By Dr. James M. Dahle, WCI Founder
I have done several articles in the past about the Roth vs Tax-deferred 401(k) contribution dilemma. If you haven't read any of them, you should start there before reading this article. When writing on this subject, I always mention that while the general rule of thumb is to make tax-deferred contributions during your peak earnings years, there are some exceptions to that rule, one of which is if you are a super-saver.
In the past, I've just kind of left it there. One reason why is that it is such a first-world problem. For example, if you weren't a great saver for whatever reason, every little bit of extra money in retirement matters. But if you were a super saver, it just doesn't matter all that much. Sure, you have a little less money to leave to your heirs or your favorite charities because you paid a little too much in taxes, but there is no financial tragedy going on. You're not going to be eating Alpo.
In addition, most people, even doctors, aren't super savers. If you're a doctor in your peak earnings years and haven't saved much at all, using a tax-deferred account might be the hugest no-brainer out there. However, the truth is those super-savers are highly concentrated on this website, so it is probably time I quit blowing them off and wrote a Roth vs Tax-deferred 401(k) post just for them.
Roth 401(k) Contributions and Roth Conversions Are Basically the Same
Before we get into this too much, the first thing worth pointing out is that if making Roth 401(k) contributions is the right thing for you to do, doing at least some Roth conversions of tax-deferred money you already have is almost surely also something you should be doing. Yes. Right now. In your peak earnings years. The equation is basically the same. You're saying — I'm going to be taking out my money from my retirement accounts in retirement at a higher or similar tax rate than I am saving putting it in now. If that's the case, Roth conversions make just as much sense as Roth 401(k) contributions. So if you're making Roth 401(k) contributions, you should be asking yourself why you're not doing Roth conversions too.
Basic Housekeeping
There are three other concepts you should keep straight as we get into this.
The first is the Backdoor Roth IRA. This is a great way to get a little bit of money ($6K for you if < 50, $7K if $50+ and you can do the same for even a non-working spouse) into a tax-free (Roth) account every year. Since you have access to a retirement plan at work, you can't deduct traditional IRA contributions AND you make too much to directly contribute to a Roth IRA. You are much better off doing Backdoor Roth IRA contributions than investing in taxable.
The third is the idea that Roth contributions and conversions, at least when you have a taxable account, have the effect of having a larger percentage of your after-tax money in a tax and asset protected account. A Roth conversion essentially takes tax-deferred money and taxable money (to pay the taxes) and moves it all into a tax-free account. In essence, some of the money in that tax-free account would have been invested in a taxable account if not for the Roth conversion/contribution. This is the reason why if your marginal tax rate at contribution and withdrawal are exactly the same that you are probably better off in a tax-free account–more of your money is protected from creditors and from the tax drag inherent in a taxable account.
The Reasons Why Roth Is Better for Super Savers
Housekeeping out of the way, let's go through the reasons why a tax-free account works out well for a super saver. The critical concept to understand when trying to decide between tax-deferred and tax-free 401(k) contributions (and conversions) is the concept of filling the brackets, illustrated for a typical doc below:
So why is a super saver different? She is different because she has filled all the brackets with other income! In fact, it is entirely possible, although admittedly quite rare, to contribute to a tax-deferred account at 22% and then withdraw at 37%!
Now, it takes a heck of a lot of income to fill up all those brackets, but it can certainly be done. Maybe it's done because you're still working after 70 because you just like to work. Maybe you have a younger spouse who is still working. Maybe you and your spouse get a ton of Social Security. Maybe you have 200 doors worth of rental properties? Maybe you just have a massive tax-deferred account. Maybe you inherited a huge taxable account at some point and it is kicking off lots of ordinary income. It is different for every super saver.
Another reason why tax-free accounts are great for super savers is that super savers tend to spend less money. They get annoyed that the government makes them start taking Required Minimum Distributions (RMDs) at age 70 1/2. Unlike most people, who are spending the RMD (and more), they are just moving money from a tax-protected account into a taxable account. Better to be in a Roth IRA (not a Roth 401K of course) where RMDs are not required.
So Are You a Super Saver?
So how do you know if you are a super saver? Well, first of all, you're probably a very high earner. That's not absolutely mandatory, but it's the most common scenario. If you're making $150K, you're probably not a super saver. Even the average physician making $275K is not going to be a super saver very often. This is usually someone with a household income over half a million, a million, or more.
The reason why is that it just takes a lot of income to be able to save enough money that you will have enough income to fill up all those brackets in retirement. These are people putting $100K+ into tax-deferred accounts every year and probably a few hundred thousand more into taxable accounts. They don't tend to have mortgages or debt of any kind and are only spending a tiny percentage of their income. They also tend to work for a long time — that allows for more savings, more time for their current savings to compound, and higher social security payments. They are also often fairly aggressive investors. High rates of return make those investment accounts worth even more, and thus they provide even more income in retirement.
Let's walk through a step-by-step process to help you determine if you are a super-saver.
Step #1 – Determine Your Current Marginal Tax Rate
It is important to know your marginal tax rate now because that determines how many brackets you will need to fill up in retirement to make tax-free contributions (instead of tax-deferred contributions) now a better option. This is most accurately done with tax software by adding another $100 of unearned but ordinary income to your income and seeing how much your taxes go up. If they go up by 42% like me, you have a 42% marginal tax rate on unearned but ordinary income. (Don't use earned income because that will include payroll taxes and throw your answer slightly off.) If you don't want to go through that hassle, well, just look at these 2019 tax brackets.
Remember this is based on taxable income, not gross income, so take your deductions including the standard deduction out first. And of course don't forget to also include your state marginal tax bracket.
My current marginal tax rate is 42%.
Step #2 – Make Any Adjustments Needed
Some people plan to move from one state to another in retirement. This is where you would make an adjustment for that fact. For example, if you're going from the 10.3% bracket in California during your working years to the 0% bracket in Nevada as a retiree, you will need to adjust for that by subtracting that amount from your future marginal tax rate.
Likewise, if you have a deep, burning fear/conviction that tax rates will go up significantly. Just add however much you think they will go up. No one would call you unreasonable to include an increase of 2-5%. If you're thinking of doubling the tax rates, well, just save yourself the time and do Roth contributions (and convert everything you have, quick!)
I'm not planning on moving and I would guess that long term tax rates are likely to be a couple of percentage points higher than they are now, so maybe I would add 2% in retirement.
Step #3 – Estimate Social Security
Now go to the Social Security Website and get your statement. It'll give you an idea of how much Social Security income you (and your partner) are likely to have in retirement. If you are pursuing an early retirement, or just want to be more accurate, consider using a tool like Mike Piper's Open Social Security. There are others out there as well. But you need to figure out how many brackets you're going to be filling just with Social Security, at least after age 70. By the way, if you can't delay Social Security to age 70, you're probably not a super saver.
The maximum Social Security Benefit in 2019, assuming 35 years of maximum contributions, is $3,770 per month, or about $45,000 per year. Your spouse will get a minimum of half of your benefit. So two earners could have a maximum of about $90,000 per year and a one-earner family could have a maximum of about $68,000 per year. My best guess for my family would be about $55,000 per year. Of course, only 85% of your Social Security benefit is currently taxable, so the real number for my family would be $55K*0.85= $46,750. Feel free to adjust that number if you think Social Security benefits will go down or if you think more of it will be taxed or whatever.
Step #4 – Estimate How Many Brackets Will Be Filled by Your Current Tax-Deferred Accounts
Now you can use whatever percentage you want, 4%, 5%, 6%, whatever you'll be pulling out of that account for the first decade or so of withdrawing. But I would not use anything less than the RMD at age 70, 3.6%. Now, what do you multiply the percentage by? Well, if you're going to start withdrawing this year, you can just use the current value of the accounts. But that isn't usually the case for someone struggling with the Roth vs Tax-deferred 401(k) decision. Withdrawals are usually at least a few years away and perhaps even a few decades away. So it stands to reason that you must adjust what you have in there now for compound interest between now and when withdrawals start. This is a pretty easy future value calculation, the only question is what rate of return you use in the equation, because garbage in, garbage out, especially over a long time period. Since the tax brackets rise each year with inflation, I would only use a “real” (after-inflation) rate. So adjust whatever number you think you will earn long-term after inflation. Lots of people also have a large percentage of their bond allocation inside their tax-deferred accounts, so be sure to adjust for that.
Whitney showing off her surfing skills
So let's say your tax-deferred accounts are 50% bonds and 50% stocks. Let's say you assume you will get a 4% nominal return on bonds and 9% nominal return on stocks and that inflation will be 3%. So your expected real return is 3.5% per year.
9%*50% + 4%*50%-3% = 3.5%
Let's use my numbers to make this realistic. I am 44 years old and have about $1.6M in tax-deferred accounts. Given the size of my taxable account and my desire to work, I think there is a VERY good chance I won't be touching that money until I am 70. So that's 26 years to compound at 3.5%.
=FV(3.5%,26,0,-1600000) = $3.9 Million
Now, ask yourself if you are still contributing to the account. If so, you also have to adjust for that. Just to keep things simple here, I'll ignore that.
If I multiply $3.9M above by 3.6% (the RMD at age 70 1/2), I get $141K.
Step #5 – Estimate Other Ordinary Income
Here is where you include other income you might have in that first decade of retirement or so. Maybe some spousal income. Your rental property income (at least the amount not sheltered by depreciation). Other investments, etc. I would not include qualified dividend or long-term capital gain income, especially if you have lots of tax losses saved up. Don't include “income” that wouldn't be taxed like borrowing against your home or life insurance policy either.
This is VERY difficult for me to estimate 2 1/2 decades away, but a hundred thousand dollars in today's money seems entirely possible to me as I look over my taxable account and real estate holdings.
Step #6 – Put It All Together
Assuming we take the standard deduction in retirement, currently a little over $24,000 (which is actually likely to be a low estimate for us given our charitable giving habits and income/property taxes), our Social Security will fill up the 0%, 10%, and part of the 12% bracket. Our withdrawals from tax-deferred retirement accounts will fill up the 12% and part of the 22% bracket. The ordinary income from our taxable account will fill up the rest of the 22% bracket and a good chunk of the 24% bracket. Even if we had another $100K in ordinary income, we would still only be a little way into the 32% bracket. Now add 5% for our state taxes and 2% for an increase in taxes over time. That gets us to 39%.
Given that our current rate is 42%, we figure we're still better off FOR NOW doing tax-deferred contributions. As we continue to work, earn, make those tax-deferred contributions, and save in a taxable account, that will gradually change. We're getting very close to being enough of a super saver that we should be doing Roth 401(k) contributions and Roth conversions.
A couple of more years of saving like we are and we're likely past that point. Certainly, the advantage of tax-deferred contributions for us is much smaller now than it was when we started saving 15 years ago. It's probably a good thing we're now doing the Mega Backdoor Roth IRA with the WCI 401(k), although that change had more to do with the 199A deduction than us being super savers.
I suppose the key principle to remember here as your future income grows is to compare your marginal tax rate now to the marginal tax rate on the dollars you are now contributing when you withdraw them. If your past tax-deferred contributions (and other income) filled up all the brackets already, then you might as well start making tax-free contributions and conversions, even in the highest marginal tax bracket.
Two Other Factors to Consider
If for some reason, you are able to earn VERY high returns on your investments (as some highly leveraged real estate investors claim) or you are likely (due to death or divorce) to spend a great deal of retirement single after spending your peak earnings years married, those should cause you to lean a little more toward Roth 401(k) contributions (and conversions).
What do you think? Are you enough of a super saver that you should be making Roth contributions and conversions in your peak earnings years? Do you anticipate getting there before you retire? Comment below!
Mega back door is the best. I was lucky to have the opportunity to use it at my last 3 employers. I did a similar calculation and did not want to end in a RMD situation. Of course that would also have meant that I worked longer than needed.
Why are you not including qualified dividends? While tax rate is lower on those, don’t they move you up in income bracket? So if I had ten million in taxable accounts in basic mutual funds and pulled in 2% dividend, that’s an additional 200k a year that will move me up in income brackets. Moving you into highest marginal rate?
As an alternative that could be toyed with, if you plan on leaving this money to your children anyway, couldn’t you max your tax deferred first as usual, say with a defined benefit plan to really build it up, and then taxable. Then just prior to retirement, move taxable into irrevocable trust for children and then draw from tax deferred without having to worry about income from taxable since you’ve already given it away?
You would be using up a lot of your estate tax exemption to give all that to your kids at once. Might matter, might not, depends on the size of your estate at death and your state of residence.
Besides, trusts are taxed at a pretty high rate, so you’re probably not saving much there.
Definitely. He does refer to “ordinary income” from a taxable account a couple of times, and qualified dividends aren’t ordinary income exactly, but either can fill the low brackets. I’ll have about $35k in qualified dividends this year, and the tax drag on those is a drag, but it comes with the territory of a large taxable account.
Best,
-Pof
I define super saver as someone with assets approaching 10 million. It;s a number I hear my fellow physicians throw around when they talk about having enough money to retire. If that’s true, then much of what people are commenting doesn’t really apply. No matter what you choose to do, where you sock your money, choosing assets with little income, etc., it seems to me that you will always be in the top tax bracket now and in the future.
Furthermore, I think most people would agree that tax rates will go up in the future.
Therefore, the only option that seems to make sense for a true super saver is to pay taxes now. Forget about a 401k or defined benefit plan and convert to Roth / Mega Backdoor Roth — because the highest tax bracket now will be less than the highest bracket in the future.
Alternatively, like I mentioned above, the other option is to get the money out of your name and into your kids’. That said, even an irrevocable trust option is likely not worthwhile because as I understand it, an irrevocable trust has its income taxed at an extremely high level as well.
The only other option I can think of is placing money into assets with absolutely no income at all. Like gold or Berkshire Hathaway and then holding it until death at which point you get the stepped up basis when you will it to your kids.
There’s no guarantee the top tax bracket now will be lower than the top tax bracket later. People said that 4 years ago too and now look….
$200K doesn’t get someone into a higher tax bracket by themselves, but you’re right, any time you have additional taxable income from mutual funds, social security, rental properties, or a pension, it will fill tax brackets prior to tax-deferred account withdrawals. Maybe LTCGs and qualified dividends should be looked at a little differently, but you can work through that worksheet in the 1040 instructions to see exactly how they apply.
If you are planning on your tax rates going up because you anticipate being divorced in retirement then I think you should be spending less of your focus on which is the best retirement account and more on your spouse 😛
Great points made. It will not be applicable to 99% of people including me at this point, but it may be useful for a sizable percent of people who follow this blog.
Is it possible to do Roth conversions with an inherited IRA?
No.
My understanding is no.
Great article as always…
Two points:. My parents have 4-5mil mostly in retirement accounts and my wife’s parents have about the same amount. I have never been to keen on including that in any of my calculations for FI as I have seen countless horror stories with family money. However, this is where the rubber meets the road. If we inherit 1-2mil from my dad’s 401k when I am in my 50s– even if we can still “stretch” it– then this will likely make Roth a better option now. Definitely a first world problem, I admit.
Second, my dad is a retired financial advisor and he regales me a time in the late 70s (when he was starting out) where all retirement accounts had an extra 1% “surcharge” for being over 1mil. He opines that the government is going to find a way to tax retirement accounts because that is where all the money is.
Since my crystal ball seems to be nonfunctional (though my magic 8 ball is on point) this all is conjecture. I still max out my solo 401k because I just hate paying taxes now. Like many financial decisions it seems to come down to risk tolerance. I would likely have more money later on if I do Roth conversions now but I run the risk that my parents and in-laws will spend all their money on Teslas and Faberge eggs.
1. I agree. Good reason to lean more toward Roth.
2. Entirely possible.
Find a balance.
Although I agree that it is possible that retirement accounts will be taxed differently in the future, I think it is less likely than your father believes. The main reason for this is that people over the age of 60 (who are most concerned about their retirement accounts) are the best voter’s. Politicians really try not to upset the vast majority of their voting population when their jobs depend on it….They would rather tax the heck out of the young (less likely to vote) than raise taxes on the old…
At the end of step 4 (tax deferred account income) you talk about multiplying by 85% because only 85% of social security income is taxable. Shouldn’t that instead be at the end of step 3 (social security income)? I doubt it will change the conclusion, but it’ll push your retirement marginal rate a bit closer to the break even point.
You might be right. There may be a paragraph in the wrong place. I’ll take a closer look later after a few meetings today.
Agree with this typo (I think)
85% should be 0.85 x $55k (your social security estimate ) = $8250 less from your final income number.
The $141K RMD stays as it is (please confirm).
Great article, very detailed… right up to that first paragraph of Step 6! Please include a table to walk through all these numbers that you’ve used in the article to show your totals and how they actually fill up the brackets. Prose is nice…. tables are nicer. This will help readers sub in their own numbers and understand how the brackets actually fill up (I could use the teaching!). Thanks as always for your help
Sure tables are nicer, but they also take 10 times as long to make. 😉
These posts are often written for the “married practitioner in private practice” perspective.
There are thousands of physicians in federal service within 10 years of retirement who have a pension coming to them, many of them single. A single, federal physician nearing retirement (at 62) with 30 years of service currently making about 165 after a standard deduction will, in the future, have their bottom brackets filled with ~60K from a federal pension. This makes it easy to hit higher tax brackets once TSP-RMDS, SSI, and dividends from sizable taxable savings are factored in. It also limits the amount of Roth conversions that can be made from ages 63-70.5. Thus, I believe some federal physicians are also faced with this supersaver dilemma, and despite their relatively lower income.
In my case, my savings (taxable plus Roth IRA plus tax deferred TSP) already cover my retirement needs, so last year I decided to contribute to Roth TSP despite being pushed into the 32% bracket. I was able to offset this by donating about 20K from an appreciated taxable account to a donor advised fund (plus SALT deductions) to stay within the 24% bracket. Moving forward through another 8 years of service, I may have to donate as much as 25-35K/year into a DAF to stay within the 24% bracket, which sounds like the tax tail wagging the dog. So I may break down and partially revert to regular TSP contributions. However, since I have already met and exceeded my savings goal, I want to try to continue to contribute to the Roth TSP and DAF and stay at 24%. This plan for the last 8 years will decrease my total TSP RMDable account by over 200,000, by age 62.
At some point I may move out the Roth portion of my TSP and add it to my Roth IRA. Between ages 63-69, before claiming SSI, I may do some limited Roth conversions, requiring moving money out of TSP to Vanguard. I may also move out some tax deferred TSP savings into a regular IRA, in order to enable the possibility of QCDs, a strategy often mentioned by Christine Benz of Morningstar’s podcast. That’s if I will be making more than i need and want to lower the taxable income (instead of taking a deduction) for charity.
The Schwab Charitable DAF is excellent, and it been wonderful to be able to give more easily to charity without pulling from annual income. Since I donate about 12K per year from the DAF to charities, I invest the remainder and will donate it in the early years after retirement, before starting to donate via QCDs from RMDs.
Of note, why has WCI not commented in this post on the rumors that Roth conversions may someday be taxed again? Please comment on that risk. Those not in favor of Roths cite the congress having considered a bill to tax 529 plans; although that bill did not pass, some take it as evidence that nothing tax-free is truly safe. What do others think about that risk?
I agree, a pension should make you more likely to do Roth contributions. In fact, I think it is a very rare military doc who shouldn’t be doing all Roth.
A big pension, a big taxable account, and a big TSP puts you into super saver category of course.
If you are really worried about legislative risk, then take your tax break now.
Like Federal Doc I reject the idea that I’m not a super saver if I don’t have 5-10 million dollars. If you figure the amount spouse and I will get on our military and government pensions, and pick some arbitrary rate of return and from that calculate the value of the pension, we can argue for bragging rights that over $5-10 m is the actual value of our investments (investments in time worked in addition to money). Just to confuse the issue though, widowhood for either of us would drastically change the “value” of those pensions but then of course that single survivor will still be in super saver territory.
Definitely planning on Roth conversions during the gap between retiring and social security and RMDs. However my crystal ball did not recommend doing that during my higher-income working years since I planned on retiring prior to 70. (And just did! Hurray!)
I realise I already made the comment I felt compelled to make rereading this, re us who are actually supersavers with under $5M. However I think both Fed Doc and I failed to mention that unlike private practice high dollar baller super savers, we start with a comparatively low tax rate in government or military service so it is easy for that to rise in retirement with a smaller nest egg especially with our pensions. – Super saver with well under (for now) 5-10M$
Yea, the pensions are a big deal as they fill the lower brackets with ordinary income.
cannot convert inherited ira
if one spouse dies, best that other becomes the owner of the ira
WCI- Could you share why you multiplied your tax-deferred RMD by 85%, reducing it from $141k to $120k/year? I was under the impression that it’s your $55k/year in SS income that would need to be multiplied by 85% before filling up tax brackets are considered, not your tax-deferred account RMD. Am I missing something?
I think there is a paragraph out of place. I’ll look more carefully when I get a chance.
It seems to me that, particularly for super savers, it makes more sense, to the extent you can, to minimize the growth and even the size of your deferred accounts in order to reduce the amount of your RMD, in order to keep you out of the higher marginal tax brackets which will apply to you IRA/401k distributions, income and non-qualified dividends. Of course, this assumes that you plan to live off of your taxable accounts until 70 1/2 and paying the lower long term capital gains tax rates both on both on the sale of appreciated stocks as well as qualified dividends.
Based on this reasoning, it seems that this alone justifies putting bonds in tax deferred and to keeping equities that appreciate in taxable. This is particularly true for people who are or anticipate being single in retirement.
Also, allocating at least some of your retirement to Roth 401k, and then rolling it over it into a Roth IRA, also supports this goal, as does Roth conversions in retirement, while allowing you shelter money from creditors/lawsuits and then leave it to your heirs tax free and compounding all the way through their lives.
Is my reasoning correct on this?
No, you don’t want to minimize the growth. That’s letting the tax tail wag the investment dog. The solution is Roth conversions if you’re worried you’ll have an RMD problem. I mean, a great way to lower your tax bill is just to make less money, and you’re effectively doing the same thing by minimizing the growth of a tax-deferred account. Not smart.
The tax location issue is separate and best not conflated.
Thank you for taking the time to reply. I would ask that you consider this further as when I run the numbers it seems to make sense for a super saver at least.
Not to belabor the point but I believe that tax location needs to be considered as part of the holistic approach, particularly during the 10 years preceding retirement (where I am) . I suppose that my strategy was to put my higher yielding tax inefficient bonds in my 401k and supplement with tax free municipal bonds in taxable to bring my percent bonds to my target.
Since my deferred accounts represent nominally 15-20% of my total holdings, and probable even less at retirement, I concentrate all of my highest appreciating stocks to my taxable account to take advantage of the lower taxable gains rate. I certainly want to make less money or minimize growth but I am considering the tax implications on my annual tax bill each year, as well as down the road in early retirement. I am in the highest tax bracket. This strategy allows me to tax loss harvest more effectively with equities (which I obviously can’t do in my tax deferred accounts), focuses the growth into taxable where I have more control as far as selecting less appreciated (higher cost basis) assets when selling and minimizing capital gains and leaving the lower cost basis lots for my heirs and allowing them to take advantage of the step up basis.
Do you believe that I would be better off with more bonds in my taxable (tax free or otherwise) and put more appreciating assets in my deferred accounts?
Thank you again for addressing my comments
I agree with your plans Sandy. I just retired. I placed lots of bonds in My tax deferred for this reason. I also Have munis in taxable.
Thanks for your input Hatton.
No, there’s a very good chance your bonds are in the right place. More discussion here in this recent post:
https://www.whitecoatinvestor.com/asset-location/
In step #4, don’t you have to account for continued contributions over the next 25 years?
If you are making continued contributions you should account for them, yes.
One should be careful of the trap “predict high taxable retirement income (e.g., by assuming continued traditional contributions) -> contribute to Roth (instead of traditional, thus violating that assumption) -> get low taxable retirement income.”
The way WCI did it in the article seems best.
Well, I thought I was a super-saver til this post! Funny to watch my savings rate drop as I get older (I am working less).
I suspect that your tax-deferred will grow bigger than your estimate (I assume you’ll be putting in another 50-100 yr for the next few years, at least?)–but I also suspect that you know that.
But what if you are planning on retiring early and will have a lower tax bracket and therefore can do roth conversions for many years? Wouldn’t it be better to use a traditional 401k vs a Roth?
This is a good point, Sam, and one that I’ve been pondering.
In your situation (and hopefully my own), an early retirement would give many years to do Roth conversions until retirement age of 65 when your income would go up from tapping retirement accounts.
So for those seeking FIRE, tax deferred for now and Roth conversions after early retirement seems like the play.
Of course, depends on other sources of income after “retirement.”
Do we have this right?
— TDD
This defines my plan. Stuff as much into tax-deferred as possible, then start slowly but surely doing Roth conversions over 15-20 years. I had hoped to start doing it when part-time, but I’m still in a high bracket–first world probs for sure.
Pretty much. Unless you FIRE like PoF, who now has an unexpected blog income to deal with.
Yes.
Overall good post. The super saver physicians will worry about RMDs. The concept will upset you as well as the increases in Part B and D medicare that the larger RMD will trigger. To counter this “problem” I put my bond position (some of it) into tax deferred, did some Roth conversions, and used my hospital Roth 401K option with my last little job. I plan to do some additional conversions from 63-70.
Thanks for your input Hatton. I hadn’t even considered the impact this would have on Medicare premiums. Thanks. It sounds like either you share my holistic approach to this.
I also diversified again rising tax rate risk by dividing up my deferrals with half going to Roth 401k and the other into a Keogh/Profit sharing plan for 10 years until hitting 50. More recently, we also started a cash balance plan which I’ll contribute to for another 10 years. This will cause my tax deferred account to swell more than I had anticipated. I suppose there are pluses and minuses to that.
It was a choice between taking the post-tax dollars in taxable vs. contributing roughly 4x more to tax deferred than I had been doing previously (or 8x if you consider the period when I split it between tax deferred and Roth). So it seems that with the cash balance plan that I am sort of counterbalancing my Roth 401k efforts except that I managed to squeeze more money into Roth vs. just into taxable.
There are so many permutations and considerations of this stuff it can make your head spin. If nothing else, its a stimulating mental exercise which gets more complicated with each change in the tax and retirement laws.
Lots of people do this calling it “tax diversification.” I think it’s mostly an attempt at regret minimization–“I know one of these is wrong, but I’m not sure which one, so at least I’ll only have half my money in the wrong thing.”
This is why my current plan is 50% Roth by the time when have rmds. Hedge our bets. Will at most be only half wrong.
Why would it upset me?
I am very hesitant to assume the federal government will honor that tax free, no RMD Roth deal for the next 40 years. That aline makes Roth less appealing.
On the other hand, estate taxes could go up. As long as income tax rates are below estate tax rates there can be an advantage to reducing the size of the estate by paying income taxes on conversions. While the estate tax exclusion amount is large, this will not affect many people. If they reduce the exclusion, raise the estate tax rates, or both then Roth converting could make sense accounting for estate taxes, even if it is not justified on income tax considerations alone.
Given that one will have a bond position somewhere, there is an argument to put it in tax deferred. I think the finance buff pointed out that this conventional wisdom might not apply during periods of low yields.
I think you were right at the beginning. First world problem!! At some point all the machinations of Roth, etc., really don’t make much of a difference especially compared to the investment of time to do all these calculations.
Medicare rates have limited impact. Although they go up with income, the overall affect is minor. Rates do not increase forever as income rises. If income goes from $218k to $272k the premium goes up by $170/month, ish. For a couple, this would be an annual increase of a little over $4,000. Given all the uncertainties of future tax rates, it is hard to predict small effects of this magnitude with enough accuracy to bother. Doing a big Roth conversion would lead to paying far more than this amount in taxes.
Well done. The earlier article referenced also did a nice job on the Super Saver financial analysis.
Basically, it amounts to that no one is going to be earning as much in retirement as earlier in their career, right? If that actually happens through an act of God, etc, much of the retirement income will be taxed at LTCG which is considerable lower than employee taxes. It’s hard to picture any realistic situation (Super Unlikely) based on today’s information where Roth would ever come out ahead.
What exactly is tax drag in a taxable account? Taxes generated from churn on the investment funds?
No. The idea is that A FEW PEOPLE (the super savers) are going to be earning as much in retirement as at the time of contribution to retirement accounts during their careers. Roth will come out ahead for them.
Tax drag is when a taxable account grows slower than a tax protected account because taxes much be paid on the distributions each year, reducing how quickly the account grows. Churn makes it even worse, but even without churn there is a drag.
WCI,
If I’m not mistaken the spousal maximum benefit is 50% of the other spouses PIA, which is $36,132 in 2020. This would leave the total @ around $63,000 and not $68,000 for a one-earner family.
Dave
I calculate $68,200. If the max monthly benefit for 2020 at age 70 is $3790, then multiply that by 12 months and then x 1.5 for both spouses. Maybe $63K was the 2018 or 2019 number, dunno.
The calculation of the max benefit for someone today where their FRA is 67 is 124% of their PIA.
Let’s say that 124% number is $45k, then 45000/1.24 = $36,290 – that is a close approx of their PIA.
Since the maximum the spouse can get at her / his FRA is 50% of that PIA, then that number is $18,145 + 45,000 = $63,145.
All from Mike Piper’s book on SS.
If you converse with Mike he will also tell you the real math of what the spouse gets in spousal benefit is 50% of the difference in (PIA1 – PIA2) + their own benefit. In other words the spousal benefit is really on top of what they are already due and is how the SSA thinks of it.
All of this is in today’s dollars, so obviously in the future the numbers will most likely be larger.
I’m certainly not going to argue that I’m right and Mike is wrong on a SS topic. Maybe my mistake was assuming the spouse could get 50% of what the higher earner would get at 70 and it sounds like that’s not the case.
Above footnote on the true SSA calculation is a little misleading – a simple example will clarify:
Jane’s PIA per month is $1200 & Dick’s is $500.
1/2 of Janes PIA is $600 per month so that is the max of a spousal benefit. In this case, the $600 is made up of $500 which Dick is due to begin with and a $100 spousal benefit, not a $600 spousal benefit as most people talk about it. Only semantics in my mind as the math is the same, but SSA (and Mike) think of it otherwise.
Hi Dr. Dahle. I discovered your work a little over a year ago and I’m a big fan. I’m not a physician, but I’m a Chemical Engineer earning a high enough level of compensation that your books, articles, and podcasts are of great value to me and my family. This is the first time I am leaving a question so I hope you will see it and respond. I’d also welcome the opinion of your other subscribers.
It seems to me there might be a couple of additional benefits of the traditional 401k/IRA. My understanding might be off so I’d appreciate your point of view. In step #4 of your above article you use an estimated rate of return to determine how large the balance of a traditional tax protected account can be before it fills up the lower tax buckets. Lets assume that a person is not clairvoyant (probably a good assumption) and will not realize the precise gains estimated in step #4. In the event that the realized gains are lower than hoped for then current assets will fill less of the lower tax buckets. In this case the saver can either take on more risk to make up for the shortfall or can simply live on less (with Uncle Sam subsidizing a portion of the shortfall due to lower taxes on withdrawals). In the event the realized gains are higher than hoped for then our saver has the option of either paying more in taxes, donating more to charity, or shifting to a more conservative asset mix since he/she requires lower returns in the future (with Uncle Sam providing the saver with this added flexibility). With the Roth the saver pays his/her highest marginal rate NOW regardless of what future returns are realized.
So it seems to me the traditional tax protected accounts offer two additional benefits: 1) reduced risk resulting from uncertain future returns, and 2) added flexibility to adapt. Am I wrong in my understanding? What could I be missing?
Best Regards,
Paul
I think your points are valid, and one reason why the default strategy is usually to use a tax-deferred account during peak earnings years. But a super-saver as I have defined it is long past those sorts of concerns. If returns are low they’re still in the top tax bracket in retirement etc.
Paul,
I think you are on the right track – to the extent a person “falls on hard times” and they have to cut back on their spending due to a smaller Traditional account, you will most likely be in a lower marginal tax bracket overall.
You do however have to remember the traditional / Roth choice has very little to do with the expected growth rates of your account as what it mostly does is multiply or lessen your mistake or correct choice, which of course you cannot know in advance.
I think what you are getting at is you should not be afraid of “making more money” and having to pay more taxes. Most of my work indicates you are still going to have to fill up the lower tax brackets and that is going to favor the traditional side of the equation. Especially for someone that does not have a large pension or annuity.
biden wants to eliminate the stepped up basis
we are 69-70 with 4.5M in IRA-doing some roth conversions as legacy, but otherwise no effect on us
not unhappy paying 18% effective tax rate on 300k
don’t think the govt might go after the roth as well
sanders and warren want to lower estate tax exemptions as well
they gotta raise taxes to fund entitlements and the deficit
Not according to Modern Monetary Theory, which seems to be becoming more and more popular.
Wondering whether your perspective may change based on reports that the SECURE Act will be included in the year end spending bill (and assuming that it does pass/get signed into law)? Especially with the focus by many in this group on creation of generational wealth?
10 yr forced payout on remaining pre-tax IRA balances could be a real shame for my sons (I believe spouse continues to be able to take over their lifetime). Especially if it occurs during what were already their peak earning years…More things to discuss w Estate Attorney…
Not really. Reducing the stretch to 10 years doesn’t really affect the roth vs tax deferred decision much. Frankly, most heirs don’t wait 10 years anyway.
I am a doctor, an entrepreneur, and a supersaver.
I maxed out the alphabet soup of retirement accounts, and I even started some of these accounts before I was a doctor. 401k, 403b, 457b, SEP-IRA, tIRA, Keough plan, profit sharing plan. I did them all. I started a business, invested in the market and in real estate. Some things panned out more than others, but overall, things have worked unfathomably well for us. I never started a Roth account. My current marginal income tax rate is 46% (9% state and 37% federal).
I continue to work on my terms, see patients part time, manage my business, and we collect real estate income too. I anticipate retiring perhaps at 70, or perhaps never because as a business owner doing important and meaningful work, I get to define work however I want to define it.
Estimated assets at 70:
~10.5M tax deferred
~14M taxable
~5.5M real estate equity
~6M business value
No Roth accounts
Projected estimate of annual taxable income at 70 (assuming no business income):
SS 60k
Real estate 120k
RMD 383k
Dividend income 140k
Projected income tax at 70 (assuming no business income):
220k federal
46k state
266k total
Desired income at 70
360k spending and 266k taxes, total 626k
As of today I calculate FI at an overweight ratio of 30x spending. At age 70, I will be morbidly obese FI at an asset to spend ratio of 55 or more. Should I rollover my T-IRA and SEP-IRA to the 401k so that I can start a backdoor Roth? I know it is minimal for us, but the other question is large Roth conversions even at 46% marginal rates as it would reduce the estate tax exposure.
These questions are perhaps moot because we have accumulated so much.
Charitable considerations become bigger every year as the asset to spend ratio grows ever larger. We doubled our charitable giving this year, and we will keep increasing charitable contributions as the numbers grow ever larger.
The BD Roth doesn’t matter so much for you, but the Roth conversions sure will. I’d definitely do that but mostly for estate planning purposes!
The estate attorney said that supposedly the mega Roth conversions don’t matter all that much. We were told that if there is estate tax paid, that the amount of estate tax paid on tax deferred accounts then passes as a credit to the heirs for purposes of taking that tax credit against any income tax owed when they take the RMDs. The purpose of the tax credit is to avoid double taxation on the retirement accounts at death.
However, despite all of this, the idea of Roth accounts is quite psychologically appealing. Unfortunately, we don’t have any at the moment.
Interesting. I’ve never heard that before nor could I find anything on it with a quick Google search. Might want to double check it before relying on it as it seems pretty odd to me. Why would a tax assessed to one person/estate become a credit on someone else’s taxes? Doesn’t make sense.
But even if it is real, you lose the time value of money on it and the estate still has to come up with the money to pay the tax, which may require raiding tax protected accounts.
You probably have not heard of this double taxation credit because it has become so rare to face estate taxes for the overwhelming majority of docs.
From:
https://www.nolo.com/legal-encyclopedia/question-estate-tax-shield-ira-funds-28397.html
“But there is also an offsetting deduction for the estate tax that the beneficiaries can take on their personal returns. The estate tax and the offsetting deduction would not quite be a wash, but your beneficiaries would not be hit with a double tax, either.”
Interesting. Thanks for the resource. What tax form do you take the deduction on?
Jim,
It drops into Sch A under Other Misc deductions and is not subject to 2% limit. I tried it in 2019 H&R software and it drops into line 16 on Sch A.
It is an IRD deduction — Income in respect of a decedent and is taken as the money is withdrawn.
Dave
Jim,
If you want to know how the IRD deduction works, Micheal Kitces has a decent explanation here:
https://www.kitces.com/blog/understanding-the-irc-section-691c-income-in-respect-of-a-decedent-ird-deduction-for-the-beneficiary-of-an-inherited-ira/
Thanks. Always good to learn of new things.
For those following along at home, it’s in Pub 559 page 12.
Income that the decedent had a right to receive
is included in the decedent’s gross estate and is
subject to estate tax. This income in respect of
a decedent is also taxed when received by the
recipient (estate or beneficiary). However, an
income tax deduction is allowed to the recipient
for the estate tax paid on the income.
The deduction for estate tax paid can only
be claimed for the same tax year in which the
income in respect of a decedent must be included in the recipient’s income. (This also is true
for income in respect of a prior decedent.)
Individuals can claim this deduction only as
an itemized deduction on line 16 of Schedule A
(Form 1040). Estates can claim the deduction
on line 19 of Form 1041.
If income in respect of a decedent is capital
gain income, you must reduce the gain, but not
below zero, by any deduction for estate tax paid
on such gain. This applies in figuring the following.
• The maximum tax on net capital gain (including qualified dividends).
• The exclusion for gain on small business
stock under section 1202.
• The limitation on capital losses.