold anything for a loss).
Despite potential tax concerns, this alone should not dissuade you from exploring different account options. In fact for many executives and key employees there are some employers that offer additional accounts to their employees.
The most common of these employer arranged accounts is a non-qualified deferred compensation plan. This option allows you the ability to defer your income today lowering your taxes at this time and it will be paid back at a future date. Your employer runs this account and typically there is an agreed-upon rate of return on the growth. One can then take various distributions payments that start at a certain time period and can last for a set time.
Location, Location, Asset Location…
What accounts you choose, as well as what you invest in are vital to your retirement planning. However, another thing to consider is where and how you structure your total investment portfolio. Asset location is an important concept to understand when constructing and running your total investment portfolio. The general idea is that you want to place more growth-oriented investments in your Roth or after-tax retirement accounts and place the more conservative (and thus less growth oriented) investments in your pre-tax accounts.
This strategy adds significant value by creating a higher after-tax growth rate and can lead to more tax-free assets while maintaining proper risk allocation. The reason for the total higher rate of return is due to less tax impact on the distribution. Below is a rough example of how different accounts can be structured to have different investment locations to maximize total returns in tandem with your asset allocation and investment strategy.
Joe & Jane Situation Today:
I’ve examined ways that Joe and Jane could have changed their retirement situation with the gift of hindsight. Given that they have already built their retirement wealth with pre-tax contributions, what can they do now? Even with retirement nearing there are several strategies to counter holding a large amount of pre-tax funds in order to help lower long term taxation for these two super savers!
Roth Conversions in Low-Income Years
I’ve discussed the importance of contributing to Roth accounts, as well as where to locate assets. It is important to also find opportunities during early retirement that can set you up for further success and tax savings. One strategy to consider is looking to convert the Pre-tax Contributions inside your 401(k) or IRA to a Roth Account. Keep in mind, this will trigger a taxable event.
Referring back to our sample couple Joe and Jane’s current and future estimated tax rates, we can see that from age 62, when they leave their job, they jump down from around a 16% effective tax rate they move significantly lower effective tax rate ranging from 12%. It then ranges between 12%-10% until social security income starts coming in at age 67. This allows for them to live mostly off of social security and a low distribution from their pre-tax contributions giving them two years at a 4% effective tax rate before RMD being mandatory.
By working with a Certified Public Accountant (CPA) and a Financial Coach you can get help in starting to shift some of your portfolios into Roth Contributions. A common strategy is to convert an amount each year that pushes the individual to the upper limits of their current tax bracket without pushing it over to a higher level which could bump up the effective tax rate and overall taxation.
For Joe and Jane, the years from age 62-70, they will have a lower effective tax rate based on current tax law. This could be a great time to convert funds over each year to help provide balance and flexibility when it comes to taxation from age 71 through their retirement.
Another great option for these super savers is to consider gifting excess funds to their loved ones. Joe and Jane are currently spending less than what their portfolio is growing at. The IRS has a gift tax in place, where when someone gifts a significant amount to someone they will be taxed on the amount given.
Fortunately, there is a $15,000 a year exclusion per person which is not subject to the gift tax. If one is married, each spouse can give $15,000 to another individual for a total of $30,000 a year in 2019. Joe and Jane may want to consider providing gifts each year to help reduce future growth by transitioning wealth today and future taxation.
There is also a Lifetime Gift Tax Exemption which is the total amount over a lifetime above the annual exclusion that you can give away tax-free. In 2019, the amount per individual is $11.4 million dollars which comes to $22.8 million with a married couple over their lifetime.
Often, this Lifetime Gift Tax Exemption is used at death to avoid estate tax. Keep in mind, these tax exemption laws have historically been changed multiple times. Working with an estate planning lawyer is vital in being tax-efficient, protecting your family, and having your final wishes followed.
Qualified Charitable Distribution (QCD)
Gifting over your lifetime is helpful to reduce your overall taxable estate, but it doesn’t quite solve the problem of being taxed on large qualified plans and Traditional/IRA distributions. The great news though is that one of the best strategies for helping lower the tax impact with RMDs is to consider a Qualified Charitable Distribution (QCD). This is a strategy to use part or all of your RMD to go to a charity and avoid the taxable impact (currently congress has set this at a maximum of $100,000 annually). The rules around QCD can be detailed and so additional tips can be found in this article by SmartAsset.
To provide an example of how a QCD could assist Joe and Jane did not need all of the RMD amount that year for spending. They could send the rest to a qualified charity of their choice. For example, if the RMD amount is $156,585 and they only need $120,000 this year for spending, Joe and Jane can take that distribution (presumably pay taxes on that amount) and they can then give the additional $36,585 to a charity resulting in a lower tax bill and helping a cause they are passionate about.
Making tax-efficient retirement decisions is a way that helps stretch out assets, get a greater rate of return, and help those that you love. Make sure you take the time to think through your contributions today and the tax implementations in the future. A little bit of planning now, lets you build a tax-efficient investment portfolio and distribution strategy to help you get a better overall rate of return along with the flexibility to balance life goals and decisions along the way.
Retirement planning has many steps, and you do not have to do it alone. If you are looking for a financial coach to help educate you through these decisions reach out to us here at My Financial Coach. Get one-on-one advice from a Certified Financial Planner™ that will help you understand your total financial picture allowing you to make the best decision for you and your family.
James Hargrave, MBA, CFPⓇ, CLUⓇ
Director of Financial Planning