Boosting Tax-Free Retirement Savings One Year at a Time

Imagine yourself at 65 years old, worn out from a long-sustained career, and trying to piece together what your retirement will look like. After all, a large part of the “American Dream” is to have done enough while working to realize a well-traveled, hobby-filled retirement so it should be easy, right? Think again. 

According to an article recently run by SmartAsset, the average 401(k) balance for those 60-69 years old is $167,700. For some that may seem like a lot, but if you really think about the implications of that figure over a long retirement, it is actually very troubling. Utilizing the long-recognized 4% rule, the $167,700 balance would only afford someone $6,708 per year in income. Tack on the average annual Social Secuity payments of $17,532, and you’re looking at about $24,240 per year in income, before the IRS and state tax board take their shares. Depending on where you live, this could be considered below the poverty line.

 

To me, this represents one of our generations’ greatest challenges. Americans are living longer, have higher expenses, and aren’t receiving the pensions that propped up the retirements of the previous generation. Now, I won’t get into who is to blame, but this is definitely a frightening issue that must be planned for and addressed in advance. 

 

It is with these current challenges in mind that people should be scrutinizing their own savings. The IRS allows for three major buckets that savers should try to build up balances in:

1.    Taxable accounts including checking/savings bank accounts, investment accounts, etc with normal tax features like capital gains, interest and dividends.

2.    Tax-deferred accounts including 401(k)s, IRAs, and pensions. Taxes are deferred until the time of withdrawal.

3.    Tax-free accounts including Roth 401(k)s, IRAs, and certain life insurance policies. Contributions are post-tax, but there are no taxes on withdrawal.

 

The reason it is so important to build up these different balances is that it allows a person to draw from different sources at different times depending on what their current tax situation is

 

There should be a clear order of operations while saving with retirement in mind: First, save for more immediate cash flow needs, then max out tax-deferred savings like 401(k)s (especially when there is an employer match), and then seek to maximize what you can get into tax-free savings.

 

When talking with clients about these buckets, a common question I hear is “how do we build up Roth balances?” The answer is that there are two ways: 

1.    You could utilize an employer-sponsored Roth 401(k) plan. One big problem for most is that anything you contribute to these plans will count as income in the current year.

2.    Convert IRA balances to a Roth IRA. One thing to keep in mind here is that if an IRA balance was contributed pre-tax, it will be counted as current year income.

 

No one, I repeat no one, wants to be taxed further, and that’s normally where the questions end. But can we build a strategy around the layout of the current tax law for Roths? The answer is yes, and I find it to be one of the least-known and under-utilized tax strategies. 

 

Here is how the strategy goes: Contribute after-tax dollars to an IRA, convert immediately to a Roth IRA. These after-tax dollars would also not contain any taxable gains, and therefore go smoothly into a Roth IRA without increasing tax burdens. 

 

Let’s backup and try to see the power of these contributions. Now imagine you are 30 years old, and you start contributing $5,500 per year to an IRA and immediately converting to a Roth. Even if we apply a modest 5% growth rate to these contributions, by the time you are 65, you would have an additional $527,099.77 of tax-free money to use in retirement. Using the 4% rule again, that would be an additional $21,083.99 of tax-free income. That money would make a real difference in a retiree’s life.

 

It is important to consult with your accountant and advisor to learn the rules of the road. For instance, there are certain income restrictions, tax implications, etc. to keep in mind while planning your personal savings. Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation. 

 

 

Where do we go from here? This is the March 2019 volume of a monthly blog series where I’ll be sharing insights and education from actual experience in working with clients. This blog is designed to reduce the complexity of managing your finances and provide transparency into how I work with you, my valued clients. I look forward to connecting with you here. Feel free to email me with your questions or comments at brandon.harvey@lpl.comor give me a call at (415)966-1133.