Source: Google from Retirement Planning website
“Bulls Make Money, Bears Make Money, Pigs Get Slaughtered”
This is part II of an article I wrote earlier this year that received a lot of attention called The Risk Of The Roth IRA Revolution, which you can find by clicking this link. The previous article dealt with trying to figure out what is the right size for your Roth. In the end a strong case can probably be made that most people don’t need much of a Roth at all from the mathematical point of having more spendable income in retirement. By the end of this article I hope that it will be clear why I have been “pounding the table” to not oversize your Roth, but let’s not get ahead of the story. In this part two, I will suggest by example why many may be applying their Roth funds in a manner that may be less than optimal for them. If you are concerned your spendable money in retirement is marginal, you certainly want to try and maximize it. Like most of my articles, first we must understand what the optimal condition is before we can decide whether it needs fixing.
Be sure to realize these examples do not consider the effect of state income tax, the non-linearity of the taxation of Social Security, or the effect of increased Medicare premiums, or other nuances that are unique to your own situation. The intent is to just give you a baseline of knowledge.
I will, however, add some techniques that are rarely used even in published works of this type, but I believe are important to the overall view. One is inflation adjustment of the Social Security payment as well as the income need by the couple. Secondly, and even more important is the inflation adjustment of the tax brackets and Standard Deduction. I first introduced this in my article titled “Surviving the Tax Bite in Retirement.” In that article I used a 2% inflation factor based on the historical data available at the time, but in this article I have chosen to use 1.5%, in line with my other inflation factors used. The new standard deduction levels of 2018 will be inflated by $100 per year starting in 2019 as another estimate of what could possibly be expected based on past history. Once again past history is no guarantee but it is important to consider these factors that both make the Roth money less attractive in retirement and have usually been neglected by most other authors on this subject.
Reviewing the Ground Rules
First, some definitions and abbreviations are in order:
I will use the term Roth to indicate any number of what are typically tax-advantaged retirement accounts funded with after-tax dollars for which you can withdraw all contributions and earnings tax-free later. These come in many different forms such as the Roth IRA, Roth 401(k), Roth 403(b), and others. I will use the term IRA to indicate any number of tax-advantaged retirement accounts funded with pre-tax dollars for which you withdraw all contributions and earnings paying ordinary income tax on them at the time of withdrawal. You could find many types of these such as Traditional IRA, Traditional 401(k), 403(b), SEP-IRA, 457(b), SIMPLE IRA, and others. It should be noted that it is possible to have a mix of after-tax and pre-tax dollars in most of these accounts, but when I use the term IRA from now on, I will only be considering these accounts will all pre-tax dollars in them. This article is mainly concerned with contrasting the Roth and IRA to determine what techniques can be used to maximize your income during retirement. If you are putting money in a taxable account consider that money more like a Roth, as it is after-tax money, with at least a lower tax bracket of the money withdrawn for all long-term capital gains and qualified dividends.
Let’s review the characteristics of the two accounts types.
Tax deferral on all earnings inside the Roth if you follow IRS guidelines. Tax free withdrawal of all contributions and earnings (subject to 5-year holding period plus age restriction of 59 ½. Tax free withdrawal of your contributions at any time or age from a Roth IRA. A note on this as it applies to employer-sponsored plans is that you should check with your plan administrator as each plan has their own set of rules as to when withdrawals are allowed. Tax planning flexibility – Since there are no forced withdrawals by age 70 ½, you have more tax-planning flexibility during retirement. If a Roth IRA owner dies, certain of the minimum distribution rules that apply to traditional IRAs will apply to the Roth.
Tax deferral on contributions during working years will lower your taxable income while working and can increase some tax-credits. Increasing some tax-credits could actually allow you to save more. The required minimum withdrawals must begin prior to April 1st of the year after you turn 70 ½, but can be paid as early as the year you turn 70 ½. The RMD for any year after the year you turn 70 ½ must be made by December 31st of that later year. If these are not made you can incur a 50% penalty on any amount not taken that was due. Inherited IRAs have a complete set of RMD tables and rules which will not be discussed here.
There are many other nuances to the above two types of accounts and even within different types of Roth or IRA accounts, most of which can be found in the IRS publication 590, which has now been split into two parts – pub 590-A (contributions) and pub 590-B (distributions).
In the previous article, I compared different tax rates while working as well as different tax rates in retirement. In this article, I will drill down into the specific details of what might be an average retirement and how that is affected by the tax rates already paid while you were working. I will study 3 different couples, the IRAs, the Roths, and the Optimas, all of which decided to emphasize their Roth and IRA contributions differently.
The results are for a married couple both age 70.5 in December of 2018, which is the starting year for this analysis. The result of this is their first RMD will be paid in 2018 on the starting IRA balance at the end of 2017. The IRA or Roth withdrawals required for the year are withdrawn at the start of the year on January 1st. The couple has a combined Social Security income of $40,000 per year, which will be inflation adjusted at 1.5% per year. The couple’s total income need starts at $100,000 per year and will also be inflation adjusted at 1.5% per year for the 20 years of this study. Each couple has saved $10,000 per year for 30 years, and gotten an annualized return on those investments of about 7.32%, which translates to a pre-tax IRA balance of $1 million or split-adjusted amounts with varying dollars of after-tax Roth money as detailed in the case outlines below. The annualized growth rate of their IRA and Roth investments will be 6% in all cases. The tax brackets used to calculate their tax will also be inflation adjusted at a 1.5% rate. Tax year 2018 will be the starting point for the tax tables. In the examples studied it turns out that Social Security will not be taxed in years where the supplemental funds are 100% Roth and 85% of the Social Security will be taxed in all other years. Each couple takes the standard deduction which for them starts at $26,600 and increases at $100 per year. Three tax rates for Roth contributions will be studied to contrast how your working tax rate later affects your spendable income when a Roth account is involved.
The three couples which decided to invest in Roth accounts will be studied under three different cases in which they were able to put their earnings into the Roth at the below rates:
- Money went into the Roth while working at an average of 12%.
- Money went into the Roth while working at an average of 18%.
- Money went into the Roth while working at an average of 25%.
In each of the cases below the families have a different idea of how much money should be devoted to the Roth account. The IRA’s true to their namesake put all their savings, pre-tax, into the IRA, while the Roth’s do just the opposite and put all their savings, after-tax, into the Roth. The Optima’s feel that putting most of their savings into the IRA will be less risk for them and decide only at age 65 to try and calculate the appropriate amount of Roth based on their current tax rates and those that they foresee coming up in retirement. They do a very good job of this calculation as we shall see below.
The following tax tables will be used:
Results for the IRAs
As you might have guessed, the working tax rate does not matter to the IRAs as their retirement will always end with effectively $156,400 of after-tax money, or $172,114 of pre-tax money, left to spend after 20 years. As you will find out later on, it may not be optimal but it won’t be far from it for the simple fact that most of their IRA money is spent in the 10% and 12% tax bracket. This is an important point to remember when considering where most of your working savings should go, and as you will see, the higher your working tax rate the more important it will be to stress the IRA over the Roth, for the average couple.
Results for the Roths
First, let us look at results when the Roths keep their average Roth tax burden while working at 12%.
In the above case, an interesting thing happens because the couple has no other taxable income such as a pension or even taxable gains from a taxable account and that is that the Social Security taxable income does not become greater than the Standard Deduction so no tax is generated. Because $120,000 of tax has already been paid on contribution of the Roth funds the total advantage over the 100% IRA account is only $36,683.
Second, let us look at results when the Roths keep their average Roth tax burden while working at 18%.
In this case the Roth account is almost expended and if the Roths live to age 90 they have drained all their supplemental income and are stuck just living off Social Security.
Finally, let us look at results when the Roths keep their average Roth tax burden while working at 25%.
As can be seen from the above, the lack of tax diversity in their savings has caused them a serious setback in their retirement cash flow as they ran out of savings at age 86 and are therefore forced to live only on their Social Security income.
Results for the Optimas
The Optimas have figured out from reading other articles on Seeking Alpha that if you want to have more money in retirement it is best to save your Roth money for expenses that push you into a higher tax bracket in retirement. To be more specific, spend Roth money in retirement in a higher marginal tax bracket than when your money went into the Roth in the first place. For example, if your average working Roth marginal tax rate is 21% then use that money to supplement your income when other methods would put you in the 22% tax bracket or higher.
First let us look at results when the Optimas keep their average Roth tax burden while working at 12%. In this case the optimal Roth size is just enough money to keep them out of the 22% tax bracket. They are extremely lucky by estimating this is going to be about a 2.1% allocation to their Roth account, and here are the results:
In this case, the money left over in the IRA account is slightly larger than the 100% IRA account by about $8600 pre-tax dollars. It does fall behind the 100% Roth account for reasons mentioned above concerning the non-taxable Social Security. That is something to be aware of if you are in that situation and have a very low tax base of Roth contributions.
Second, let us look at results when the Optimas keep their average Roth tax burden while working at 18%. In this case, the optimal Roth size is still just enough money to keep them out of the 22% tax bracket. They are extremely lucky by estimating this is going to be about a 2.2% allocation to their Roth account, and here are the results:
In this case, the money left over in the IRA account is slightly larger than the 100% IRA account by about $3780 pre-tax dollars. It was the most efficient use of their savings dollars when the working tax rate for Roth contributions was 18%.
Finally, let us look at results when the Optimas keep their average Roth tax burden while working at 25%. In this case the astute reader might notice that there is really no time frame when the retirement marginal tax rate is above 25%, so it makes no sense to spend any Roth money, and the 100% IRA allocation will be the best they can do. Just for fun the Optimas decide to at least pay the 22% bracket with the small 2.4% allocation they have saved, so let’s see how much that costs them:
In the above case, what is verified is that the Optimas had $2954 less than if they had left 100% of their savings in the IRA account.
Summary of Results
Below are the summary of all results in tabular form:
First place goes to the Roths who managed to get $880,000 of their savings into their Roth account with an average 12% tax base. $27,145 behind them was the Optimas that put only a 2.1% allocation into their Roth at a 12% tax base and then the Optimas that saved a 2.2% allocation at an 18% tax base.
The IRAs come in fourth, not far behind with their 100% IRA account and so forth down to the Roths who saved their money at an average 25% tax rate and whose income fell almost $500,000 short of their neighbor Roths who were able to save their Roth funds at an average 12% tax rate.
Even though everyone’s tax situation is different, I would hope the takeaway from this article is something that is not often stressed by advisors, other authors, or those commenting on these articles. When deciding just how much tax diversity you should have or can afford, it is important to understand the upside of being right as compared to the downside of being wrong when you are deciding how much Roth allocation to target. In the examples above, the upside of having the optimal Roth allocation was measured in tens of thousands of dollars out of $2 million, while the downside of being wrong was over ten times that amount or a half million dollars.
The reason for the above is also something that is not stressed often enough, but I intent to do a better job of it in the future. While working it is your marginal tax rate that is paid on your Roth savings that is important. Over your lifetime this number may go up and down so I would use what I call the average working marginal rate. To decide in retirement when it is efficient to spend your Roth dollars you need to know which tax brackets they are being spent in and the fact that your Roth and or IRA dollars may span any number of tax brackets from zero to the maximum and that it usually does not make sense to spend those Roth dollars in a tax bracket lower that the average working marginal rate that was already paid on those Roth dollars. What I have heard too many times is the statement:
Since my marginal rate in retirement is higher or going to be higher I should put all my effort into minimizing my IRA and RMDs and saving as large of a Roth allocation as I can.”
I would hope by now most can see the shortsightedness of that thinking.
Finally, when I use the term ‘average working marginal rate’ for Roth contributions I also mean that you need to average in the taxes paid on Roth conversions from your IRA while you are working or retired. In recent years, many individuals were busy in early retirement converting large sums of their IRA to Roth at a 15% marginal tax rate, only to be stuck (in most cases) with no efficient place to spend that Roth money since they are now in the 12% tax bracket.
While RMDs can raise your taxable income and your tax rate in retirement they should not be something that is feared to extremes. In an article I wrote entitled Surviving the Tax Bite of Retirement, I pointed out that over the previous number of years the personal exemption, standard deduction, and the top of each of the tax rate bracket have grown by around 2% per year. With completely revised lower tax brackets for 2018 and the foreseeable future this has only improved the odds of you having a lower tax bracket in retirement, compared to while you were working. Hopefully, you have learned that this favors the IRA owner and the results are not insignificant. Who would not want 10-20% extra money in retirement or for their beneficiaries. I do understand that on the other end you do not want to be seen as the one who increased someone’s taxes with an inheritance. I personally think it is up to you to educate your heirs and make them see that a little bit of tax on a larger sum of many can in many cases be better than no tax on a smaller pool of money.
In my volunteer work helping people with their taxes each season, there are always cases where having some of their retirement in a tax-deferred IRA could have resulted in some tax-free withdrawals from that IRA, due to their low income level. For others the converse is also often true – that with at least a small Roth account it would have been possible to lower how much of their retirement savings goes to the taxman. It is never a bad idea, in my opinion, to have both Roth and IRA funds going into retirement. In my case I was able within the first couple of my retirement years to use some of that Roth to keep my tax rates reasonable while I paid off a sizable mortgage.
Of Notable Mention
For more detailed information on these subjects covered I suggest reading at least a couple of times the two IRS publications mentioned at the outset. Understanding the rules can avoid costly mistakes on the road to retirement as well as later when you are in retirement. I have also written an Instablog article titled, Roth Vs. Non Roth (401k, 403b, 457, Etc) & The Time Value Of Money which adds a casino example to the mix which you may find interesting.
Once again I also want to shout out a special thanks to Bruce Miller, who made my job much easier by providing a tax calculator for the new tax law going forward in 2018 as well as a Social Security tax calculator.
All tax calculations were started from a base of the new 2018 tax law and as I outline, they were inflation adjusted at 1.5% going forward from there.
This study is only as good as the data presented from the sources mentioned in the article, my own calculations, and my ability to apply them. While I have checked results multiple times, I make no further claims and apologize to all if I have mis-represented any of the facts or made any calculation errors.
The information provided here is for educational purposes only. It is not intended to replace your own due diligence or professional financial or tax advice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.