Wrong advice: Shift FROM tax-deferred retirement accounts?

[Rapid Robert]

By coincidence I was advising someone today on tax planning under a similar scenario, and then saw this excerpt from Kiplinger regarding "the Distribution Phase of Retirement". I completely disagree with this advice. If in the last few years working full-time, pre-retirement, it will pay to max out the 401k, not the Roth. Even to the point of taking money out of an existing Roth to make up the difference. It can always be converted back into the Roth at lower future tax rates (due to no longer working full time).

The reason is simple: the marginal tax bracket will be lower in the future post-work, than it is now, pre-retirement. Trad. IRA/401k is designed to reward having a lower tax bracket in the future;by contrast Roth IRA is designed only to reward having a higher tax bracket in the future.

"The secret to mitigating taxes? Plan ahead. You can lower your tax bill by shifting your retirement nest egg from tax-deferred accounts like IRAs or 401(k)s to Roth accounts. While your tax bill will increase in the year of the shift, you can time it correctly to ensure that this occurs while you still have a paycheck coming in and while tax rates are lower.

Remember that tax rates tend to increase year after year, much like inflation, and one thing is certain: You will have to pay them. It's better to do so while you still have a paycheck coming in and when tax rates are lower, so you won't feel the tax burden as acutely."

https://www.kiplinger.com/retirement/threats-to-the-distribution-phase-of-retirement

[TaxGuyBill]

Yeah, I've seen some questionable advice from Kiplinger a number of times.

While I generally agree with your viewpoint for the Traditional vs Roth near retirement, it can have a significant problem - Social Security. Withdrawing from non-Roth accounts (including RMDs or converting to a Roth) can affect how much Social Security is taxable. In some cases, it can effectively almost double the tax rate due to an increasing amount of Social Security becoming taxable.

One potential method to minimize that problem is to delay taking Social Security (allowing the benefit amount to increase) and withdraw and/or convert the Traditional retirement accounts during their early retirement.

But it varies from client to client, so it can be difficult to have an all-purpose recommendation due to varying circumstances.

[kathyc2]

People shouldn't put a lot of stock in generic advice. For moderate income people, this can make a lot of sense. Each situation is different, and you need to look at the overall picture, understand how SS becomes taxable, look at the totals they have in deferred accounts, it they plan on being charitable after 70 1/2, if they have money they can get to tax free for an unexpected large expense, etc. People need to get over the defer, defer, defer mentality. Playing later rather than sooner isn't always the correct answer.

[Anarchrist]

I have a few clients with multi-million dollar 401ks and IRAs. Their RMDs will put them in a higher tax bracket than they are now. There will be many more people like this in the future as most middle class taxpayers maxing out their 401k for the life of their career will be in the same situation. I have a friend who considered converting his IRA to a ROTH when ROTHs started but decided not to because he didn't think he could afford a $40K tax hit. Now he has to take RMDs he doesn't want or need from a million dollar IRA. This creates a substantial tax bill, increases his medicare premiums, and his beneficiaries will have to withdraw all the funds within 10 years of his death. His biggest financial regret is not converting his IRA to a ROTH when he was younger.

[rbynaker]

I agree with Kathy. There's no blanket statement that will apply to everyone. Some of the assertions made in the article were questionable (tax rates only go up? really?)

An issue that I haven't seen discussed much is the future collision of inherited IRAs with substantial balances and the new RMD rules. I think a lot of people working will inherit retirement assets at a time when their wages are at their lifetime high. Once they get the tax bill on what may be their highest W2 earning year plus having to drain parents' IRA accounts across no more than 10 years I think a lot of folks will opt for early retirement.

Another factor I rarely see considered in these articles are state taxes. If I'm living and working in CA but plan to retire to FL, why would I ever want to do a Roth conversion at CA tax rates?

Rick

[FEDUKE404]

I fully agree that the "one size fits all" approach is generally not wise.
Many (most) of my clients already pay federal taxes on the maximum amount of 85% of their Soc Sec benefits. Not much is going to change for them in that area.
Those with wage income frequently max out their 401k contributions as that door to saving on taxes begins to close. Taking advantage of such options is generally a prudent move for higher income individuals in their working years.
But then the (frequent) fallacy of "you will be in a lower tax bracket when you retire" raars its ugly head. Stir in taxable Soc Sec, RMDs, maybe some annuities and then top that off with NIIT grab and paying multiples (both spouses) for Medicare premiums via the insidious IRMAA, and a lot of the general "advice" falls by the wayside.
The newest money grab by the government is the rules for cashing in funds from an inherited 401k et al. Having been reasonably successful over the years, my children will inherit sizeable 401k balances AND will face some significant income tax bills for (earlier) mandatory cashing in of same. My guess is that, under current rules, they will be absolutely shocked to get those income tax bills.

So, again, having a "lower tax rate when you retire" is only part of that overall story. . .

[kathyc2]

Something else that is rarely mentioned is to convert when markets are down. 2009 markets were down close to 50%, and at the beginning of COVID they were down 20-25%. Converting during the dip and having the rebound in Roth rather than Tradtional would be true tax savings.

[Lion]

I fully agree that the "one size fits all" approach is generally not wise.

The newest money grab by the government is the rules for cashing in funds from an inherited 401k et al. Having been reasonably successful over the years, my children will inherit sizeable 401k balances AND will face some significant income tax bills for (earlier) mandatory cashing in of same. My guess is that, under current rules, they will be absolutely shocked to get those income tax bills.. . .

So, depending on your economic circumstances, the market, that conversion year(s)'s income and tax rate, and more, you might want to convert some 401(k) monies to a Roth in a specific year or years, so your children have that one less shock and that one account to draw from to pay your final expenses without incurring more tax and to have that one account to draw from that's treated differently than their inherited 401(k)s. I like the "Don't put all your eggs in one basket" approach. But the timing of that approach is a moving target and different for everyone.

[TaxGuyBill]

Something else that is rarely mentioned is to convert when markets are down. 2009 markets were down close to 50%, and at the beginning of COVID they were down 20-25%. Converting during the dip and having the rebound in Roth rather than Tradtional would be true tax savings.

That's a good point. I didn't think of that (or forgot about it). Thanks.

[kathyc2]

That's a good point. I didn't think of that (or forgot about it). Thanks.

Gov't realized by waiving RMD's for 2020 they would collect more in the longterm!

[Rapid Robert]

I appreciate the discussion. In the particular case I was referring to, it is a single taxpayer mid-60s no dependents who is working full time now, low six-figure salary. When he quits as planned in a few years, it is pretty certain his income tax bracket will go down from where it is now.

One thing that inspired me to bring up this topic is the following simple math which shows that if your tax bracket in the future is the same as at present, then a Roth IRA is EXACTLY THE SAME as a Trad IRA/401k as a tax-favored investment, on its own and all other things being equal, such as investment allocation. Yes, there are secondary effects from things like RMDs that can drive up other taxes, in particular the Soc. Sec. tax, but once you reach 85% max threshold for Soc. Sec., that doesn't matter. My own approach is rather than delay SS and RMDs as long as possible and then getting a big income increase all at once in my 70s, I am spreading out my SS over more years by starting before age 70, and also taking some early distributions from Trad. IRA every year close to what the RMD would be, to bring the balance down.

ROTH VS. TRAD with CONSTANT TAX BRACKET

Suppose you get a $1,000 bonus from your job, your tax rate is 20% now and in the future, and the market grows 7%/yr. You can either

• 1) put it in a Trad IRA (or 401k, same thing)

or

• 2) pay $200 tax now and put $800 in a Roth IRA.

Now five years go by, and your investment either way has grown by a total of 40% (7%/yr compounded over five years).

So you now have either:

• Trad IRA = $1,400

• Roth IRA = $1,120

Applying tax of 20% to Trad IRA, you can take out net amount of [ $1,400 * 0.8 ] = $1,120

So you can see that if your tax rate remains constant, the Roth IRA has identical result to Trad. IRA.

This is the myth of the Roth IRA -- getting "tax free earnings" exactly cancels out the fact that you had to pay tax upfront on the investment, yet somehow "tax free" in our minds sounds like it should be better -- it's not. The only thing (other than secondary effects) that matters is whether your future tax bracket will be higher or lower than current one.

[Rapid Robert]

"There will be many more people like this in the future as most middle class taxpayers maxing out their 401k for the life of their career"

Minor quibble, if someone is able to max out their 401k most every year throughout their full-time working years, I'd say they are higher income than middle class. Socking away $20K or more every year for retirement is only possible for someone who has plenty of other income, or else, dare I say, not much of a life outside of work.

[TaxGuyBill]

• 1) put it in a Trad IRA (or 401k, same thing)

or

• 2) pay $200 tax now and put $800 in a Roth IRA.

Yeah, that is what many pro-Roth advisors miss. They tend to assume you are putting the same/full amount into the Roth as you would the Traditional.

However, a Roth still has some advantages. For example, you can withdraw the Basis tax-free and penalty-free before retirement. And after retirement, if the taxpayer's Social Security is not at the full 85%, a Roth withdrawal won't increase the amount of Social Security subject to tax. Many of my clients are lower-to-mid-income, so the effect on taxable Social Security is a huge factor. But most of my clients are in a lower tax bracket during retirement, so it is challenging thing to figure out the lower tax bracket versus making more Social Security taxable.

But it can be fun to tinker with Traditional IRAs for low income taxpayers. The 50% "Saver's Credit" is great. And I once saved somebody over $12,000 by telling them to contribute $300 to a Traditional IRA (the Premium Tax Credit cliff). :-)

[kathyc2]

"Applying tax of 20% to Trad IRA, you can take out net amount of [ $1,400 * 0.8 ] = $1,120"

However, if someone is in the range where some SS is taxable but not the full 85% taxable, the calculation changes. The 1,400 will also make 1,190 more SS taxable resulting in tax of 518, of an effective rate for that portion being 37%, not 20%.

Using the 1,000 from your example wouldn't make much difference, but something else to keep in mind is if the higher income from Traditional (along with more SS taxed) pushes LTCG rate from 0 to 15%.

[kathyc2]

But most of my clients are in a lower tax bracket during retirement, so it is challenging thing to figure out the lower tax bracket versus making more Social Security taxable.

If they are under the 85% taxable, just take the marginal rate times 1.85. The 12% rate becomes 22.2%, so a little more than they deferred if marginal was 22% while working. For people in 12% while working, the only time I see it makes sense to do Traditional rather than Roth is if the amount in Traditional is so low that they can get the money back out tax free after retiring or by having RSC available or to increase PTC.