Conventional wisdom suggests you should save everything you can in tax-deferred retirement accounts to minimize taxes in the current year. For many, that may still be good advice. Certainly, you should be saving everything you can for retirement. But for higher earners who save a lot, this may prove to be bad advice. Why?
Snowballing Tax Liability
First, tax-deferred savings have an associated tax liability that you will have to pay someday, at a minimum when you start taking Required Minimum Distributions (RMDs) at age 72. That liability continues to grow through contributions, employer matches and your investment return. Over time, this tax liability can snowball.
For example, imagine a couple aged 40 who have saved $500,000 combined in pre-tax 401k accounts. By all accounts, this couple is tracking well for a secure retirement. They keep contributing the maximum amounts each year ($20,500 each through age 49, then $27,000 from age 50 to 64), and each get a $6,000 employer match. For simplicity, assume contribution limits don’t rise. They are in a growth allocation that earns an annual 7.0% return. By the time they retire on their 65th birthdays, their 401k accounts will have grown to an impressive $6.4 million! They’re in great shape, right?
Again, for simplicity, assume they don’t draw down their pre-tax savings early in retirement, so tax-deferred savings grows to $10.68 million by age 72, when they take their first RMD of $389,731! That’s considered taxable income, on top of any income they may receive from Social Security, pensions or other sources. The RMD grows to $473,702 at age 75, $646,519 at age 80, $866,273 at age 85 and $1.1 million at age 90.
Do you think they may have a tax problem in retirement?
Medicare Means Testing
But the story doesn’t end there, and it gets worse. If you’ve saved a lot in tax-deferred retirement accounts, your RMDs are likely to trigger Medicare means testing surcharges (a tax by a different name) during retirement in the form of higher premiums on Medicare Part B and Part D. The couple in our example above are likely to face hundreds of thousands of dollars of means testing surcharges over retirement. You can read more about this issue in my ground-breaking white paper.
Future Tax Rates
A third consideration is where future tax rates are going. Current tax rates are near historical lows and may be the lowest we’ll see for the rest of our lives. Consider solvency issues with Social Security and Medicare, chronic infrastructure issues, exploding deficits, climate change, and pandemics. Each of these issues in isolation will require a lot of money. And that doesn’t even account for the agenda being pursued by many politicians to tax the wealthy more. Simply put, paying taxes today may be a bargain compared to deferring (and growing) your tax liabilities into the future.
Tax Burden for Heirs
The 2019 SECURE Act eliminated the stretch IRA, which allowed your heirs to stretch out RMDs from inherited IRAs over their projected life expectancy. Under the new law, RMDs for inherited IRAs no longer exist, but the entire account must be depleted within 10 years. All withdrawals are taxed as ordinary income at your heirs’ marginal tax rate. Our young couple above are projected to have tax-deferred assets of $13.3 million by age 90, even after distributing more than $13 million from their accounts through RMDs. If the couple has two children inherit these accounts, each kid will inherit $6.6 million in tax-deferred assets. If the accounts don’t grow at all once inherited (unlikely), and the kids spread out distributions evenly over 10 years, they’ll each have $665,000 of taxable income every year, just from their inherited IRAs. Clearly this is a first-world problem, but do you want your kids to inherit that kind of tax burden?
These are not tax issues unique to the super-rich. The couple in this example are upper-middle class, and are simply good savers doing exactly what conventional wisdom has suggested they do. But they clearly need to plan a longer-term tax and financial planning. Yet few financial advisors and CPAs are providing good advice on these issues that balances the goals of minimizing taxes today and in the future.
The solution to these issues typically requires implementation of a complex, multi-year plan. Some of the strategies I use with my clients include the following:
- Save in Roth Accounts. Shift retirement savings contributions from pre-tax 401k and IRA accounts to after-tax Roth 401k and IRA accounts. You’ll lose the tax deduction in the current year, but your tax-free savings will snowball into the future in a good way. This is usually the easiest strategy to implement. It’s even more impactful for younger savers who don’t earn as much (the reduced tax deduction won’t sting as much) and who will have more years of tax-free growth. Note that 401k plans do not have an income limit. Most people I speak with aren’t aware they have a 401k Roth, so find out if your plan offers a Roth option. If your income is low enough, you can also save in a Roth IRA (eligibility in 2021 phases out beginning at $198,000 of modified adjusted gross income for married filing jointly).
- Save in HSA Accounts. If you have a high-deductible medical plan, contribute the maximum amount ($7,300 in 2022 if married) to the associated Health Savings Account (HSA). But pay medical expenses out of pocket (not from the HSA account) and invest the account so it grows to cover medical expenses in retirement. An HSA account is one of the few accounts where you get a tax deduction on contributions and money is tax-free when withdrawn (for medical expenses).
- Roth Conversions. A Roth conversion involves transferring money from an existing tax-deferred account to a Roth account. The transfer amount usually is fully taxable as ordinary income. This is a good strategy to consider in low-income years, especially for people who retire early in their 50s and early 60s who may have several years to do conversions before RMDs and Medicare means testing surcharges kick in.
- Asset Location. This refers to placing different asset classes into different tax buckets, such as placing all of your bonds in tax-deferred accounts and investments with the highest expected returns (for example, small value or emerging market stocks) into tax-free Roth accounts. The net effect is that your tax-deferred accounts will grow more slowly (and hence so too will your future tax liability), while your tax-free accounts will grow the most. Few investors have even heard of asset location and it can be hard to implement, but it can make a big impact over time on your after-tax wealth.
Sometimes conventional wisdom can lead you astray.