[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!
Thank you for the article and the comments. I learn so much more from the combination of the two.
While difficult to make generalizations as every individual is faced with their own unique circumstances and challenges it is true that many good savers accumulate a substantial part of their wealth in deferred (qualified) accounts. The distributions from these accounts that become mandated as we age beyond 70 are not only subject to maximum tax rates, they also expose people to potentially substantial surcharges on their Medicare Part B premiums not to mention increased tax exposure on social security benefits. These days, hopefully most of us should hope to live way beyond 70 and should at least thoughtfully evaluate long term tax exposure. It seems that no matter how rich (or thin), RMDs and IRMAA letters (informing of substantial surcharges on Medicare Part B & D premiums) provoke colorfully angry reactions in most.
Skewing contributions towards Roth 401k can be helpful in the long run and should be considered. And Roth conversion strategies over time can ultimately make longevity more pleasant and secure. For anyone who thinks that there is a reasonable chance that they live well beyond their working years it would be fruitful to manage that risk.
While the topic appears somewhat controversial here, I think that Whole Life Insurance can be a wonderful tool if you in a situation where you are confronted with estate tax challenges; whereas it may not be quite as useful for income tax planning or managing longevity risk.
I agree that a whole life policy in an ILIT can be a useful tool if someone actually has an estate tax problem.
I aggressively harvested tax loss as well as had some real side business loss following 2000 crash, to the tune of about 400K. I carried that forward and used it to rebalance post tax accounts, whittling it away prn. In 2008 I became a client of Dr DeMuth, and promptly was presented by Mr. Market with another opportunity to tax loss harvest, so I did. I carried this forward till I retired. My post tax account was twice my pretax account and the loss made holding the post tax money much like having a Roth. Stock could grow freely and taxes would be countered with loss. LT cap loss is fairly easy to generate. Example: if you buy GLD and it goes underwater sell it, book the loss and buy the goldminers. This will effectively give your portfolio a similar gold exposure, plus LT cap loss to hedge your taxes. Rinse and repeat.
With retirement I needed to convert some Trad IRA to Roth over several years, because my Trad IRA was too big and I want to control the tax bite RMD will cause. Having a large LTcap loss, and a lot of post tax stock allowed me to slice off some post tax stock, pair it with loss for a $0 tax hit and put that cash into short term muni’s to live on for 5 years (sort of a home brew early retirement annuity). This means my tax bill for living for the next 5 years is $0, which will allow me to convert Trad IRA to Roth at only a 15% tax bite, and whittle down my eventual RMD at age 70. The Muni’s have some inflation protection and move my overall portfolio towards bonds as is recommended in early retirement, but as I spend down the muni’s the portfolio will tilt automatically back toward stocks and I will have 5 years of Roth conversion in my Roth accounts, on the cheap.
My projected RMD at that point mixed with SS which I will also take at 70 will be at 15% taxes and if I need a car or something I will sell some post tax stock and pair it with some cap loss and go buy a car, or I will recreate a second home brew annuity at a $0 tax bite depending on market conditions. I think pretax money is groovy except for the dire wolf grinning at the window if you have too much of it, and I’m all out of red whiskey. I think Medicare is groovy too except I made too much money 3 years ago so they charge me double for part B, etc and I’m all out of KY. It looks to me like the gov’t has little interest in stopping the steam roller before it flattens us.
Consider the utility of LTcap loss and post tax stocks It’s equivalent to a rich man’s Roth, and adds considerable cash flow flexibility to surviving post FIRE.
Best
Sounds like some excellent tax planning.
However, it’s important for people to realize, and I believe Mr. Demuth agrees, that it is usually a bad decision to invest in a taxable account when you haven’t already maxed out a tax-protected one. And the reason is obvious for someone in the top tax bracket- you can always just pull the money out and invest it in taxable, but you can’t do the opposite.
I am a married semi-retired MD in my late 60’s with a defined benefit pension, about $3.5 million in pre-tax and about $0.8 million in after tax liquid assets. My current federal tax bracket is 24%. Assuming no change in the current tax rates, I can see that in about 5 years my RMDs will start to push me into higher tax brackets, eventually to the 37% bracket in my 80’s! I am interested in the concept of a Roth conversion. If I needed to access the Roth to fund my later retirement years, the math generally favors a conversion now at the lower tax rate to reduce my tax rate later. Given my spending habits however, my projected pre-tax assets at my life expectancy will still be substantial. Since I don’t expect to actually withdraw from the Roth during my lifetime, does paying the up-front tax now for a conversion benefit me and my wife, or just my kids and grandkids? If there is no benefit to me and my wife from the Roth conversion, then maybe it would be better to have the after tax money to give to my kids now when they are trying to build their lives, rather than have them inherit ( granted probably a larger amount) but only after I’m deceased.
Yes, the benefit is likely mostly or your heirs. But it could benefit you if you use it to “set your tax rate in retirement”.
Have very SIMILIAR problem
Filling up 24% bracket with Roth Conversions
Might to more up to 20% effective tax rate
GOOD TROUBLE WE ARE IN