You May Need Tax Planning

Too much money tucked away in pre-tax accounts may lead to paying extra taxes, both in your lifetime and beyond.

Changes to Retirement Took Place During Your Career

In past RetireMentorship podcasts, we have discussed how new (and how complicated) the retirement math problem is. To jog your memory, if you are turning 65 this year, and started working at age 20, you are a member of the first age class with access to the 401(k) for your entire working career. Believe it or not, the 401(k) is only 45 years old!

While you were focused on your career and saving for retirement, the IRS introduced the Roth IRA (in 1997, to be exact). That is, the Roth IRA is only 26 years old!

Tax Planning from a CFP (and EA)

The interaction between Pre-Tax (Traditional 401(k) and IRA) Accounts and Post-Tax (Roth) Accounts presents a tremendous ‘financial planning’ opportunity… but technically, it is a tax planning opportunity, and not everyone offers tax planning.

Unfortunately, most tax filers are so focused on filing annual returns and maximizing current-year refunds that they don’t do much (if any) tax planning. Some have even objected to mathematically justified tax planning strategies that were recommended by Certified Financial Planners. And technically speaking, Certified Financial Planners are not allowed to give out tax planning in the form of tax advice. The work around for CFP’s is to offer tax planning advice by illustrating scenarios while offering tax education in the form of recommendations “for you to present to your tax preparer.” Rather than using a loop hole to offer tax planning, the best approach for tax planning is to work with a Certified Financial Planner who also holds his Enrolled Agent designation, which we offer here at La Crosse Financial Planning. This way, your CFP can also offer legitimate, straightforward tax advice (without resorting to loopholes) while filing those pesky taxes for you, too.

Paying Extra Taxes

Back to the 401(k) and Roth discussion. No one wants to pay extra taxes, right?

If you have over $1M in your 401(k), you will likely have a Social Security income that is above average. This means that a considerable amount of retirement income will come you’re your retirement paycheck from Uncle Sam, which reduces your dependency on your 401(k) assets. This can lead to an issue. Since retirees are not forced to take distributions to cover their living expenses, the next time they are forced to take distributions will when they reach the IRS-defined age that triggers “Required Minimum Distributions.”

RMD’s

RMD’s, as they are known, must start at 72 (or later, depending on your birth year). The key element of RMD’s is that the IRS will require that you take a taxable distribution from your 401(k) at some point in the future. And the amount you must take out is based on your age and the account balance.

With 7 or more years to grow between 65 and 72, and with limited distributions during this time, 401(k) balances will swell before retirees reach RMD age. These big retirement accounts will generate big RMD’s that push retirement income into higher tax brackets. This means that Uncle Sam gets a larger portion of larger distributions as the account grows and your age increases.

So how do we avoid overpaying taxes as RMD’s force us to take extra taxable income in the future? Easy! Roth Conversions early in retirement.

After retirement, you have the option to move your 401(k) to an IRA. Once the funds are in an IRA, you can convert from an IRA to a Roth IRA by taking a perfectly calculated amount of pre-tax money and “filling up” the right tax brackets with a taxable Roth Conversion. These Roth conversions serve 3 purposes.

Roth Conversions Serve 3 Purposes

Purpose 1

They reduce the amount of RMD’s you’ll need to take later. The IRS wants their share of taxes that haven’t been collected IRA funds. RMD’s will force big distributions, which force big taxes to be paid on big IRA funds. But by converting IRA funds early in retirement, rather than waiting for RMD’s, we control how much we pay in taxes by converting up to the top of a predetermined tax bracket. For example, rather than waiting until 72, and being forced to take RMD’s that inflate your income into the 24% tax bracket, you may be able to convert in the 22% tax bracket now, and never enter the 24% tax bracket. Even at RMD age, the account balance is lower after performing Roth conversions. This can save married filers hundreds of thousands of dollars over their lifetime.

Purpose 2

They increase Roth funds. Roth funds grow tax-free and come out tax-free… 5 years after the conversion. Once available, you can take as much as you want tax-free. This means we can distribute Roth funds without worrying about Uncle Sam’s cut or overpaying in taxes. Since Roth funds reduce the dependency on IRA distributions for retirement income, we are free to execute future conversions with complete control over how much comes out of an IRA and avoid those higher tax brackets, once again.

Purpose 3

They reduce taxes for beneficiaries. This is a big one. 30 years from now, your beneficiaries will inherit your accounts. Without Roth Conversions, they will inherit only pre-tax IRA money. The current law dictates that beneficiaries have 10-years to distribute the funds from an Inherted IRA. How old will your beneficiaries be in 30 years? How much growth will your accounts experience over the coming 3 decades? When we run this projection for clients and point out that their now-25-year-old-children will be 55 and in peak earning years when they pass away, the light bulb comes on. Beneficiaries are forced to pay income taxes on the IRA funds with a 10-year window to distribute IRA funds.( ON TOP OF THEIR PEAK INCOME. WHICH WILL LIKELY BE AT EVEN HIGHER TAX BRACKETS THAN WHAT YOU COULD HAVE PAID BY COMPLETING A ROTH CONVERSION!)

It is worth noting here, that Inherited Roth IRA’s have already been taxed. So, inheriting Rote IRA’s creates no tax bomb. One more reason why the Roth Conversion is so valuable.

Conclusion

If you have over $1M in your 401(k), you may not “need” to take distributions from your 401(k) to meet your retirement income needs. However, tax laws may force you or your beneficiaries to pay higher taxes later through RMD’s and the 10-year rule for distributing Inherited IRA’s. The only way to know if Roth Conversions are right for you? Run projections to evaluate the optimal time to move funds from your pre-tax retirement accounts into a Roth account. After all, we should pay every penny we owe in taxes, but we should never leave a tip.

This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are those of the people expressing them. Any performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be directly invested in.