[Editor's Note: This is a guest post from Phil Demuth, Ph.D., one of my favorite financial authors who recently finished the excellent The OverTaxed Investor. It was written in response to this post from a few months ago on Tax-deferred Retirement Accounts where he participated extensively in the discussion in the comments section. We have no financial relationship.]
Here is the problem: you’re slaving away for years, dutifully slogging money into your 401(k), 403(b), IRA, and defined benefit plans just like your accountant says. But then this marvelous tax-saving strategy tees up a brand new problem for you once you are staring down the barrel of retirement. The IRS is going to demand that you start taking required minimum distributions from these accounts at age 70. Plus, the IRS timetable requires you to pull out a greater percentage every year. Welcome to the retirement tax bracket creeps.
Phil Demuth, PhD
As you may have noticed, the United States has a progressive tax code. It’s not that you pay more taxes if you earn more money – that would be true even if tax rates were flat. Rather, you pay an increasing percentage of your income in taxes the higher your income goes. Instead of a peaceful retirement whittling on the porch and fishing, suddenly you find that your retirement accounts have turned into unstoppable doomsday machines disgorging ever-larger amounts of taxable income that you don’t need or want, all to be taxed at marginal rates for the greater pleasure of our taxing authorities.
Consider the case of Dr. X: retired, married, age 66, with a spouse his same age. Between them, they have $2.5 million in their IRAs and another million in a taxable account that throws off some income and capital gains. Their mortgage is paid off. Right now, they are in tax Valhalla – the 10% bracket. Life is good. But look what lies in wait in the years ahead:
Once Dr. X hits 70, the Required Minimum Distributions (RMDs) kick in. Making matters worse, Social Security payments also start the same year. He immediately jumps from the 10% bracket into the 25% bracket, and then a few short years later he will be in the 28% bracket. One of the joys of his late retirement will be crossing into the 33% bracket (if tax rates aren’t even higher by then). Get the picture?
The chart below shows how much they will pay in taxes at each bracket as time goes by:
What can be done?
The big idea is that Dr. X needs to do long-range tax planning. If he just plans year-by-year, he optimizes today at the expense of higher taxes tomorrow. The smart move is to pay as much of his taxes as he can in lower brackets and pay as little as he can in higher brackets. For example, at a minimum, Dr. X should do partial Roth conversions every year to completely fill up the 10% bracket. He will never see a deal this good again.
Depending on his situation, it could even be desirable to pay taxes up to the top of his 25% bracket starting immediately:
While painful, he will pay less tax in the long run, because less of his money will be taxed at 28% (the yellow columns above) and he will never taste the bitter 33% bracket. He also really wants to stay under the $250,000 income level, where his dividends and capital gains will start being subject to the additional 3.8% Obamacare tax.
But wait – there’s more!
Dr. X could convert even more money to a Roth IRA earlier and stay within the lower bracket if he donated appreciated securities from his taxable account to charity (ideally, to a donor-advised trust that would allow him to sprinkle out the donations on his own timetable). This is not perfect, because the charitable donations would have been worth more had he made them during his peak earning years.
Dr. X could also take out a mortgage. This would provide him with more liquidity and give him a tax deduction to offset higher initial Roth conversions. Holding a mortgage in retirement is undeniably controversial, but rates are currently low and it serves as a hedge against inflation, which historically has been retirees’ public enemy number one.
Dr. X needs to allocate his assets correctly among his accounts. He should fill his retirement accounts with low-growth assets like bonds and position the stock side of his allocation to his taxable account. This will go a long way toward preventing bracket creep due to RMDs, since the bonds should not grow much faster than the rate of inflation (to which, mercifully, our tax brackets are indexed).
It goes without saying that his taxable account should be managed with ruthless tax efficiency. No playing the market. Index funds (or, my personal predilection, which I do not expect you to share: zero-dividend stocks).
If Dr. X can relocate to a low tax state like Florida or Texas, he will get to keep more of his money.
He should draw his accounts down in the correct order: RMDs from his retirement accounts, then taxable withdrawals (harvesting losses and letting winners ride), and finally from his Roth. Roth withdrawals also can be used to fine-tune his brackets year-to-year to keep him from jumping to a new level.
In sum, for most physicians, retirement will be all about careful tax-bracket management. You want to learn to ride the brackets like a broncing buckaroo.
[Editor's Note: I agree with almost all that is written above, but wanted to make a couple of general clarifying comments and provide one small criticism. First, it is important to realize that the issue discussed in this post is one that very few people, including physicians, will ever have to deal with, although won't be uncommon among readers of this blog. The problem is having more retirement income than you actually want to spend. Great problem, huh? A real first-worlder there. Most retirees, including physician retirees, would love to have more retirement income, even if it were taxable. For example, the $160,000 IRA RMD at age 70 in chart 2 suggests an IRA of $4.4 Million. Granted, it could be smaller if you have a big Social Security benefit or other source of taxable income. But the point remains this is not an issue you have with a half million dollar tax-deferred account as your only retirement asset like many docs.
Second, and I'm sure Phil agrees with this but didn't specifically say it. The solution to this issue, should you be enough of a super-saver to have it, is Roth accounts, not avoiding retirement accounts in the first place. That means Backdoor Roth IRA contributions, Roth conversions in lower income years (especially between retirement and taking Social Security at age 70), and maybe, just maybe, Roth 401(k) contributions even during peak earnings years.
Last, Phil's recommendation to put low-growth assets in retirement accounts is at best controversial. An excellent explanation of why this might not be a good idea can be found in James Lange's excellent Retire Secure, (which also explains well why you usually want to deplete the taxable account first.) Basically, there is some real benefit to having a larger tax-protected account, even if its withdrawals may be taxed heavier than the dividends and capital gains coming out of a taxable account. Yes, you'll pay more taxes, but you'll end up with more after-tax. It is obvious to most that high growth assets are great things to put into Roth IRAs, but what most people fail to realize is that a tax-deferred account is really just a Roth IRA coupled with a government owned account and the same benefit exists.]
What do you think? Will you have an RMD problem? How do you plan to deal with it? Does it affect your Roth vs tax-deferred 401(k) contribution decision now, or will you just try to do Roth conversions later? Are you retired or semi-retired in your 50s or 60s? Are you doing Roth conversions each year? How much? How did you decide? Comment below!
Excellent article Phil. Your book, The Overtaxed Investor, was one of the best I read this year. Thanks for writing it! If it were possible to get a no-dividend index fund, I think I would.
Jim’s got me convinced that bonds go in taxable accounts. Any thoughts on that and his editor’s note at the end of the article?
My no divident index fund is BRK. You can buy it comission free through loyal3
Yes! I bought some this year in my taxable account.
It’s the only individual stock I own.
I would like to sidestep the general issue of “bonds in taxable” for the nonce, as that gets complicated. What I was intending above is a more narrow application: if you look ahead and see that your IRA growth and consequent RMDs are going to push you into higher brackets over retirement, one fix can be to tame the growth of your IRA by changing your asset location: moving the IRA into low-growth assets like bonds and moving stocks in taxable. You might say, this could be a mid-course tax correction for people who have been following WCI’s “bonds-in-taxable” approach. This often can be done without stirring up too much in the way of capital gains in the process, since your (muni) bonds in taxable may not have appreciated very much, especially if you sell them these days.
I’m going to go out on a limb here and say that this article is fundamentally flawed. The problem with it is that the focus on short term tax savings ignore the bigger picture.
The particular points I would like to address:
Moving to a no/low State to avoid taxes: Yes, it could reduce taxes, but life, especially a retirement for a wealthy person isn’t about reducing taxes, it is about enjoyment. To focus only on saving a little State tax is a case of Tail wagging the Dog. The reality is with these sorts of assets saved, you’re going to outlive them, barring some exotic lifestyle issues. This is a petty example from me, but it shows the concept of struggling to lower taxes ‘at all costs’ which comes up throughout this article.
Taking a mortgage to reduce your taxable income via interest deduction, to then top it up with partial Roth conversions… this is just silly. If you pay out $20,000 in mortgage interest, and theoretically are using it to top up a 25% bracket then you’re really losing $20,000 of Net Worth in order to save $5,000 in taxes in that particular year.
Donating to charity to reduce taxes – same as above. Donating to charity reduces your Net Worth, and shouldn’t be a tax strategy. You get pennies back on the dollar. While donating to charity is a great thing, and can be something that you elect for the altruistic reasons, the strategy to donate appreciated assets sounds clever, but it ignores stepped up basis on wealth transfer.
The key here is wealth transfer. A Doc (who doesn’t carry a mortgage, and doesn’t give everything to charity) in this sort of situation is very likely to be looking at transferring wealth. There are advantages to not draining the Traditional IRAs because they too have inherent wealth transfer abilities, such as a Stretch IRA. This means that to look at the ‘long term plan’ requires you to consider the next generation, or generations. If we look holistically at the strategy to convert the Traditional to Roth, it should be that the Roth funds are never touched, and are a wealth transfer vehicle (a great one, but not one worth paying top dollar taxes on now).
The reality in a case like this one is that the Doctor over-saved. Once done, there’s not much that can be done to “reduce taxes while not harming net worth”. The best solutions have passed him by, where he should have retired earlier, and used that window for the partial Roth conversions without the pressure of SS and RMDs. Once that time has passed people focus too much on trying to realize taxes today, without fully considering the bigger picture of their wealth.
Last up, you shouldn’t let your winners ride when tax loss harvesting. The losses in this strategy would therefore be capped at the $3,000 OI. It’s important to remember that you’d lose Cap Loss carryover on death, and that the gains step up, but also, laws change. I would suggest that you keep a reserve of losses in excess of the $3,000 OI, but trim gains too, so that if something does change regarding stepped up basis you have kept things under control.
In closing – I don’t blame the author here, what is written here does seem to be conventional logic, but I disagree with it 🙂
Replies like this are why this site is always a great read! If I’m 70 and well provisioned for the years I have left such that marginal tax rate implications of growing MRD’s is even a thing, I sure hope I’m doing things more enjoyable than wasting time taking out a mortgage so I can pay thousands of dollars in interest to a bank to avoid paying a few less thousands to the IRS.
I disagree about keeping a reserve of losses. I think they should be used as much as possible. If you have extras then you have to carry them forward, it’s not an option.
The “move to a low tax state” thing works for lots of people, but not everybody. Moving NY to FL, MN to AZ, WI to TX, WA/OR/CA to NV etc. Happens all the time.
The reserve of losses is important because you cannot guarantee that you can generate them in any given year. Capital losses attributed to OI will always be more beneficial in tax arbitrage than long term gains, so if you use them up to net out LTG you might find yourself without any losses to claim in the following year.
My reserve amount varies based upon the individual. For a person with managed investments, I would know how much capital gain will be created in any future year, and in the ideal case (ETF investor, managed) it would only occur when triggered intentionally. Those people I could say we have a carryover of perhaps $3000 (or less, perhaps $1500 if you think you can harvest the balance in the next year).
However, some people have funky investments, for example they might put money into an Angel fund, and be notified in November that this year they have a Realized Cap Gain of $X.. a highly unpredictable amount. For those types of people, a larger buffer can be carried forward to tidy up those uncontrollable events.
The moving state thing is valid to lower taxes, and should be considered – everything here is valid to lower taxes.. I’m just saying that maybe a different way to look at it isn’t to lower taxes.
I don’t think you can pass up using losses against LTCG in order to “save” them unless you simply don’t realize the LTCGs. You don’t get to choose. If you have them and you have income/gains, the losses are put against them. So a reserve is nice, but not something you can really build/manage very well.
You will always get to choose when to realize the LTCG unless you are involved in a third party investment that just spins them out, such as the Angel fund example, when they hit a startup out of the park.
As such, you can harvest losses, but allow gains to run between years quite easily. In the example where you retained $3,000 in realized losses from say, 2016 in excess of the $3,000 you will apply to the 2016 return.
If it gets to say, March 2017 and you’ve caught another $6,000 in losses, you could then trim your gain position and lower your retained loss carryover.
The key is knowing that a realized loss by 12/31 is attributed to the income tax for that year, however, if you elect to realize a gain in that same year it nets out. Therefore, you lock in ‘enough’ to ensure that you take $3,000 to OI for the 2016 taxes, and if your reserves top up, you tax gain harvest to to reduce it.
It is something that I build and manage consistently.
Not necessarily true. Even owning a very tax-efficient mutual fund like TSM you’re going to get 1% or so in LTCG distributions each year. If you’ve got $500K in that fund, that’s $5000 in LTCGs that you didn’t have to sell anything to get stuck with.
I agree you can harvest losses. I agree you can allow gains to run for the most part. What I don’t agree with is that you can easily build up a reserve of losses to use for decades. It takes a lot of taxable investments to make sure you always have $3K for your taxes because they are always getting used up by CG distributions, intentionally selling investments with gains, and of course the $3K a year against ordinary income. A $100K taxable account isn’t going to cut it no matter how well managed it is.
I’m not familiar with TSM mutual fund. But to say any Mutual Fund is tax efficient with a 1% gain distribution is disingenuous. Why even have such a fund in taxable in the first place? An ETF is much less likely to spin off such a distribution, you could take VTI for example.
Now, $100K may not generate $3000, but also, it doesn’t need to.
Your mission, should you choose to accept it, is to apply Capital Losses to OI wherever possible. If you are able to harvest just $100 from the $100K, you’d be better off reducing income than intentionally harvesting a gain. Building a $100K ETF portfolio will increase your chances of success here, both due to the generally lower Cap Gain aspect, and the liquidity allowing you to capture the losses.
In terms of unintentional gains, you need to consider this during asset selection and location.
Worst case – if you didn’t consider this and have $500K of some mutual fund sitting in taxable, you better have at least $2M in assets, else you are way under diversified, and have bigger issues that tax to worry about!
You’re not familiar with Vanguard’s Total Stock Market Fund but you have an email address with the words “wealth management” in it? That seems unlikely. Maybe you just aren’t familiar with that abbreviation.
The yield on the fund is 2%, but that includes dividends. It is a very tax-efficient holding with minimal turnover. That said, distributions from the fund can be seen here: https://personal.vanguard.com/us/funds/snapshot?FundId=0585&FundIntExt=INT#tab=4
Looks like year to date they have a capital loss of 6 cents a share. So you’re probably right that 1% would be quite high. Looking at the old reports, it doesn’t look like they’ve distributed gains in the last 5 years.
https://www.vanguard.com/funds/reports/q850.pdf
Probably flushing them out using the ETF share class.
So you’re right that a 1% LTCG distribution wouldn’t be so tax-efficient. But there are funds out there than claim to be tax-managed that make distributions like that. BRSIX comes to mind.
Date Per Share Amount Reinvestment Price
12/16/15 $1.52874 $12.77
12/16/14 $1.63816 $14.94
12/17/13 $1.59482 $16.23
Those are more like 10% distributions.
Ah, yes, I’m familiar with VTSAX, I just wasn’t able to discern if that was the fund you were discussing from the letters TSM. I’d imagine there are a few other funds that could be broadly described as a total stock market fund.
I’d still recommend looking at ETFs.
You do realize that Vanguard has set up VTI and VTSAX to be the same underlying fund, right? They track exactly the same thing. What other Vanguard funds could be described as a total stock market fund other than the Vanguard Total Stock Market Index Fund? TSM is a common acronym to describe VTSAX/VTI/VTSMX because investing in index funds vs ETFs really is a personal preference.
WA is a low tax state
Oh, you’re right duh. Should have used CA.
Matt,
I agree with what you have to say that focusing on minimizing taxes is allowing the “tail to wag the dog.” I recently read The Affluent Investor and have nearly completed The Overtaxed Investor. I really have enjoyed both books. Phil’s argument is that it is time to “let the tail wag the dog.” His argument as I understood it was the cost of taxes have surpassed many of the costs that we often focus on such as ER. I think he has elegantly described methods to minimize taxes and everybody has the option to pick and choose from his menu.
Nick
Nick,
The key point is that if you give away $1 to lower your taxes by 30 cents then that isn’t savvy.
So when you do pick and choose, don’t be blinded by present year tax savings, and think about your total net worth, knowing that every bucket of assets has their own inherent tax rules attached:
Deferred (Trad/401K etc) can be assigned to younger beneficiary, if you have one
Roths are great, but aren’t for you, they are for the next generation (if you saved this much) so why are YOU paying the tax on them, when the next gen could? This is case by case and depends on your family dynamic
Taxable accounts have stepped up basis AND can be trimmed by gain/loss harvesting.
The big difference that people struggle with is this:
In their working years, lowering the tax bracket via deferral = keeping money IN the family, and grows net worth. In retirement, lowering the tax bracket by Charity or by Debt = sending money OUT of the family, and lowers net worth.
Mortgage in Retirement: Like all these ideas, they are only meant as options to consider and accept or reject based on individual preferences and circumstances. A mortgage deduction can be used strategically to avoid jumping tax brackets. Since money is fungible, it effectively leverages your whole portfolio. If your total portfolio compounds at a higher rate than your mortgage interest rate over the long run, you come out ahead. Given the recent exceptionally low mortgage rates, that has not been a high bar. But I agree, this is not for everyone.
Charity: yes, you always come out ahead financially by keeping the assets vs. donating to charity. This technique is purely for someone with charitable motives.
Wealth Transfer/Bequest Motives: not considered in the above! It comes down to weighing your bracket in retirement vs. your kid(s) brackets after you depart this dim, vast vale of tears. If your bracket is higher, spend down the Roth and leave them the Traditional IRA. If their brackets are higher, spend down the Traditional IRA and leave them the Roth.
A big question mark hanging like an anvil over our heads is what happens to the estate tax post-Trump. There are proposals to eliminate the IRA stretch provisions, to force Roth assets to be pulled out within 5 years, and to eliminate the capital gains step up for taxable accounts. Any of these could be far more consequential to most physicians than the elimination of the estate tax per se. Most people who can afford to wait are putting their estate plans on hold until we see what happens.
The Doctor Over-Saved: The problem is that ultimately we only know this after the dear Doc has departed. Warren Buffett had an aunt worth hundreds of millions of dollars courtesy of Berkshire Hathaway stock. She used to write him in her 90s concerned that she was running out of money. This woman over-saved.
The rest of us may not have that problem. There are so many significant unknowns in the future — tax rates, growth rates, and thanks to physicians, longevity risk — that I believe most of us would do well to err on the side of oversaving. As Ben Franklin said, “There are three faithful friends – an old wife, an old dog, and ready money.”
Harvesting Tax Losses: I have a physician client who came to me having harvested a large capital loss from his previous investments. While no one would seek out this circumstance, it does happen. He considers the capital loss carryforward to be almost like an asset class — one that he can put against ordinary income ($3,000/year), use to offset mandatory capital gains distributions from his mutual funds, and one that will assure him of significantly less tax on his capital gain income during retirement.
I would only caution that it is a wasting asset, as it will be gnawed away by inflation every year. The sooner it is used, the more valuable it is.
Even ordinary tax loss harvesting generally can postpone recognizing taxes on capital gains from a taxable account for many years when drawing it down in a rising market environment.
Phil I loved your books. I have read the affluent investor and the overtaxed investor as well as the books you cowrote with Ben Stein. I highly recommend all you regular blog readers read these as well as WCIs book. No I am not being paid! I have been worried about RMDs for a good while. Too much money in retirement is a good problem. I am starting to Roth convert this year. The math is tricky. I think account diversification makes sense. I converted 38k this year. My first baby step. I don’t think I can follow your advice about 0 dividend stocks however. I am old enough to have had lots of zero dividend stocks in the past and I really like being passive now.
Thank you! (Your check is in the mail)
Like WCI, I think I mostly agree with Phil…
Two additional things (which may be rationalizations because, er, I might just have the “problem” Phil describes)…
If someone lives long enough for the RMDs to get painful, it’s also possible those tax returns are loaded up with medical itemized deductions.
If someone is married and a spouse with IRAs dies, this problem might be mitigated by disclaiming IRAs to kids.
PS. Just to underscore something WCI says: This is really going to be a problem only for the people who do a great job of saving…
That guy looks like George Costanza
It’s an old photo. Now I look more like Jabba the Hutt.
When we saw this issue in our future, our solution was/is to spend more now, gift more now, and give more now. When we better defined our point of enough, this solution seemed to be best for us. It allows us to enjoy the gifting and giving now. And, it forces us to learn to loosen purse strings, which is surprisingly difficult after years of saving. BTW, for any readers who haven’t read Phil’s The Affluent Investor I will again stress how much it helped clarify how we think about our finances. It is a great read. Best wishes and happy holidays to all.
Quote = Matt
“The reality in a case like this one is that the Doctor over-saved. Once done, there’s not much that can be done to “reduce taxes while not harming net worth”. The best solutions have passed him by, where he should have retired earlier, and used that window for the partial Roth conversions without the pressure of SS and RMDs. Once that time has passed people focus too much on trying to realize taxes today, without fully considering the bigger picture of their wealth.”
I see this on bogleheads where investors feel like they must save for 2% withdrawals. These are the people that will be paying ridiculous taxes due to what I believe are unfounded fears.
As for physicians, the right time to retire is a very difficult decision. I am 40 years old and if we downgrade our lifestyle we can easily retire today. But why retire now? I continue to enjoy my work despite the bureaucracy, I get paid good money for doing something that I would like to think I am good at, and I have plenty of free time. I look ahead 5 years from now when I hope we will have enough to retire with our current lifestyle. Do I retire then or should I work part time for the reasons I described above? Do we upgrade our lifestyle or just sock that money away only to pay more taxes in retirement? These are all very tough questions that we are fortunate to have to think about. Maybe we will get a wake boat 🙂
You don’t have a wakeboat yet? Crikey.
It would certainly help solve this RMD issue. If you have a really big RMD issue you could churn wakeboats.
definitely get the wake boat, Matt good comments. I find lifestyle creep keeps creeping in every year. Home improvements (actually they are all needed), spend more on kids, wife just spends more this year every month than she did last year, soon will need a new car. God knows what future holds. I think If I can cut down work by age 55, and then work part time it would be great.
Maybe it will happen sooner. Maybe my job wont be there in 5-10 years, who knows, I just keep working and preparing.
But Wake boat is fun 🙂
Dr. PK,
You bring up a great point. Having a job in the medical field is guaranteed for as long as we stay competent. however, our future reimbursement is completely unknown and we may be forced to cut back on our lifestyle. Might as well make hay while the sun shines, and live well below our means now to protect ourselves from future government cuts.
I figure by front loading our retirement, we are set no matter what the future holds.
I wanted to comment about the lifestyle creep you mentioned.
One thing I notice amongst my colleagues is the nonworking spouse tends to continuously spend more. Especially on the kids. The kids always need something. Sometimes these are expensive activities, but more often than not they are many many small items killing wealth with a thousand paper cuts. I see physicians forced to work extra shifts or extra hours to pay for these extras.
Don’t get me wrong, making sure the kids are healthy and happy is important. But I believe the most important is to spend time with them, teach them, and love them. It is way more important then the thousands of dollars spent on these activities. Plenty of kids grow up to be outstanding citizens without a $30k/yr price tag.
You are right, time with kids is very important. A commodity most physicians run short on. I always feel good on the days I can pick them or drop them to school. I have so many good ideas to do things with them but all get lost between feeding them, homework, school, soccer, music, dance, cleaning/picking up the house, emails, researching on what ever we need to do next to fix the house or planning vacations.
I always feel good when I go to in laws and get stuck there with nothing just kids and what ever you want to do with your time with them. They are indeed expensive with preschool, organic groceries, music soccer dance classes, shows/plays. But they are also a lot fewer then they used to be, only 2 or 3 usually instead of 4-5 (not counting WCI), so we tend to give or have experiances with them a lot more than usual.
I dont think there is any right answer, hopefully a balance some where.
Time is the most valuable thing. I do not work extra shifts anymore since taking a higher paying job without more hours of work and keep planning my potential scale down date where I can go to 80 or 60%. Likely 5 to 10 years.
I don’t know, 4 doesn’t seem all that many here in Utah. As I go down the street from my house it’s 6, 4 (now grown), 4, 2, 3 and growing, and 11 or something (I lost track.)
You can dish out quite a few 529’s with the kids, grandkids, and even nieces and nephews. Obviously it can raise the problem of having deadbeat kids who know that their Uncle Doctor did pretty well for himself, but that is another problem to have.
I’m still waiting for the day where I don’t feel the cost of having to mow my lawn!
I appreciate this guest post and agree one of the better written and more interesting to be submitted. One of the ideas I’ve had regarding this topic is using a SPIA funded by my 401k assets to attempt to minimize my tax burden in retirement. This was not addressed in the article or comments section. My thought is that it would provide a reliable fixed income during retirement, decreasing the volume in a taxable retirement account (essentially avoiding the RMD)and allow me to hold my Roth and taxable as a supplement to be used only as necessary and to be saved as a wealth transfer vehicle across generations.
Thoughts?
I’ve written about it here:
https://www.whitecoatinvestor.com/individual-retirement-annuity-the-solution-to-the-spia-rmd-dilemma/
Basically, yes it lowers your RMD, but it also increases your income by even more than the RMD would have, which actually raises the tax rate on the remaining RMD. It works out about the same and maybe even a little worse.
Very interesting article and at ages 52 and 51, Drbaseballdad and I are starting the conversation about converting IRAs from previous jobs to a solo 401k in order to take advantage of a backdoor Roth IRA for him. I have one but he doesn’t due to the large amount in his other IRAs. This Roth conversion topic has been the most confusing for me in my financial education.
Also thought-provoking are the comments about physicians who have oversaved, such as Dr. Mom’s comments. From her previous posts, I found her situation very relatable in that she and her husband are in a similar age, income and networth bracket. We are constantly worried about having enough for Drbaseballdad to retire and maintain our standard of living and I really can’t grasp the topic of oversaving. Anyone want to take a stab at clarifying this foreign concept 🙂 ?
I think it’s only oversaving if you’re denying yourself something you would like to purchase in order to acquire a nest egg larger than you will need. It is an unusual problem to say the least.
As far as Roth conversions, remember a backdoor Roth IRA is different from a Roth conversion. The backdoor Roth is mostly a no-brainer as you are comparing investing in taxable to Roth. The decision about converting pre-tax money to Roth is much more complex and difficult to figure out.
WCI, the backdoor Roth is a no-brainer except for people who already had existing IRAs when the Roth IRA first came into existence in 1997. Right now, my husband has $900,000 in past IRAs within Vanguard and Schwab so it is more complicated to roll everything into a solo 401K at this point. Should we have done this in 1997 before he had so much in IRAs? Yes, but that was before we understood this concept. Not sure if it is worth it at this point in time. If we roll everything into a solo 401K at Schwab or Fidelity, the costs may not be worth it, along with the fact that the majority of this money is in Vanguard and Schwab index funds. He has a SEP IRA in Vanguard for 1099 Income. What would you recommend? Should we wait until he retires and then begin incremental conversions until age 70?
There is a very easy workaround.
Have your husband start a side business. Taking online surveys for instance. Make $10. Get an EIN. Open an individual 401(k). Roll the IRA in there. Start doing Backdoor Roths.
Whether that hassle is worth it to you or not is up to you.
But Roth conversions are not some kind of substitute for a backdoor Roth IRA. You can do both.
If I were your husband, and wanted to do a backdoor Roth IRA, I’d open an individual 401(k) at Fidelity, roll the big IRA in there, roll the SEP-IRA in there, and start making my self-employed retirement contributions there. Then I’d do a backdoor Roth IRA on the side. He doesn’t even have to open up a side business. He already has one.
This sounds like a good workaround for my situation. Dumb question…..What is an EIA? I googled it along with financial terms but nothing obvious presented itself. Thanks.
Sorry, that’s supposed to be EIN- employer identification number. Available here:
https://www.irs.gov/businesses/small-businesses-self-employed/apply-for-an-employer-identification-number-ein-online
WCI. I’ve been giving this a lot of though and do have additional questions, but was wrapped up in Christmas preparations – something about my family expecting gifts and special cookies/food this time of year 😉
Anyway, so I figured, even though I’ve been thinking about this for the past few years, why not make things fun by waiting until December 27 to get serious about setting up an individual 401k by the end of 2016? Not sure it’s even possible to do so by the 31st but here are my questions:
1) We have IRAs at Vanguard and Schwab. If we set up the solo 401k at Schwab and roll the Vanguard IRAs into it, will Schwab be able to accept them as is with the Vanguard index funds without us being charged additional fees for holding these funds? I understand that we would be charged fees if we bought Vanguard index funds within Schwab but if they are already exisiting assets, I’m hoping we wouldn’t be charged extra fees. Are they any management fees or other fees to hold the solo 401k at Schwab?
2) Would you recommend Schwab to hold the solo 401k over Fidelity? We have a very new $25,000 401k at Fidelity but looks like we are being charge 1% management fee on this so we don’t want to roll any old IRAs into that.
3) If we still have a $1M taxable investment account at Vanguard and a new solo $950K 401K at Schwab, should we do the backdoor Roth IRA at Vanguard or Schwab?
4) Assuming, we can open the 401k by the end of 2016, can we wait to do the rollover IRAs until January? And then still do a backdoor Roth IRA for 2016 before the tax deadline?
As always, thanks for your input! If anyone else cares to weigh in on these questions, please fee free, and thank you as well!
While perhaps not impossible, the likelihood of you opening an individual 401(k) and getting a rollover done before Dec 31st seems very low to me. Perhaps it is time to look at the next best option- doing conversions in 2017. If you need to make a solo 401(k) contribution for 2016, you could contribute to a SEP-IRA, sometimes the amount is even the same, but it can be opened and funded until April 2017 for 2016. Then fix it all next year. Open the individual 401(k), roll the SEP-IRA money in, do the other rollover, convert the non-deductible traditional IRA money etc. On to your questions.
1) I don’t know. You’d have to ask Schwab if you can transfer in kind and whether there are fees for it. Certainly for NEW purchases of those funds there will be a fee. I also don’t have Schwab’s 401(k) fee structure memorized, but I’m sure they are quite reasonable.
2) My article on where to open your solo 401(k) can be found here: https://www.whitecoatinvestor.com/where-to-open-your-solo-401k/ Mine is at Vanguard. The main downsides to that are they don’t take rollovers and you can only buy investor class shares (slightly higher ERs). I don’t think Schwab’s solo 401(k) takes rollovers. If you need that feature, I think you’re going to want Fidelity or etrade and I think TD Ameritrade as well. Not sure why you’re paying a 1% AUM fee at Fidelity. I don’t think that’s a standard mandatory feature for their 401(k). You must be using some sort of advisor whether you know it or not.
3) Either is fine. I’d eventually try to consolidate just to keep things simpler.
4) Yes you can. Your IRS Form 8606 is just a little more complicated.
Thanks for the quick response, WCI. I called Schwab and we can open the solo 401k before Dec. 31 by filing out and faxing the forms and they will accept rollovers from the Traditional and SEP IRAs at Vanguard and Schwab which can be done in January. This would allow us to set up a Backdoor Roth for 2016 and meet the April 15 deadline. I still need to talk to one of their brokers to understand whether we can transfer and hold all the Vanguard funds with no fees.
One more question: Is this actually worth the paperwork and hassle if my husband is only planning to work for 5 – 8 more years so the Roth would only be worth 30,000 – 50,000 by the time he retires? Although I suppose we could continue to convert taxable money into it. Thank you again for your guidance and insight! Still trying to get his residency program to buy your book for all the EM residents:)
Remember the benefits of a Roth IRA last throughout retirement, not just 5-8 more years.
WCI, a backdoor Roth IRA is a no-brainer for people who didn’t already have existing IRAS when the Roth IRA first started in 1997. Currently, my husband has $900,000 in IRAs at Vanguard and Schwab so we can’t do a backdoor Roth unless we convert everything into a Solo 401K at Schwab or Fidelity. Wish we would have done this back in 1997 when he had a tiny IRA but we weren’t aware of the Backdoor Roth concept at that time. I understand there are additional costs and paperwork associated with the Solo 401K and since most of the money is in Vanguard and Schwab index funds, I’m also unsure about the extra costs associated with holding these funds at Fidelity or to hold the Vanguard funds at Schwab. He does have a SEP IRA at Vanguard for 1099 income. At this point, we are not sure it is worth the headache to do a rollover into a Solo 401k or just wait until he decides to retire (5-10 years) and do incremental conversions until age 70. What would you recommend?
>> Drbaseballdad and I are starting the conversation about converting IRAs from previous jobs to a solo 401k in order to take advantage of a backdoor Roth IRA for him. <<
Very shrewd.
I’ll try to clarify the oversaving concept… It is highly personal based on your own point of enough and your leanings to a scarcity versus abundance mindset. I think about it this way… We have a lifestyle that we enjoy right now. We like working and plan to continue to late 50’s to early 60’s. We are 51 and 52. We looked at our retirement numbers and conservatively extrapolated that if we keep saving at current levels in retirement we will be able to retire in 7-8 years at our current lifestyle. So for us, saving more than that just to pad retirement at the expense of now is not attractive and would be oversaving to us. I am very comfortable with my inability to predict the future and our ability to adjust as it comes to pass. Hope it helps.
Also, if your husband has any nondeductible contributions in his IRAs another option would be what I am planning for next year. Open a Roth IRA and a Solo 401k at Schwab. Simultaneously roll the deductible portion of the IRA into the Solo 401k and the nondeductible portion into the Roth. Viola, instant start to Roth. Then backdoor contribute into it in future years. To do this you need to have kept up with the nondeductible portion of the IRA on a Form 8606. I did not, but was able to go back and fix it several years ago and have kept it up since.
Dr. Mom, I don’t believe the IRS allows you to designate “I’m rolling only the non-deductible part of my IRA to a Roth”. They require that you allocate across all your IRAs. So, for example, if you have $80,000 in deductible IRA contributions and earnings, and $20,000 in non-deductible contributions, when you roll over $20,000 to a Roth, you will be taxed on (80,000)/(80,000+20,000) = 80,000/100.000 = 80% of your roll-over. (I believe your strategy would work if the deductible and non-deductible IRA’s are separate; you first roll the deductible IRA into the 401K, then wait until the next year to roll the non-deductible IRA to a Roth. You would still be taxed on investment gains in the non-deductible IRA.)
The key is to do the pre-tax rollover first into a 401(k) that generally (and maybe legally) doesn’t allow after-tax money to be rolled in. Then you convert whatever is left in the IRA, which is now all post-tax and so no tax cost to doing it.
I have researched this ad nauseam, and what I described is perfectly legal and very cool for those of us old enough to have nondeductible IRA’s. I have rolled everything into one IRA over the years. It has mostly pretax dollars but about 65K of posttax dollars all accounted on a Form 8606. I will not have to pay tax again on that 65K, but if I leave it in the IRA I will pay tax on its earnings. If I move it to a Roth, future earnings will not be taxes unless laws change. As long as the split is simultaneous it is just fine. Here you go for reference: https://www.irs.gov/retirement-plans/rollovers-of-after-tax-contributions-in-retirement-plans.
I stand corrected. As long as you didn’t take any distributions from traditional/SEP/Simple IRAs in 2016, when you fill out Form 8606, Lines 6 and 7 would both be 0, and you would not pay any tax on your Roth conversion.
Great link. Thanks for sharing. I’ve read it before but had forgotten about it.
Dr Mom,
Thank you so much for the link and great information! My husband and I are 53 and 52 and have the same problem with non-deductible IRA’s. We don’t have any deductible IRAs, just Roth and non-deductible IRAs. Can I still use this same technique to transfer and convert all my non-deductible IRAs ( with earnings) to a Schwab Roth IRA and pay no tax? Do I have to open a new Solo 401k as I already have my Solo 401k at Fidelity ( but they don’t allow Roth.) I also have an individual 401 k at Vanguard but Vanguard doesn’t allow transfers. I would rather just open the Roth IRA only at Scwabb if this is all I need to make the transfer and conversion without paying taxes.
So the only part of the nondeductible IRA that can be transferred to a Roth IRA without tax consequences are your original contributions. Any earnings on them are taxable and considered deductible. Don’t think of it as a nondeductible IRA versus a deductible IRA. It is in fact just a Traditional IRA with nondeductible contributions and deductible earnings. We chose Schwab because they allow roll in’s to their Solo 401k and we have money there already. They are used to doing these simultaneous divided roll overs. You may want to explore if you opened a Roth at Fidelity if they could handle doing it for you. It might get messy trying to simultaneously send to the 401k at Fidelity and a Roth at Schwab. I rolled all my IRA’s into one so there will be no prorata issues in my case. I don’t know if you have multiple nondeductible IRA’s how the IRS would look at that. I like to make everything look simple and easy in case it is ever questioned. Hope it helps!
RocDoc- Another thought…why not move all your accounts to one place? It has made our financial life much simpler than when we were trying to manage money at different brokerages.
I tried to comment on this early this morning but my iPad lost the comment. I read the link to the IRS. Funny my accountant never mentioned this. I also have deductible and nondeductible contributions in an IRA at Vanguard. I am going to work on this this weekend. I agree with you that consolidating into one brokerage makes life much simpler. Lets do lunch again after the holidays.
I had to explain it to our accountant. Lunch sounds great!
Dr Mom,
Thanks again for this great information. This strategy is so helpful with my non-deductible IRAs. My accountant has never mentioned this approach even though I’ve discussed options for the non-deductible IRAS with him several times. You’re the first to show me this 2014 IRS law making it possible. Good brainstorming work! I also agree with you and Hatton1 that consolidating makes it easier. Thanks again for the excellent idea!
I enjoyed the Overtaxed investor so much, I bought 2 copies. Any problem with having a small side business, LLC after retirement that only produces minimal revenues each year that allows you to avoid needing to take RMDs from your retirement accounts? I’m assuming it would need to be an active business that you “materially took part in” vs a passive income business that only holds passive income producing assets. Any thoughts here would be helpful.
That’s a cool idea. I think it’s only the 401(k) associated with the business though, not all your retirement accounts. But you could consolidate.
Again though…what’s the point? Maximize an inheritance? Die the richest guy in the graveyard? Have larger RMDs later?
Unfortunately, you can’t defer taking the RMDs post-70 if you are more than a 5% owner of the business. If you meet this test, then it depends on the plan rules whether you can “roll-in” your IRAs and outside 401ks. This sounds like a great tax-shelter idea in the making: somebody starts a company, let’s new employee’s “buy-in” to the tune of 4.9%, pays a very small salary, but offers a 401k with generous roll-in provisions. Voila, no RMDs. Not sure the IRS would love this idea, though. Send me a postcard from prison if it doesn’t work.
Thanks for the tax law info. On a side note, I have always enjoyed your writing style–dry, deadpan, but very funny! Thanks!
This discussion is predicated on advanced knowledge of the tax structure – something I don’t presume to have. Taking RMDs at the top marginal rate sounds terrible – unless someone comes in and implements a flat tax, or a populist president drops the top marginal rate to 25%. On the other hand, you have the less politically feasible possibilities of a 91% top marginal rate (like we had as recently as 1960) – or the government changing the rules altogether at the expense of a handful of savers for the benefit of the much larger numbers of those who will be receiving BernieBucks to pay tuition in 2040, or salvage social security in 2030, or keep BeiberCare afloat 2050. Perhaps you think today that Bernie Sanders will be irrelevant in 2040, or the whole social security thing is overblown, or Justin Beiber can’t become president and architect of a national heath system. If the past decade has taught us anything, it should be that anything can happen, and the most confident political prognosticators can fail in hilarious ways. In the mean time, I’ll do my best to live a good life, be a good doc, and avoid the use of a crystal ball in my financial decision making.
Kanye West/Justin Beiber 2024? I’m calling it now.
I disagree. I think taking RMDs at the top marginal rate sounds awesome. Who wouldn’t want a half million in today’s dollars in retirement income?
MAH and Happy Philosopher,
Luckily Beiber can’t run for President since he was born in Canada. Kanye will have to find a different running mate. Maybe he’ll ask Taylor Swift or Beyoncé.
The door for the Beiber presidency will be opened by a constitutional amendment to facilitate Justin Trudeau becoming president on the condition of Canada becoming our 51st state. Beiber fever and it’s antidote – BeiberCare – will be the unforeseen blow-back of our largest land acquisition since the Louisiana Purchase. You heard it here first.
This entire side-conversation is hilarious and I’m not even American.
“Tax Valhalla”–love it. I certainly anticipate having a retirement income/tax problem, assuming my portfolio doubles every 10ish years and assuming tax code doesn’t change. Big assumptions, but that’s what we have at the moment based on historic returns and current law. I look forward to part-time (low income) years to move money into Roths to help deal with this.
Two questions for Phil and Jim.
Phil, how long have you been investing in zero-dividend individual stocks and how has it worked out for you? Is the lack of a zero dividend ETF due to the high turnover relating to companies that begin paying dividends? Do you find this gives your portfolio a growth tilt that negates your tax savings?
For Jim or Phil. Every year, despite being in the top tax bracket, I consider the Roth 401k. I just don’t think there will be enough low income years in between retirement and age 70/SS/RMDs to convert enough of my tIRA to Roth or perform enough TGH to make a meaningful dent. During this time I will also be drawing down a 457b and selling a rental property.
Do either of you have a number in your heads (?5mil, ?10mil) for an eventual tIRA size that would have you consider doing Roth conversions or using Roth 401k even during peak earning years in top tax bracket?
Everyone should consider Roth conversions up to the top of their bracket and maybe the next one in those years between retirement and SS. When do you switch to the Roth 401(k)? I think if you’re anticipating a tax-deferred account over $2-3M you need to very seriously consider that. If I had known I would eventually have income like I have now I probably would have done Roth 401(k)s every year I could have up until this point and even done Roth conversions at 28-33%. But there are so many factors you can’t draw a very good rule of thumb.
Appreciate reply. Will reconsider Roth 401k again for next year.
Another benefit of a Roth 401k is that you can essentially contribute “more”, as the $18,000 in Roth 401k is worth more than the $18,000 in traditional 401k when accounting for the government owning a chunk of the latter.
One strategy if you can afford it may be to up your cash balance plan contribution or 457b contribution at the same time you swap to Roth 401k making it tax neutral for the current year.
I guess. I’m not sure I’d do a Roth 401(k) if I wasn’t already maxing out all that stuff though.
I agree 100% with Dr. Jim about the Roth 401k stuff.
I have been running the zero-dividend stock account for two years and it has worked out quite well (beating the market with no dividends or realized capital gains but only capital gains losses to show for my trouble. This makes me look smart when I am merely lucky. If I had been underperforming the market for 2 years I would feel like an idiot, even though these short-term results really mean nothing. The long-term results of this strategy should be that you lose to the market index pre-tax but win after-tax, provided you go to the trouble of having super-broad exposure to these stocks.
My personal approach is to build a core of companies I just plain like (such as BRK-B) and then rounding these out with a bunch of zeroes with reasonable valuations to build a “minimum variance” zero dividend portfolio. There are other ways to skin this cat but this is what I have settled on.
My general advice would be *not* to do this unless you are a tax-obsessed high-net-worth type, but instead zoom in on investing with great tax efficiency in your taxable account: did someone mention VTI (the Vanguard Total Stock Market ETF)? I also like low-tax factor-based strategies (small/value and momentum ETFs). And keep turnover to an absolute minimum apart from harvesting losses.
Great article and great discussion!! A few comments:
1. If you are in a low tax bracket post-retirement and pre-age-70, making Roth IRA conversions is one excellent option. For some people, an alternative is to realize long term capital gains (which are taxed at 0% while you are in the 15% tax bracket).
2. The Obamacare thresholds ($200K singles/$250K marrieds) is not indexed for inflation, so may become a much more significant factor moving forward. (However, there’s a good chance the Trump administration/Republican congress will repeal this tax.)
3. There are also significant Medicare premium surcharges for high income participants. The base Medicare B premium is $121.80/month; it increases in a few big “steps” to almost $400/month (plus a $72.90 surcharge on Medicare Part D) for singles with income > $214,000/marrieds with income > $428,000. These thresholds are not indexed for inflation. Keeping your income below one of these “step thresholds” may be of interest to some.
4. The Alternative Minimum Tax (AMT) is also a factor. In my case, living in California, my marginal (Federal plus State) tax rate increases from 34% to 42% when I cross the AMT “threshold”. A big part of my own tax planning is to keep my taxable income as close as possible to the AMT “threshold” each year.
(The AMT is a strange beast. It increases your de facto Federal marginal tax rate to 32.5%/35% at income threshold X, (the actual dollar value of X is dependent on your individual circumstances – for most, the amount of state income tax/property tax paid, and the number of personal exemptions, are the biggest factors). Then it decreases your marginal rate to 28% when the AMT exemption is fully phased out. The best explanation I have seen was written by Michael Kitces, in his post “https://www.kitces.com/blog/evaluating-exposure-to-the-alternative-minimum-tax-and-strategies-to-reduce-the-amt-bite/”
Good points, all.
Kitces made the AMT “bump zone” famous. Let’s hope Trump does away with the AMT, which is of no value to anyone except accountants at this point.
The Medicare premium surcharges may sound modest but can add up to hundreds of thousands of dollars of extra taxes over the course of retirement for a high income couple. It is worthwhile to limbo under this downward-ratcheting bar if you can.
According to Lange conversions to Roths are always appropriate and always create more wealth
read his book
Lange does not advocate for unlimited Roth conversions in his book. Always is a very dangerous word.
This will be a controversial statement but I think Lange’s math is clearly wrong when he advocates for very high income individuals making large Roth conversions during peak income years. I believe the discrepancy is in the accounting (or lack there of) for inflation adjusted returns in coming up with the staggering quoted lifetime “savings”. Haven’t seen anywhere close to those values reproduced in other sources.
Now as WCI states, it MAY make sense for a high income individual to make Roth conversions even through the 28% bracket, if one assumes a very large IRA account, BUT seems to me one is taking an awful risk that there will not be a future period in which the top tax bracket drops significantly. May happen in a few short months.
I rarely see a discussion or calculation about the opportunity cost of a Roth IRA conversion. Sure, one can save taxes down the road, but what about the $10,000 you no longer have (or whatever the number) to put into an index fund or non-dividend paying stocks? That is, $10,000 went to the tax collector today instead of being invested today—and then growing over 20 or 25 years. Does the $10,000 grow more than the future tax bill savings? Will $10,000 invested 25 years from now cover the tax that I am now required to pay because I have a required minimum distribution? Are we discounting the time value of money to an excessive extent?
That’s calculated in most of the time. Essentially you’re moving money from taxable into a Roth IRA because the money in the tax-deferred account was partially the governments. Lange does a nice job of doing that in his books.
This shows why an individualized analysis is required that takes the opportunity cost of the tax dollars into account. Since we are making assumptions about the future of the tax code, we want to proceed with a margin of safety. Nonetheless, there are currently many bad and non-obvious things that start happening as we cross certain thresholds (that are not indexed for inflation) even beyond getting whacked by higher brackets: Obamacare tax, Medicare surtax, Medicare premium surcharges. You really can’t plan for retirement without taking careful stock of your probable tax liabilities.
Some of us are so far out we can’t even guess at our possible tax liabilities, much less the probable ones. I mean, Obamacare tax might not be there in two years, much less twenty.
Great guest post. I have to buy The Overtaxed Investor this weekend. I have read The Affluent Investor and loved it.
Dr. Mom, thanks for the info on how to handle the non-deductible portion of IRA’s.
I generally find dividend payouts from my taxable account to be trivial. Yes, they add small amounts to my AGI. They cannot be offset by losses as cap gains can be, but I don’t find this a big deal.
A “no-dividend” account is as undiversified as a high dividend account i.e. S&P500 index. They will essentially be a small collection of growth stocks. Minimal exposure to small cap value or international stocks. Highly prone to changes in cap gains/dividend taxation; something Congress does frequently.
Taking cap gains when you retire or have a low income/high deduction tax year seems to be a no-brainer to me as it is hard to beat 0% tax rates. A Roth conversion can wait.
In California a high bracket investor pays 33% tax on dividends. I wanted this money to compound for my benefit rather than the government’s. Over time, it adds up.
While historically you beat the market post-tax by owning all the zero-dividend stocks, my approach has been to select among them to avoid the growth bias you mention. I especially like stocks that are like mutual funds such as Berkshire Hathaway.
I am a 57 y/o retiree trying to decide how much Roth conversion is appropriate for my situation. My 401K is in the $2,500,000 range. This money will not be needed for personal use because of significant taxable account and RE holdings. How much conversion do you recommend …. to fill the 15% bracket? 25% bracket? 28% bracket? etc? It is hard to run the numbers with so many variables in play.
congratulations to have this fist world problem. You did well 🙂
Consider converting up to the top of your current bracket for 2016, with the fallback position that you can recharacterize this next year if it looks like a mistake (which I doubt). Then I would wait for Trump & the Republican’s new tax plan, and do the kind of long-range tax-planning analysis shown above and see if there are any obvious moves. I fear you may be in the same position as the mysterious Dr. X spoken of in the post.
We did some projections for 2016. We have approximately $25,000 to fill in the 15% bracket. Not much ….. but a start. Next year will be a totally different story ….. closing on two RE flips (sales side) early next year. I purchased and read your book last weekend. Really enjoyed your writing style. Thank you for your assistance.
Oh yea, no brainer to fill the 15% bracket. The question is whether to do the 25% too.
I guess if you have enough money in taxable to live on and pay for Roth conversions, I’d do some pretty big conversions. But the fact that you include the 15% bracket as a possibility tells me you don’t have that much in taxable and real estate income. Certainly you want to convert up to the top of a bracket, but which one is hard to say without knowing more about you like how much you spend, how much real estate income we’re talking about, how much SS you’re expecting, how big that taxable account is etc. You know, like real honest to goodness financial planning. But given what you’ve told us so far, it seems unlikely you’re going to want to do conversions at 28% to me.
I’m curious. What would people do if they were me? wife and I are 40ish. Both working. Both have 401k balances around 600k. Mine is growing faster than hers. I contribute 18k Roth and 35k profit sharing. She contributes 18k and her company contributes 5k. By the time RMDs roll around in 30 years we may have 4M or 12M in these tax deferred accounts. How does one know what the future holds? Right now, we are just trying to save as much as we can in hopes of waking up one day and being pleasantly surprised at our nest egg. I think for the foreseeable future we will just make hay while the sun shines. When and how does one decide they are saving “too much”? Having big RMDs is a lot like having a big tax bill. It’s a pretty good problem to have.
According to Larry Kotlikoff’s analysis, the tax deduction from the qualified plan contribution plus the tax-deferred compounding makes taking the deduction today a valuable move even if it sets up a tax problem later. You can verify this for yourself by using his ESPlanner software. The tax code is so complicated that you really need a computer to figure this one out. There is a bit of a learning curve with getting ESPlanner set up, but once done it allows you to save your scenario and then modify it as your plans change or if you have “what-if” questions you want to answer.
Definitely not the worst problem to have. Does she have Roth 401k options as well? If so, perhaps she could split $13k/5k to get the match and slow down the tax-deferred buckets. Perhaps in another 5 years you could reassess. I’d imagine that you’ll have quite a bit built up in your taxable accounts as well.
Sounds like you’re in a similar situation to me. Might be time to start doing some or all of your employee contributions as Roth. Impossible to know for sure.
you cannot be too rich nor too skinny
oversaving in a tax deferred account suits all just fine
its a good problem to have; don’t worry about the tax bill
While you can certainly be too skinny, I agree that this is a first world problem for sure.
I have a question about the bar graphs. Why does one have *more* taxable income in the second scenario (where Roth conversions were done early on) than in the first scenario?
Also, the bar graphs show the taxable income, not “how much they will pay in taxes” as the post suggests. I think this is very misleading analysis, because what matters is not the taxable income, nor the total taxes paid, but the total after-tax spending power of the entire portfolio for the life of the investor. For example, if one contributes to a 401k and lets it grow for your working year (and reinvest the dividends), the total taxes paid in the end after withdrawing from the 401k can be higher than if you don’t contribute to a 401k at all, but the *total value* of the portfolio after 401k withdrawals is also higher. Total value is a better metric than total taxes paid.
(I posted a similar comment earlier, but maybe it got caught by a spam filter?)
Sharp eyes! There is something screwy in the second bar chart scenario; it should fall somewhere between the first bar chart scenario and the third. And yes, the bar charts show how much taxable income is recognized each year broken down by bracket.
My contention is precisely that the total after-tax spending power over the life of the investor can be increased by partial Roth conversions in early retirement in cases where there is bracket creep due to large RMDs later.
A qualified account like an IRA or 401k is really two accounts: one owned by you, and one by the government. The boundary line between the two accounts is your marginal tax rate the year you pull the money out. Basically, when you progress from, say, the 25% bracket to the 33% bracket, you have just enlarged the government’s account by 32% (8 percentage points – !) at the expense of your own. Your example of the 401k assumes a static tax rate, not one that is lower at the start of the year and higher at the end of the year, as is the case with RMD bracket creep.
Sorry, I wasn’t exactly clear in my comment. I totally agree that a Roth conversion when one is in a low tax bracket is a great thing to do. And my example of the 401k was supposed to say working “years” instead of “year”. I mean that contributing to a 401k during high-tax years is better than contributing to a taxable account, even if the former means Uncle Sam gets more total taxes in total (because the investor gets more after-tax wealth!).
I meant that focusing only on tax bracket and taxes paid instead of basing the analysis on and emphasizing *after-tax wealth* can lead to silly things like paying more in mortgage interest or donating to charity in order to minimize taxes (and at the expense of wealth). The entire push of the post is to minimize taxes paid and lower tax bracket, but the analysis does not emphasize wealth. That was my main criticism.
My goal is *not* to starve Uncle Sam. My goal is to have the most after-tax wealth. 🙂
If you want to send a replacement chart, I’ll swap them out.
Okay, charts fixed.
Back to the topic at hand, you are all leaving out important strategy, and it is called WHOLE LIFE INSURANCE. So, if you die in the first 15 years, ROI is awesome. If you live to ripe old age, it is a flexible tool with safe annual returns when you need the most, with excellent tax benefits.
Is there a cardiologist on board, b/ WCI is about to have a coronary.
Using whole life insurance instead of a retirement account would certainly solve the problem of the doctor having too much money in retirement.
Seriously though, if you have a tax-deferred retirement account large enough that your RMDs into the highest bracket I don’t have a problem with you buying a cash value life insurance policy or a wakeboat, whichever one you think is more fun. They are both similar wastes of money.
But keep in mind what that means. 3.6% is your first RMD. In 2017, the top married bracket starts at $470,700. You can probably scrounge up $29,300 worth of deductions so we’ll say you need $500K as an RMD to even touch the top bracket. $500K/3.6% = $13.9 Million tax-deferred account. What does it take to get there? Let’s assume a really long career- 40 years. So out of residency at age 30, and maxing it out until age 70. We’ll assume a 5% real return.
=PMT(5%,40,0,13900000) = $115K a year. A little less thanks to Social Security and even less if you have other taxable income in retirement. So if you’re deferring that much or more every year, and expect to work a very long career, then go ahead and get yourself some cash value life insurance. Or a wakeboat. But most of the docs I talk to are doing well to defer $30K a year, didn’t start until 40, and want to stop working at 60. That’s just not going to create an IRA big enough to give you an RMD problem barring large amounts of income elsewhere.
Based on the example given in this post, only whole life insurance would solve the problem for same risk. One can forego retirement funds all together and buy equity funds at higher volatility.
Here is the take home point, if you are a high earner, and have bonds i your portfolio, you must allocate some funds to WLI.
Lastly, WCI examples are based on todays tax code. Which can change and will impact RMD. In history of this nation, law changes impacting WLI have been grandfathered (including withdrawls)
Rather than saying things, could you give numerical evidence of what you say, otherwise your words don’t mean anything. I do agree that there is a tax percent where life insurance as an investment would outperform a indexed mutual fund. Show us.
Jim, I am not being difficult when I say to do your own math. Secondly, objective of my existence is not to beat equity index fund. All I am saying is that WLI is an excellent financial tool for many folks. Not for all the folks, and not even for most of the folks. Certainly for the folks used as an example in this article and probably for many of the readers of this blog if they are young enough and healthy and with intention of ever holding cash / CD’s/ rentals or bonds.
Lastly, two of my family members with 2 other partners have been running very successful medical practice. An LLC. Even after paying expenses / including generous retirement plans they have large flow through income taxed at the highest level with state tax rate north of 9%.
They are in process of establishing WLI for each partner paid by LLC to lower tax exposure. as well as to have ability to tap into funds if needed. Some issues have arisen which partners have to resolve but are about to pull the trigger in 2017.
I wonder if anyone has done this and / or is familiar with this strategy?
Have these two family members looked into a defined benefit/cash balance plan? I bet they would find it much more attractive than whole life insurance if they really look at it. Do they have a 401(k)/PSP and are they maxing it out? Are they doing personal and spousal backdoor Roth IRAs? Are they maxing out HSAs? In addition to all that, are they investing substantial amounts in a taxable account every year?
It’s rare that I run into a doc who can answer yes to all those questions. But if they can, really understand how the insurance works, and still want to buy some cash value life insurance, I think that’s fine.
https://www.whitecoatinvestor.com/12-questions-to-ask-before-purchasing-whole-life-insurance/
Inside a tax-deferred account? Unlikely. The only chance WLI ever has against a conventional portfolio is in a taxable account invested in relatively low returning assets.
I totally disagree with several of your assertions. It’s amazing how many threads whole life advocates can start their repetitive arguments in.
First, skipping retirement accounts all together and buying WLI or even equity funds in a taxable account is stupid. Whole life has some tax benefits, but they pale in comparison to the use of retirement accounts, whether tax-deferred or tax-free.
Second, saying you “must allocate some funds to WLI” is also ridiculous. At its very best, WLI is optional. And usually it’s a bad idea.
Third, the only tax benefit life insurance offers is a tax-free death benefit. That’s it. When you unpeel all the hype and smoke and mirrors, that’s all that remains. “But you can borrow against it tax-free,” they say. Well you can borrow against anything tax-free, and usually with better terms. Your house, your car, your mutual fund portfolio, whatever.
Fourth, of course the examples use today’s tax code. What tax code do you think they should use? If I had the tax code in 50 years, I’d use that. But it seems silly to use anything else but today. But as will likely be seen in 2017, taxes sometimes get more severe and sometimes less severe. From 2000-2008, taxes went down. From 2008-2016, they went up. Now they’re likely to go down again. It’s important to stay flexible. Yes, changes could be made to the RMD rules, but I haven’t seen any of those proposed pretty much ever.
Fifth, you mention “the problem.” Let’s not forget what the problem is. There are basically two RMD problems.
The first is someone who doesn’t want to spend their entire RMD. They basically have to pull some money out of their IRA, pay the taxes on it, and reinvest it in a taxable account. Waaa! What a terrible life! You have so much income in retirement that you don’t even want to spend it all. The solution is to spend more/give more away or if you insist on leaving it to your heirs (and probably ruining their lives), doing Roth conversions.
The second problem is someone who saved so much money that they put it in the IRA at a lower tax rate than they pull it out at decades later. This problem is best solved using Roth conversions, which a super saver won’t have trouble paying for.
Whole life insurance is not the solution to either problem. In no situation is the problem “Is there some low-return asset I can invest in that has a death benefit I don’t need that I am locked into for my entire life and that I have to pay interest to access?” Nobody asks that question. That’s why WLI is a product made to be sold, not bought.
Now, if someone has such a large IRA that they have an RMD problem, they may also have an estate tax problem. In that situation, perhaps it makes sense to give some money away to an ILIT and maybe even buy a WLI policy inside the ILIT, but that’s not what we’re discussing here.
You buy ink by the barrel. Anyway, to each his own. As interest rates hike, so should my WLI dividends. I for one am thankful to IRS for wonderful benefit of not having to pay close to 43% tax on distributions every year.
I’m glad you’re pleased with the performance of your whole life policy. I wish most doctors who have purchased them could say the same.
WHITE,
WCI buys ink by the barrel because he has something meaningful to say and because there are many people who flock to read what he writes.
[Ad hominem attack deleted. I appreciate the defense, but I’m much quicker to censor an attack on another commenter than an attack on me, for which my threshold to censor is actually reasonably high as can be seen in the lengthy comments threads on the posts that are actually about whole life insurance.-ed]
Phil
Great article. I read the Affluent investor. I just purchased the Overtaxed investor from Amazon and will enjoy reading it. I anticipate being in a lower tax bracket for the future as I have backed off work substantially. I am considering systematic Roth conversions from my 401K. I already have a Roth 401K plan and understand about tax diversification but I love the fact of not having to take RMDs. I anticipate using the stretch Roth IRAs vis a vis James Lange. Do you know if there are any calculators available to figure out the conversions? I have only found general rule of thumbs like converting up to a certain marginal tax rate at the end of the year.
I don’t know of a calculator. You need to apply the general rule of thumb to your situation. So you figure out what your taxable income is going to be, subtract it from the top of the bracket, and convert that much.