This article originally appeared in Aldrich Community, a client experience offering from Aldrich Wealth.
The pandemic triggered a tidal wave of changes for our clients, from a worldwide shutdown to emergency relief funding and so on. On the heels of these changes, a new administration entered the White House, bringing additional proposed changes to tax legislation. Naturally, some of the proposals prompted questions from our clients about the impact on their retirement and strategies they can deploy in anticipation of any or all proposals passing.
For two clients, a married couple, the potential tax bracket changes were their main focus. At ages 54 and 50, they had finally hit their financial stride. Both earned significant salaries and were finally able to double down on retirement savings with their children out of the house. Their worry was that high and increasing, income taxes now would prevent them from building a suitable nest egg.
While the conversation was tax-driven at the surface, the couple’s underlying concern was about maximizing the value of their investments for their retirement and for their heirs. Specifically, our clients were asking whether they should defer to a traditional 401(k) or utilize their ROTH 401(k) option. Typically, for people in high tax brackets now that expect their brackets to decline in retirement, it’s sensible to contribute pretax dollars to retirement plans by utilizing a traditional 401(k). That said, nobody knows for certain what rates will look like in the future, and in some cases, brackets don’t change in retirement. Given their significant pretax savings, we felt our clients had a good chance of being in that boat. Below are some of the strategies we shared with them as a result.
Diversify Account Contributions During Working Years
If you earn significant income and have already set aside pre-tax assets (traditional), it may be beneficial to devote some of your income to build up after-tax retirement assets (ROTH). In the case of married couples, one spouse can continue making pre-tax deferrals to their IRA or employer-sponsored plan while the other contributes to a ROTH account. While the switch from pre-tax contributions to ROTH will increase current taxable income, it creates complementary income buckets in retirement: the pre-tax bucket can be distributed over time, spreading out taxable income over the years, and the after-tax bucket can be distributed tax-free.
Above certain income thresholds, you won’t be eligible to contribute to a ROTH IRA. That said, a growing number of employers are allowing ROTH contributions to employer-sponsored plans like 401(k)s, which are a great vehicle for after-tax retirement savings and can eventually be rolled over into a ROTH IRA to avoid required minimum distributions, which we will cover more in depth shortly.
Make ROTH Conversions
You can also build up your after-tax retirement assets using existing pre-tax accounts in what’s called a ROTH conversion. ROTH conversions are most commonly used after retirement and before required minimum distributions begin. Income often declines in these years, so income in retirement may be subject to lower tax brackets than during working years. A ROTH conversion can be utilized to create just enough taxable income to fill up the lower tax brackets available. Finally, the account owner deposits those funds into a ROTH IRA, where any future growth is tax-free. While a bit less conventional, it might make sense to make ROTH conversions in working years even if the income earners expect a decline in tax bracket in retirement. Here’s why…
Avoid Forced RMDs
One of the most notable features of IRAs and qualified retirement plans is the required minimum distribution (RMD). At a certain age, currently 72, account owners must withdraw a percentage of the account value annually, and these withdrawals are subject to income tax. The larger the account, the higher the RMD, which means more taxable income and thus, higher tax rates. Furthermore, these RMDs often come when the account owner doesn’t want or need the income.
On the other hand, any contributions and subsequent growth in a ROTH IRA are tax-free if distribution criteria are met, as with a ROTH 401(k). As an added bonus, ROTH IRAs are not subject to the RMDs that IRAs and employer-sponsored plans [including ROTH 401(k)s] require, so the account owner is not obligated to take distributions until they are ready. This makes contributions to a ROTH IRA, or contributions and subsequent tax-free rollovers from a ROTH 401(k) to a ROTH IRA, more attractive.
Essentially, by hedging your bets and splitting deferrals between pretax and after-tax accounts, you still save for retirement while decreasing balances in your tax-deferred accounts, ultimately reducing RMDs.
Limit Social Security Benefit Taxability
As a form of taxable income, distributions from traditional IRAs or traditional qualified retirement plans may increase the portion of Social Security benefits subject to tax. As a reminder, Social Security benefits can be taxed up to a maximum of 85%.
Distributions from ROTH accounts are not considered taxable income, and thus do not affect taxability of Social Security benefits.
Limit Taxability for Heirs
Should you choose not to deplete the account in your lifetime, gifting ROTH assets increases the impact of the gift to your heirs. Not only will they receive an inheritance, but they will also avoid shouldering the burden of tax liability during the required drawdown period. Since the inheritance isn’t taxable income to them, as it would be with an inherited IRA, it won’t add to their earned income and related tax liability.
A Few Cautions
As we discussed, ROTH IRAs avoid several restrictions that plague other retirement accounts. That said, ROTH IRAs have a unique restriction that traditional IRAs and employer-sponsored plans do not: the 5-year rule. While contributions can be withdrawn from the account at any age, for any reason, the 5-year rule stipulates that the ROTH IRA account must be open for at least 5 tax years and meet age and/or purpose restrictions before any earnings and converted dollars can be withdrawn. Otherwise, the distribution will be taxable and possibly subject to penalties. When you withdraw from the account, the IRS considers any distribution to be taken in the following order: contributions (tax-free), conversions on a first-in-first-out basis (there is a new 5-year clock for each conversion), and finally earnings. With that in mind, we recommend that those who want to implement the strategies above “start the clock” by opening a ROTH IRA as soon as possible.
It’s important to note that the ROTH conversion strategy is most effective if you have funds available to pay the tax outside of the funds you are converting. If you cannot do so, you will be depleting your retirement savings to pay the tax, so the Roth IRA will need significant market growth to return to its pre-conversion value. This typically isn’t an advisable route for that reason.
As we shared with our married clients, whether a ROTH strategy is right for you depends on your unique financial goals and the makeup of your retirement income streams. The strategies above hinge on obtaining the highest investment balance from a wealth transfer perspective, as opposed to minimizing taxes in the near term. As a result, these strategies may not be applicable to everyone. If you’d like to explore opportunities such as these, we, your financial advisors, are here to identify strategies that make the most sense for you.