Nearly every educated financial advisor agrees that tax diversification is a great idea when planning for your distributions in retirement. Tax diversification means having some of your assets in tax-deferred accounts (fully taxed upon withdrawal), some of your assets in Roth accounts (tax-free upon withdrawal), and some of your assets in taxable accounts (earnings taxed at lower long-term capital gains/dividend rates, or tax-free in the case of municipal bonds). However, it can be very difficult to make recommendations as to what the ratio of one type of account to another should be. Here are some thoughts on determining what you are aiming for.
Controlling Your Effective Tax Rate In Retirement
The point of tax diversification is to control how much tax you pay and when you pay it. Consider a married retiree taking the standard deduction with a $1,000,000 traditional IRA and a $1,000,000 Roth IRA and no other source of income. He figures he needs $75,000 in after-tax income to maintain his standard of living. How much should he take from each account? There are an infinite number of combinations. Here are a few:
- Take all the money from the traditional IRA and allow the Roth IRA to grow for heirs. He would withdraw $83,585 and pay $6,770 in taxes, for an effective tax rate of 8.1%.
- Take all the money from the Roth IRA (this is only an option before age 70 1/2 when required minimum distributions must begin.) He would withdraw $75,000 and pay $0 in taxes, for an effective tax rate of 0%.
- Take $20,300 from the traditional IRA and $54,700 from the Roth IRA. He would withdraw $75,000, pay $0 in taxes, have an effective tax rate of 0%, lower future RMDs, and preserve $20K more in the tax-free Roth IRA. Is it becoming clear yet why tax diversification is a good thing?
- Take $38,450 from the traditional IRA and $38,365 from the Roth IRA. He would withdraw $76,815 and pay $1,815 in taxes, for an effective rate of 2.4%.
- Take the RMD from the traditional IRA (if he is 70, this is 1/27.4 or 3.65% of the balance of the account, or $36,500) and $40,120 from the Roth IRA and pay $1,620 in taxes for an effective rate of 2.1%.
- Take the maximum amount of income allowed without making your Social Security income taxable ($32,000 for married filing jointly) and $44,170 from the Roth IRA, for a total withdrawal of $76, 170, a total tax of $1,170 for an effective tax rate of 1.5%.
Take Home Points From That Exercise
I want you to notice a few take-home points from that exercise.
- The difference between your marginal tax rate now and your effective tax rate later on withdrawals from tax-deferred accounts can be dramatic.
- Having a Roth account of significant size in retirement gives you a ton of options and can lower your tax bill significantly.
- There are a lot of factors that go into this decision of how to withdraw from accounts of any given size, and these need to be considered when deciding the ratio of Tax-deferred to Roth to Taxable you are looking for in retirement.
Methods of Increasing Your Roth to Tax Deferred Ratio
There are several methods of increasing your Roth to Tax Deferred Ratio. One way that most physicians ought to be taking advantage of is to make a personal and spousal Backdoor Roth IRA contribution every year. Another way is to make Roth 401K and Roth 403B employee contributions instead of tax-deferred employee contributions. This comes with the downside of raising your taxes while working, and probably raising your overall lifetime tax bill (at least when accounting for the time value of money.)
The Mega Backdoor Roth IRA is an option for a few. Another great option is Roth conversions. These can be best done in years when your taxable income is low, such as sabbaticals, deployments, while working part-time, while living in a low income-tax state, or after retirement but before taking Social Security. Converting money at 0%, 10%, and 15% rather than later withdrawing it at 25% or more is obviously a smart move.
Don't Forget State Taxes
State income taxes are also a factor to keep in mind. The higher your state taxes, the worse of an idea making Roth contributions instead of tax-deferred contributions or doing Roth conversions may be. If you're working in New York City or California, but plan to retire to Florida or Texas, withdrawing tax-deferred contributions in retirement won't be nearly as painful. If you plan to stay in your high-tax state in retirement, the arbitrage between your marginal tax rate while working and your effective tax rate in retirement is larger than for someone in a low-tax state.
The Taxable Account
Taxable accounts make these decisions even more complicated. One of the most important factors is the basis on those investments. If your basis is high, you can “withdraw” a lot of money from your taxable account while paying a very low amount of taxes on that money.
For example, if you sell $50K in stock to spend in retirement, but the basis on that stock is $45K, then your tax bill on that money will be only $750 ($5K*0.15%) for an effective rate of just 1.5%. On the other hand, if the basis were just $5K, your tax bill would be $6,750, an effective rate of 13.5%. This factor suggests that taxable account contributions should be less of a priority early in your career as compared to tax-protected accounts.
Current law provides for a better benefit for a taxable account. If you can keep your marginal tax rate to 15% or less, your long-term capital gains and qualified dividend tax rate is just 5%. So if your investments kicked out $10K in distributions, and you sold another $40K of stock with a basis of $20K, your taxes on that $50K could be as low as $1,500, for an effective tax rate of just 3%. Possession of a taxable account of significant size is yet another reason to try to limit the size of tax-deferred account withdrawals in retirement.
Pensions, Individual Retirement Annuities, Income Property, and Working In Retirement
The largest benefits of using tax-deferred retirement accounts to save for retirement accrue to those who have no other income in retirement. They can then use their withdrawals to “fill-up” the 0%, 10%, and 15% brackets. However, if you have significant other taxable income from pensions, IRAs that you converted to an SPIA, paid-off investment properties (although this income can still be sheltered somewhat if you are still depreciating the property), or heaven forbid a job at Wal-Mart, this income will fill up those brackets. If you made 401K contributions at a marginal rate of 33%, then later withdraw the money at an effective rate of 33%, your only benefit of using the account was the much smaller benefit of tax-deferred growth.
Social Security Taxation
One of the most troubling aspects of determining the ideal Roth to Tax-deferred to Taxable ratio is the phase-out range for Social Security taxation and its effects on your true marginal tax rate. If you can keep your taxable income under $32,000/$25,000 (married filing jointly/single) then your Social Security benefits aren't taxable at all. If your income is over $44,000/32,000 (married filing jointly/single) then a maximum 85% of your Social Security benefits are taxable at your regular marginal tax rate. Within this range, your marginal tax rate can be as high as 46%. Contributing money to a 401K at a 33% marginal rate, and withdrawing it at a 46% marginal rate is a losing formula if there ever was one.
Some Rules of Thumb
Obviously, this process is very complicated. There simply is no rule of thumb of what percentage of your retirement assets should be in Roth, traditional, or taxable accounts. However, here are some general guidelines for both the accumulation stage and the distribution stage.
Accumulation Stage
- Residents should go Roth. Early in your career, such as during residency and fellowship, contribute preferentially to Roth accounts (Roth 401(k)s, Roth 403(b)s, and Roth IRAs.
- Max out your personal and spousal Backdoor Roth IRAs each year. You are not comparing these to a tax-deferred account, but rather to a taxable one, and the Roth account is far superior to a taxable one, not only for the tax-protected growth, but also the tax-free withdrawals.
- Convert taxable + tax-deferred assets to Roth assets during low-income years. You don't necessarily want to use tax-deferred money to pay the taxes on a Roth conversion, but if you have money from current earnings or a taxable account (especially with high basis) to pay the taxes, you can increase your Roth percentage without too high of a tax bill.
- Read your 401K document to see if a Mega Backdoor Roth IRA is an option for you.
- Roth money is better than tax-deferred money, but you generally don't want to pass up opportunities during your peak earning years to contribute to tax-deferred accounts. Exceptions to this rule are noted in 6 and 7 below.
- If you expect to be in the top tax bracket in retirement, make Roth 401(k)/403(b) contributions preferentially, or take advantage of the Mega Backdoor Roth IRA variation using a SEP-IRA.
- Consider Roth 401(b)/403(b) contributions if you have a very low Roth to Tax-deferred ratio. The flexibility may be worth losing the tax arbitrage.
- If you expect significant taxable income in retirement (real estate investments, pensions etc), such that the lowest tax brackets will be filled before you get to your tax-deferred withdrawals, then make more Roth contributions and Roth conversions now. If there is no tax arbitrage, Roth accounts are just as useful as tax-deferred accounts, and you can put a lot more money into them when considered on an after-tax basis.
- If you expect huge RMDs in retirement (the RMD is 5.3% at age 80) due to huge tax-deferred accounts, then start converting. An orthodontist on Bogleheads recently noted his RMDs were larger than his salary when he was working. I'm not sure if he adjusted for inflation, but you probably don't want to end up with a traditional IRA larger than $2-3 Million in today's dollars (RMD at 80 = $106K-159K.) Truly a first world problem, but the larger your retirement stash, the higher your Roth to tax-deferred ratio ought to be.
- Consider easing into retirement if possible with part-time work, allowing you a few years of lower earnings to increase your Roth to tax-deferred ratio using contributions and/or conversions. Filling up the 10% and 15% brackets with Roth conversions is generally considered a smart move.
- Use proper asset location strategy to maximize the size of retirement accounts. Although it is nice to have tax-inefficient assets in tax-protected accounts, you must also take into account the expected return of the asset when determining appropriate asset location. Putting high expected return assets preferentially into Roth accounts over tax-deferred accounts is really just taking on a more risky portfolio when considered on an after-tax basis, but it does serve to increase the likely Roth to tax-deferred ratio.
- Taxable accounts are better if the basis is high. Contribute to taxable accounts only after the other accounts are already full. To suggest otherwise is generally bad advice. It would be a very rare person who should preferentially contribute to a taxable account (at least for retirement purposes) instead of a tax-deferred one. It is easy to get to tax-protected money without penalty before age 59 1/2.
Distribution Stage
- Delay Social Security to age 70 (although if married, the lower-earning spouse should take theirs earlier). Aside from the obviously larger payments and better longevity insurance, this allows you some years between retirement and receiving Social Security to do some Roth conversions. Filling up the 10% and 15% brackets with Roth conversions is generally considered a smart move.
- Determine how close you will be to the Social Security taxation range. If you're way over, no big deal. If you're easily under, good for you (although it might not be that comfortable of a retirement.) If you are anywhere near that range, a careful withdrawal strategy is critical to avoid ridiculously high marginal rates.
- There isn't much you can do about RMDs once you hit age 70 1/2. That will be your minimum tax-deferred withdrawal. Might as well pay your taxes and spend them. Only if you have a very high ratio of tax-deferred to Roth and taxable accounts do you need to consider taking your RMDs and investing them in a taxable account to ensure you don't run out of money.
- Use your Roth IRA to keep you in a lower bracket. Try to fill the 0%, 10%, 15%, and (depending on the level of assets) even the 25% bracket using tax-deferred money. Any additional money needed above that can come from the Roth.
- Taxable accounts can also be used to keep you in a lower bracket.
- Spend the taxable assets with high basis first. Not only does it lower your tax bill, but it maximizes the benefit of the step-up in basis at your death.
- Your heirs will prefer a Roth IRA to a taxable account and a taxable account to a traditional IRA. That said, if your heirs are poor, the overall tax burden may be lower if they pay the taxes on traditional IRA instead of you. Besides, beggars can't be choosers. They should be grateful for whatever you leave them.
- Charities, however, are perfectly fine with a traditional IRA. They don't pay taxes anyway. So when doing estate planning, leave the Roth and the taxable to the kids, and use the traditional IRA for any charitable bequests. If you wish to maximize the amount left to kids, spend the tax-deferred money. If you wish to maximize the amount left to charity, spend the Roth and taxable money.
I hope those 20 rules are helpful to you in deciding how to acquire maximal tax diversification in retirement, without paying unnecessary taxes now. What do you think? Did I miss anything? Any questions? Comment below!
Phenomenal post. A lot to think about. Has anybody out there taken a year off or purposefully worked less to take advantage of Roth conversions and other tax benefits? Obviously, not the main reason to spend a year with Doctors Without Borders, but could be an interesting fringe benefit.
great post! i was under the impression that long term capital gains/qual dividends are taxed at 0% if one ends up in the 15% or lower tax bracket?
Yes. Might be tough to stay there without kids or a mortgage and while getting SS income though.
What a wonderful post! I have been trying to wrap my head around this very topic for the last couple of weeks. Thanks (again) for putting it all together for me!
This is a great topic and as you mentioned can be very confusing due to the numerous options. Is there a particular source or book that you would recommend for a better understanding of these issues? Furthermore, is there a particular advisor that you would recommend to help someone with these issues since they are so individually specific?
I don’t know of a book, unfortunately. Nor do I know of any particular adviser specializing in this subject. However, any good adviser ought to be able to help. Have you seen my list of recommended advisers here:
https://www.whitecoatinvestor.com/websites-2/
Hi Mark,
As White Coat Investor says, there isn’t a book (aside from this blog, which I always read for ideas and inspiration) that deals with all of these strategies. They are all individualized, and have to be implemented at the right time for each individual/family. Majority of ‘financial planners’ are asset aggregators, so very few will take the time to do the actual planning. We do not charge any asset-based fees, and we do not do 100-page ‘financial plans’ that are dead on arrival, instead concentrating on working with each individual to address their entire financial situation proactively and in an ongoing fashion, all for a flat monthly fee. We specialize in working with medical professionals, and one of our concentrations is setting up retirement plans for small medical and dental practices.
WCI,
Great post with a few income tax “clarifications”:
1) For a married couple both age 65 or older, the standard deduction for 2013 would be $14,600 and with two personal exemptions of $3,900 the first $22,400 (as opposed to your figure of $20,300 in example 3) would be tax free.
2) As an earlier responder noted, at the 15% marginal tax bracket, both long term capital gains and qualified dividends are taxed at 0% rather than 5%.
And even staying with the Standard Deduction, a married couple (assuming both are age 65 or older) could have a total income of $94,900 ($72,500 plus $22,400) before hitting the 25% marginal tax bracket.
3) Your example 6 is a little bit misleading. How much of Social Security is subject to Federal tax is computed by first adding 50% of the total Social Security yearly benefit to the couple’s other income and only if that computed figure exceeds $32,000 for a Married Filing Jointly couple, is any of the Social Security subject to 50% tax; but, another good reason for a higher earning to spouse to “file and suspend” at Full Retirement Age, and have the lower earning spouse take a spousal benefit beginning at his or her Full Retirement Age (I am assuming that both spouses are close in age).
Thanks for being a wonderful tax and financial and investment resource.
Sam
I think you are not quite correct. You said “only if that computed figure exceeds $32,000 for a Married Filing Jointly couple, is any of the Social Security subject to 50% tax”
I think you meant only if that computed figure exceeds $32,000 for a Married Filing Jointly couple then up to to 50% of the Social Security may be subject to tax.
Jon
Great point! The standard deduction IS higher for people over 65 (and blind people.)
Also a good point, which others are making, about combining 1/2 of the SS income with the other taxable income.
I should probably fix this article, although I don’t think it changes any of the conclusions.
Excellent post. Very succinct.
Doubtful many physicians will have zero earned income beginning immediately upon retirement.
All sorts of wonderful deductions for earned income, especially 1099 income.
You can’t deduct HSA contributions, CME trips, auto deductions/depreciation, meals and entertainment from capital gains, 401k or IRA withdrawals.
I’m about to finish residency. Because I didn’t discover WCI early enough, I used my program’s 403(b) instead of maxing out Roth during my 3 years. I have about 16k in it. Does anyone think it’s worth it to roll that into my Roth when residency ends, rather than into my new 401(k) (if that will even be an option)?
Yes, the year you graduate from residency is a relatively low income year, and a great year to do a Roth conversion.
I also have been thinking this exact scenario over. In addition to the 401(a)/403(b) employer plans, I have a SEP-IRA I’m considering converting during fellowship.
While I understand the advantage of doing a Roth conversion while at a lower (assuming 25%) marginal tax rate, might there be an advantage in converting later in one’s career when his/her savings goals might exceed tax-advantaged options (401k, IRA, etc)?
Especially if, as in my case, the cost of the roth conversion during fellowship may preclude maximizing my contribution to my HSA, SEP-IRA, and perhaps even the Roth itself for the tax year I convert.
Consider earnings of ~250k, W2 employment. With a savings goal of $50,0000 (~20%), tax advantaged space (401k, HSA, IRA) may be exhausted, necessitating use of a taxable account. Obviously other factors make this scenario dynamic (spouse, 1099 employment, employer match).
However, in the above scenario might one alternative to investing to a taxable account be roth converting eligible accounts, effectively expanding ones tax-advantaged investment?
If so, then perphaps money saved to convert might otherwise preferentially utilized during fellowship in maximizing tax-advantaged contributions, even if pre-tax, to effectively increase the amount available to convert during years where taxable investing might otherwise be necessary, even if the later conversion would take place at a higher tax rate?
More simply, is minimizing costs of taxable investing relative to tax-advantaged vehicles worth converting at a higher marginal rate?
I hope I have explained myself clearly enough for any comment/advice, and appreciate any wisdom offered!
Yes. If you know you’re going to be doing a lot of taxable investing later, then maximizing tax-advantaged space now can be very beneficial, and might even be worth paying a bit more in taxes.
Accumulation #6″ “take advantage of the Mega Backdoor Roth IRA variation using a SEP-IRA”
Is there a reason you would do a Mega Backdoor Roth with a SEP-IRA vs a TIRA?
The SEP-IRA/TIRA is just a pathway to get the Mega Backdoor out of your 401k and into a Roth IRA…or am I missing something?
I don’t think you’re quite getting it. The point of #6 (for those expecting to be in the top bracket in retirement-i.e. NOT MOST DOCTORS) is that those in the top bracket in retirement won’t get much of a tax rate arbitrage between contribution and withdrawal. So you’re better off doing Roth now instead of traditional. One way to do that is to use a SEP-IRA, converting it to Roth each year. While similar to a backdoor Roth IRA, it is somewhat different- more money and taking money that is pre-tax and converting it to Roth instead of a relatively small amount of after-tax money with the Backdoor Roth IRA.
Rather than taking money out of a Solo 401(k), you’re just putting it into a SEP-IRA instead, and then immediately converting it. It won’t work for an employee, only an owner.
Does that help?
I was conflating this (no tax arbitrage) version you describe here with the previous version you described a couple of posts ago where I was converting after-tax 401k contributions -> TIRA -> Roth IRA in order to do a “Mega Backdoor IRA” (adding 34.5k extra to the Roth IRA early).
Maybe the term “Mega Backdoor IRA” is getting overloaded. Or I’m just dense. 🙂
strike the word “early” from “(adding 34.5k extra to the Roth IRA early)” smart phone auto-completion typo.
Then if you’re just using it for a rollover, you don’t need a “SEP-IRA”. A “traditional” or “rollover” IRA is just fine.
Without a doubt the best write-up I’ve seen on this topic. Thank you!
Hello,
I’m new to the site over the last couple weeks and think it is fantastic information, very useful. Thanks!
One question regarding building “Roth” accounts. How is one able to convert taxable accounts to Roth (#3 under the Accumulation Stage)? I have been maxing out personal and spousal Roth accounts during residency (2 months to go); and plan to continue via the backdoor Roth as well as by maxing out my soon to be new HSA. Otherwise, I will be starting a 401K with the new job, for tax deferred contributions and will become eligible for profit sharing – which if my understanding is correct, are tax deferred savings as well.
Are all 401K accounts eligible to be Roth 401Ks? Or do they have to be offered as such by employer? Is converting regular taxable accounts to Roth variants an option? If so, how?
Thanks Again!
1) The way to convert taxable accounts to Roth IRA money is to do conversions on tax-deferred accounts. For example, if you were graduating from residency with $10K in a 401(k) and $10K in a taxable account, you could, upon separation, convert your entire 401(k) to a Roth IRA. That might cost you $2500 in taxes. You use $2500 in taxable money to pay those taxes. Voila, you have converted taxable money to Roth money. Does that help?
2) Not all 401(k)s have a Roth option. It has to be offered by the employer.
That is helpful, however one follow up question…
Is someone who already has been funding a Roth IRA eligible to do this?
For example, if I have been funding a Roth IRA (via the Backdoor Roth) throughout my career, as well as tax deferred contributions to a 401K, towards the end of my career, say while working part time (lower income / lower tax rate), can I convert (add) the 401K money to my Roth? Understanding that I will have to pay taxes on the total amount converted (as it was originally pre-tax money). If so I am assuming that “conversions” are considered entirely separate from “contributions” and the annual limits. Finally, does the entire account need to be converted or can this be done on a percentage of the account?
Is there an article on Roth conversions I should reference?
Thank you very much for your time and knowledge!
That’s correct. There is no limit on conversions and you can convert $2 Million+ in the same year you make Roth 401(k) and backdoor Roth IRA contributions. You can just convert a few dollars a year. What you can’t do is just convert after-tax dollars, it all must be done pro-rata.
This article might help:
http://www.bogleheads.org/wiki/Roth_IRA_conversion
Remember you usually have to separate from your employer before you can rollover or convert your 401(k) money. But that is plan specific.
Another great article WCI. Like all rules of thumb, something to consider, but not blindly rely on. Without being able to predict the future, it’s rather difficult to know the exact allocation. As you mention, the number one take away is having options. Tax laws will change, and therefore your plan most adopt. Another reason not only do you need a skilled planner, but also a competent tax planner. You can’t escape taxes, you can only hope to keep more in your pockets! Although I’m looking forward to reading Capital by Thomas Piketty to see if my thinking is off.
Awesome post. I just found your website and I am really loving it. I am very interested in personal finance and want to learn as much as I can before my husband gets out of residency.
My question is, should my husband and I start funding a Roth IRA while he is in residency? A little background – my husband is a radiology resident, about to finish his 4th year of residency. He has one more year here, and then we will move for his one-year fellowship. So, two more years to go!
We have always saved 20% of his income from the beginning (I’m a SAHM of 3). We have about 30k in savings right now. I would love to fund a Roth IRA while we still can (although I just learned about the backdoor Roth on your site!). However, my husband likes to have all that money liquid so that we can use it for emergencies, and for moving expenses next year. I agree that we should have a lot in savings, but I also feel strongly about the Roth! We would have two more years to fund one before he starts making too much money. We will continue to save 20% each year, so it’s not like the money won’t come back into our savings (barring any huge emergencies, I guess).
Would love to hear your input!
20% as a resident is awesome, but please, put it in a Roth! You can always withdraw the contributions without penalty anyway, so the money is still liquid, just in case.
If you are going to need the money sooner than later be careful with how that money is invested within the Roth. You don’t want the market to correct and now you only have part of your money. Although the Roth is accessible I would only use if you have no other options. Make sure you have plenty of savings, especially with a transition on the horizon!
WCI: Great site and great book, I have recommended both to my colleagues. I wish I had followed your suggestion that you have in your book about doing your own taxes, when young. I am not getting the same results as you post in the tax liability for you scenarios. Are you using 2013 or 2014 tax dedcution/exemptions? I would find it helpful if you could show the math in your scenarios.
If you can point out where it doesn’t make sense, I’ll take another look at it. I honestly can’t recall which year I used. I wrote this post months ago, so probably 2013.
Take the first scenario, withdraw $83,585 2013 personal exemption $3900(x2) =$7800, Standard deduction $12200, Additional deduction for greater than 65 =$1200 (x2)=$2400 so reduces income to $61185. For 2013 married filing joint 0-$17850 at 10% = $1785. $61185-17850= $43335 at 15% = $6500. 6500+ 1785 =$8285. Am I doing something wrong?
I probably didn’t do the extra deduction for older than 65.
This comment is a bit late but I’m working on a post about Roth 401ks and came across your article. I, too, am a big fan of tax diversification! One note- Roth IRAs do not have RMDs during the life of the original owner (as stated in example #2 at the top). https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions
I’m very much aware of that. I think you misread what # 2 said. It was saying you could just pull all your spending money out of a Roth IRA until you get to age 70 1/2, at which point you would have to pull some from a traditional IRA due to the RMDs.
BTW- Roth 401(k)s do have RMDs, so if you don’t want to take them, be sure to roll it into a Roth IRA.
We have about $2,000,000 in tax deferred savings ( profit sharing, iras, 401-k and sep-Iras) and $7 million in non tax deferred liquid assets ( homes not included and no Roth IRAs ). We expect to spend 200-250k annually in early retirement, after that likely less. Anticipate retiring /semi-retiring within next three years .
Are you aware of a any good software that could estimate my average taxation during retirement ? Once that is known we can get a better handle on how much we can safely draw down
By way of example, At 3% annual draw down we gross (before taxes) 270k plus 33k in social security. At 10% tax we have a spend of 270k but at 40% tax that spend drops to to 180k, less than our spend goal. ( We could safely draw down 3.5% ( according to ERN site) but want to leave inheritance fir charity and children
Our accountant states his clients in our circumstances have an average tax of about 20% but no formal analysis was ever done
How about Turbotax? That’s what I would use. But this shouldn’t be that hard to estimate. You probably want to do some Roth conversions, which will cost you more in tax in the early years. You don’t mention your age, but if we assume under 70 and you don’t do Roth conversions then you’re probably going to take all $200-250K out of the taxable account to start with and delay SS to 70. Some of the income might be from muni bonds, so that’s tax free. You get at least the standard deduction and exemptions, so that’s $20K that’s tax-free. Some will also be withdrawal of principle, so that’s tax free. The rest gets taxed at 15%. Let’s say $100K is tax-free and $150K is taxable at 15%. That’s about 10% overall. Doesn’t seem too tough to get there in your situation. But I’d probably pay some extra tax in the early years to do some Roth conversions in your situation.
Lovely post.
i’m very new to this retirement plan business.
I have a little bit of trouble with scenario #3.
Can you please do the math for me. Apologize for being mathematically challenged.
It’s basically saying the first taxable dollars you have each year are covered by the standard deduction (and the old exemptions that are now gone.)
But what are some reasonable actual Roth to pre-tax ratios to aim for?
For example, if one were to contribute $19k to pre-tax and $6k to Roth, the pre-tax to Roth ratio is about 0.3. Should the average doctor (likely to be working at least part time in “retirement” to avoid boredom) try to do conversions to get to 0.5? 0.7?
I wouldn’t “aim” for anything. I’d do Roth contributions when they make sense. I’d do Roth conversions where they make sense. Then I’d deal with the consequences.My Roth to traditional to taxable ratio used to be 100:0:0. Now it’s 10:30/60. What am I going to do? I’m not going to make Roth contributions that don’t otherwise make sense.
Thank you! That makes sense. Your ratios seem similar to my predictions if I try to get more conversions done now. It just isn’t totally straightforward – as you have pointed out – to decide when Roth contributions make sense, given uncertainty about future tax rates and ROI. But I think in general we need more Roth money and our taxes are only middling-high and so we will bite the bullet and do a conversion this year with maybe more in the future.
“Just make sure you are doing the Roth conversion for the right reason. Those reasons can be one of many such as you expect higher tax rates in retirement or that you just want to diversify your tax situation.”
Read on to see why I think I might be expecting higher tax rates than the usual 10-12%, but I’m unsure that’s why I’m asking.
Per Kinglinger, “What is the ideal mix of Taxed Always, Taxed Later (Deferred) and Taxed Rarely? Like so many things, there is no right answer for everyone. The ideal mix relates to your goals and milestones.”
https://www.kiplinger.com/article/retirement/t055-c032-s014-tax-diversification-an-untapped-resource-for-wealt.html
In my specific case, I’m in California.
You add that the tax bite of ordinary income from a TIRA would be greater in California as compared to a state with lower income taxes.
Do you have a suggestion for a middle-income family moving up to the 22% marginal tax bracket in 2022, may one day move up to the 24% bracket?
Expected gross wages $130k. We may have our Supplemental Social Security continued which gives us about an additional $16k.
We have a newborn child as of 2021.
I’m unsure whether estimating my future tax-deferred balance is necessary in tax planning and how that affects the timing of contributing to a TIRA versus a Roth, but retirement calculators say I have a 99% probability of retiring with $2.5M – $3M at 65.
“you probably don’t want to end up with a traditional IRA larger than $2-3 Million in today’s dollars”
This is assuming I never increase the amount of savings into my accounts each year, which in reality is unlikely because we’ll get raises/promotions/increase in rental income/increase in dividend income, etc.
My biggest question is what happens if through saving/investing and potentially even a reasonably large inheritance I end up with a large TIRA balance in retirement. Let’s say $25M. The RMD on that balance would be nearly $1M, putting me in the highest tax bracket.
In comparison to my marginal tax bracket now and even later on in our careers, we’re probably going to be in the 22% to 24% tax bracket.
I mistakenly contributed to a TIRA when I was in the 12% bracket the past 7 years. If we’re moving up to the 22% bracket next year, does it make sense to keep contributing to a TIRA/traditional 401k, Roth IRA/401k, or a combination of both?
Would a Roth conversion be warranted at this time or in the future?
To stay in the 24% tax bracket in retirement, our TIRA balance can be no larger than $7,740,160 due to RMD’s. This is also taking into account our SS benefit will be $55k a year if we start to take it at age 70. I’m not 100% sure if the benefit amount is correct, though.
Correct my math if I’m wrong, I’m no math whiz.
So, if our portfolio exceeds the nearly $8 million threshold I just mentioned. How should we approach the our tax diversificiation over the span of our careers.
Like I said, I don’t know if I will retire with $2-3M, $8M, or $25M, but I’ll just say my wife is late 20’s, almost 30, I’m early to mid 30’s and I believe our net worth is in the top 2 percentile for our age.
Also, having a large taxable account balance together with large TIRA balance can be a double whammy.
This phenomenon is a possibility for us.
I plan to invest exclusively in non-dividend paying companies, such as Brk.B, to address the unfavorably high tax environment in California.
We also will have at least one rental house or more. There is also the possibility of renting part of the house we live in. In either case, my point is there will likely be rental income as well but that can be partially dealt with through depreciation, etc.
Would I try to target a balance in my TIRA that would limit my retirement income to the 10%, 12% or even 22% – 24% tax bracket?
I almost assumed by default that I would be in the most common situation most people are in which is being in the 10% or 12% brackets, but I get the feeling that will not be the case.
Considering Social Security, our taxable income will probably result us in being fully taxed and I’m not sure how to address that. I don’t have a good understanding of the tax portion of SS.
“Consider easing into retirement if possible with part-time work, allowing you a few years of lower earnings to increase your Roth to tax-deferred ratio using contributions and/or conversions.”
My wife does hope to transition to part-time work, potentially, later on in her career.
“Use proper asset location strategy to maximize the size of retirement accounts. Although it is nice to have tax-inefficient assets in tax-protected accounts, you must also take into account the expected return of the asset when determining appropriate asset location. Putting high expected return assets preferentially into Roth accounts over tax-deferred accounts is really just taking on a more risky portfolio when considered on an after-tax basis”
Not sure what this means since I never did a Roth conversion yet, but I’m assuming investments made using contributions to either TIRA or Roth are invested in certain types of stocks. Like I said, I generally plan to invest in dividend stocks in an IRA/Roth IRA and non-dividend payers in a taxable account to address California’s high taxes.
“Use your Roth IRA to keep you in a lower bracket. Try to fill the 0%, 10%, 15%, and (depending on the level of assets) even the 25% bracket using tax-deferred money. Any additional money needed above that can come from the Roth.”
Spend Roth money that was ideally taxed at a lower rate if distributing TIRA money would push you to a really high bracket?
“Taxable accounts can also be used to keep you in a lower bracket.”
How? If the RMD amount is low enough, you can be taxed at LTCG rates of 0% or 15%?
Not sure what you’re asking here, but if you’re in the 22-24% bracket now and expect a $25M IRA in today’s money then I would definitely go Roth on almost everything.
85% of SS income is taxed at your ordinary income tax rates for people in your situation.