Rethinking Traditional IRA/401(k) Strategies
Conventional wisdom for retirement planning has long suggested maximizing contributions to your 401(k) and IRA and leaving those funds untouched for as long as possible, ideally until Required Minimum Distributions (RMDs) kick in. This strategy hinges on the tax advantages these accounts offer: you get a tax deduction on the contributions, and the money grows tax-deferred until you withdraw it in retirement, ideally when you're in a lower tax bracket. The assumption is that while you're working, you're in a higher tax bracket due to higher income, and in retirement, you'll be in a lower bracket as your income decreases.
For many people, this works well. You benefit from that tax-deferred growth, and your RMDs closely approximate your income needs in retirement, so there are no problems there.
However, there are three key issues with this strategy.
First, if you remove money from your IRAs to live on prior to the age of 59.5, you must pay both income tax on the distribution as well as a 10% early withdrawal penalty. There are early withdrawal work arounds via “rule 55”, which allows you to take distributions from your 401k if you stop working there between age 55 and 59.5. But, this only eliminates the 10% penalty and not all plans make it easy to do or even allow it.
Second, the tax assumptions may no longer hold true. The U.S. government currently has $34 to $35 trillion in debt, with daily interest on that debt amounting to nearly $2 billion. Given this reality and the fact that the debt is still increasing, it's hard to imagine a future where tax brackets and rates are lower. I believe that the federal government will need to generate revenue to service this debt, and taxes are their primary means of doing so, resulting in a sobering but reasonable argument that taxes in retirement could be higher than they are today, though how much higher is uncertain.
The third issue is related to the growth of your retirement accounts. If you maximize your 401(k) and IRA contributions and don't touch them until the government forces you to at age 73 through RMDs, these accounts should continue to grow, which on its surface seems like a good thing. The problem arises because RMDs (the amount the government makes you distribute at age 73—are based on the account's value. At age 73, the irs.gov RMD table says you're required to take roughly a 3.77% distribution of whatever is in your IRA. Every year after, that percentage increases as you age. For example, if you have $2 million in your IRA at 73, you'll need to withdraw about $75,400 and pay taxes on it based on your income tax bracket at the time. At age 83, that required distribution is 5.84%, which is $116,800 on the same $2,000,000 assuming it hasn’t grown.
If your income needs match your RMDs, this might not be an issue. However, if you have modest income needs or other income sources like Social Security, pensions, and taxable accounts that are sufficient to meet your retirement lifestyle, the RMDs can become a tax problem. They can increase your income, thus increasing your taxes and possibly pushing you into a higher tax bracket, which can increase the taxable portion of your Social Security (ssa.gov) and potentially raise your Medicare premiums (medicare.gov).
What can be done?
A strategic approach involves examining your income expectations in retirement and how you're allocating your savings. One potential solution is shifting some of your retirement savings into Roth 401(k)s or Roth IRAs, or converting a portion of traditional IRAs or 401(k)s into Roth accounts through Roth conversions. When you make this conversion, you pay the taxes now, at your current tax bracket, but it reduces the amount in traditional retirement accounts and, consequently, the size of your RMDs. The goal is to balance your RMDs with your income needs to avoid negative tax implications in retirement.
There are many factors to consider, such as tax brackets, income needs, retirement age, and the amounts in various accounts. When evaluating someone's situation, I consider both current and future expectations for tax brackets and the amount of income they might need in retirement. I look at their fixed income sources, such as Social Security and pensions, and determine how much additional income we'll need from their investments to bridge the gap between their fixed income and what they need to be comfortable.
If you have any questions or need personalized advice, feel free to reach out by phone or email. I'm here to help you navigate these complexities and secure a more comfortable and tax efficient retirement.
Jeremy Raffer, MBA
Director & Wealth Manager
Author “Financial Planning for Widows”
m. 201-747-2705
e. jeremy.raffer@stewardpartners.com
Steward Partners
115 W. Century Rd, Suite 145
Paramus, NJ 07652
The views expressed herein are those of the author and do not necessarily reflect the views of Steward Partners or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results.
This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be appropriate for all investors. Steward Partners recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Wealth Manager. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
Individuals are encouraged to consult their tax and legal advisors (a) before establishing a Retirement Account, and (b) regarding any potential tax, ERISA and related consequences of any investments or other transactions made with respect to a Retirement Account. Tax laws are complex and subject to change. Steward Partners does not provide tax or legal advice.
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