Why Roth/Roth(k) planning might make more sense than you think.

As you enter your peak earning years, it’s easy to get trapped by a short-term perspective on taxes.

It’s natural that this would tend to happen. Here you are seeing your salary (and retirement accounts) reach levels that are higher than your younger self would have ever thought possible, and your focus begins to shift each year towards safeguarding your progress by lowering your taxes as much as possible. One way to do this is by increasing your 401(k) contributions. And why not, since you are making more anyway. And at tax time this can reduce your taxable income by up to $26,000.

But the challenge we are now seeing among many retirees is that after years of doing this the majority of their wealth is “trapped” inside pre-tax accounts that will ultimately have to be taxed as they begin to use it. Sometimes factors they cannot control can lead to inefficient distribution situations causing higher taxes to eat into their hard-earned savings.

Fortunately, by learning the rules around Roth planning, you can make a dramatic difference in your tax future.

Strategic Roth planning is where you begin to set targets and pro-actively shift some of your savings towards Roth or begin slowly diversifying existing retirement dollars into Roth. This can be done by Roth contribution, Roth conversion, or Roth(k) deferrals. At least 1 of these 3 methods to accumulate Roth dollars is typically available to most people who are at the age to start getting serious about retirement.

How to Avoid Spikes in Taxation by Smoothing out the Ride
For accounts like IRAs and 401ks, the taxes are based on the size and timing of the distributions. These accounts are referred to as “pre-tax” because you received a tax reduction at the time the funds went into the account so the dollars in there have never been taxed. These accounts also benefit from tax deferral as each year the gains, dividends, and interest are also tax-free. But eventually, those taxes are going to come due like a credit card bill when it comes time to start liquidating that account.

It’s kind of like patiently rolling a snowball up a mountain year by year. Eventually, you’re going to have to let that thing go. And if you wait until you are 72 when the IRS forces you to do so you could be in for an avalanche of taxable income you were not quite ready for.

Required Minimum Distributions (RMD’s) Begin at Age 72.
Because taxes have never been paid on those dollars the IRS eventually requires them to be distributed so the taxes can be paid. Starting at age 72 the requirement is just under 4% of the balance per year and rises each year after that on an accelerating schedule. (Like a snowball picking up speed). If you haven’t saved much for retirement it won’t make a noticeable difference, but where this becomes an issue is when that distribution is larger than what you needed for your lifestyle anyway and now begins lifting you into ever-increasing tax brackets. For those who lived modestly and saved aggressively, these brackets could easily be higher than the salaries they retired from!

But Why Wouldn’t I Want the Tax Reduction Now? Won’t my Taxes be Lower in Retirement Anyway?
For some this is true but for many, it is not. Those who are most vulnerable to seeing taxes in retirement that are higher than when they were working are those approaching 5x their income in total pre-tax wealth at retirement. (Or are on track to do so.) (For Example: $200,000 income with $1,000,000 in retirement dollars etc.) Those with lower incomes and higher savings stand to benefit significantly more because they will likely continue to live a modest lifestyle while their substantial nest egg continues to grow faster than they will use it.

Let’s Think Through an Example:
Imagine a couple at age 62 begins claiming Social Security of say $40,000/year and they only need another $20,000 from their retirement savings to cover the gap. If they have a 401k at least $500,000 studies have shown that $20,000 is a sustainable 4% withdrawal rate, which on average, will not burden their portfolio allowing it to grow slightly faster than they are drawing on it. But what if that 401k was worth $1,500,000? Now their spend rate is only 1.3% meaning that 10 years later at age 72 it’s quite possible that 401k could be worth $2,500,000. (It would only take a 6.54% growth rate to make that happen.) For this couple, their first RMD will be $97,656. That’s a big jump from the $20,000 just a few years earlier. And that’s just year 1. Every year after that their RMD will increase causing more and more of those dollars to belong to Uncle Sam.

What’s the answer?

One way to begin reducing that future tax bomb is by identifying what your average tax rate over time is likely to be. This requires running a retirement projection to see your taxes over time so you can identify how best to structure your approach today. News flash, it likely will mean actually paying more taxes now to avoid much higher ones in the future! By pre-paying the taxes today you are lowering the amount that will be considered for RMD’s in the future and thus lowering the jump in taxes you could see at age 72 and beyond.

3 Strategies to Get Ahead of the Curve on RMD Taxes. Contribution, Conversion, and Deferrals.

Once you have identified your “most efficient” tax rate, you can then target lifting your income slightly now to that target rate and start pre-paying that future bill to Uncle Sam. Every dollar that eventually lands in a Roth then becomes tax-free for life regardless of how big those investments get.

Strategy 1) Start making Roth Contributions. This can get tricky if your income has exceeded the threshold to allow for this but don’t worry, there are still other options and honestly, they move more money into Roth anyway. Also, regardless of the income you can always make nondeductible IRA contributions and convert them later. (AKA Back-Door Roth) There are pro-rata tax rules to be mindful of here but we have many clients who have a good system in place to do this well.

Strategy 2) Start switching some of your contributions to Roth(k) Deferrals. There are no income limits to make Roth(k) contributions inside your company plan. As long as your employer offers this as an option you can contribute up to $19,500 in 2021 from your paycheck, and potentially up to $26,000 if you are over the age of 50. This can even be super-charged via MEGA Roth Planning but we’ll save that for another article  (Click Here to see my Video Series on that.)

Strategy 3) Start making strategic Roth conversions. For this, there is no income limit and there is no limit on the amount you can convert! This is a benefit and a risk because you have to be careful not to over-convert and accidentally force yourself into TOO high of a tax bracket. However, with a solid plan, you can set an annual target and begin converting up to a specified tax target every year. If a person were to convert $50,000/year for 10 years that’s and pay roughly 20% on the conversions, they would now have $400,000 of tax-free wealth growing for the remainder of their lifetime!

In the Future, Tax Rates May be Higher.
It may be hard to believe, but as I write this early in 2021 we are living with some of the lowest tax rates in US history. If ever there were a time to get serious about Roth Planning, it would be now. Imagine a scenario where you enter your 70’s with nearly half or more of your wealth safeguarded from changes to the tax code in the future. Unless taxes somehow go lower in the future, this would be a very powerful position to be in.

Author: Jeff Clark, EA, CFP®
Jeff Clark, EA, CFP® is a Wealth Advisor for Pine Grove Financial Group. In addition to serving his clients, Jeff is known for speaking on the topics of taxes and retirement with an emphasis on helping families find clarity as they approach the empty nest phase of life.

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