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IN HINDSIGHT, MY WIFE and I made a mistake by over-saving in tax-deferred accounts. It’s not that we saved too much overall. Rather, we ended up with retirement savings that aren’t diversified among different account types. In fairness, this was caused by the limitations of our work-sponsored retirement plans, coupled with the stock market’s handsome appreciation in recent years.
The classic approach is to build a three-legged stool for retirement—Social Security, a pension if available, and personal savings. I’d suggest a tweak to strengthen the personal savings leg. Savings can have any of three different tax treatments—taxable, tax-deferred and tax-free Roth money. You don’t want any one of these to become so big that it adds a wobble to the stool, as has happened to us.
When I retired in early 2017, our savings were 91% in traditional tax-deferred retirement accounts and 9% in taxable accounts. We didn’t have Roth IRA savings because our combined income put us above the income thresholds. Meanwhile, Roth backdoor conversions had only become available within our 401(k)s in our final working years. The upshot: Our lack of tax diversification prevents us from taking tax-free Roth withdrawals to keep our tax bracket low, and also means we pay higher Medicare Part B premiums.
How did this happen? We both followed the conventional wisdom to always maximize our 401(k) contributions, including the catch-up contributions I made in my final 10 working years. Along the way, we took two small pension obligations as lump-sum IRA payouts, adding further to the tax-deferred tilt of our savings. Forty years of stock appreciation and inflation did the rest.
Since retiring, the stock market has doubled again. Once our Social Security payments and required minimum distributions begin, we have a decent chance of being in as high a tax bracket as any we paid during our working years. I base this partly on the assumption that today’s lower tax brackets will sunset in 2026, as scheduled under current law.
I acknowledge that tax-bracket creep is a good problem to have. But believe me, we’ll be sharing plenty of our good fortune with Uncle Sam. In hindsight, we should have increased our taxable savings at the expense of our tax-deferred bucket. This would have been particularly farsighted during our earliest working years, when our income tax rates were the lowest we’d ever pay.
We could have limited our early year 401(k) contributions to only the amount required for the company match. Then we could have paid income taxes on the balance of our savings, and invested that reduced principal in a taxable account. Subsequent gains would have qualified as long-term capital gains, far lower than the income-tax rates we’ll pay on our required minimum distributions (RMDs). Also, the size of those RMDs would have been lower, helping to check tax-bracket creep.
Since retiring, we’ve been rebalancing our buckets by aggressively doing Roth conversions while tax rates are still relatively low. Our savings are now 86% in tax-deferred accounts, 7% in taxable accounts and 7% in Roth IRAs. That’s still highly skewed, but a little better than it was.
Perhaps we should have bitten the expensive tax bullet earlier and started a trickle into the Roth bucket through backdoor conversions. We could have paid the tax from our taxable accounts, effectively using taxable money to increase our Roth accounts. Larger Roth balances would have three advantages to us: tax-free future gains, lower RMDs and an ability to pass greater money to heirs.
Unfortunately, Roth contributions were mostly not available to us or came at a high tax cost. By contrast, today’s workers have lower tax rates and expanded Roth savings options, including within 401(k) plans. Younger workers, in particular, may want to add to their Roth or taxable savings buckets, since their tax rate may be lower now than it will be at any time in the future.
John Yeigh is an author, speaker, coach, youth sports advocate and businessman with more than 30 years of publishing experience in the sports, finance and scientific fields. His book “Win the Youth Sports Game” was published in 2021. John retired in 2017 from the oil industry, where he negotiated financial details for multi-billion-dollar international projects. Check out his earlier articles.
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I’m writing about an online Roth conversion tool that may be of interest. I was born in 1960, which proved to be the cut-off birth year for pensions in my industry (my older colleagues got both til-you-die pensions and 401ks, but my age group got just 401k matches). It also meant for most of my corporate career (I left for self-employment in 2008), Roths weren’t an option in my benefits plan. End result, I’ve ended up way overweighted in my tax deferred IRAs/i401k. Last year (age 61) I belatedly learned about both RMDs and the possibility of Roth conversions.
This led me to the NewRetirement Retirement Planner, which enables you to model a Roth conversion against your own situation to better assess how the move could impact your finances. (Presumably they will update the model to reflect any tax rate changes.) I like how easy it is to model all sorts of various retirement scenarios via the NewRetirement’s DIY interactive system, including selling my house at different age points. I pay an annual $48 subscription to have access to all their planning tools. Here’s a link to how their Roth conversion tool works.
http://help.newretirement.com/en/articles/4576142-how-to-model-roth-conversions
But I have to admit that instead of using that tool, before actually pulling the trigger on my first Roth conversion in late 2021, I talked it through with an hourly financial planner and my accountant just to make sure I wasn’t doing something useless or stupid. Both seemed to think it was a fine idea but not imperative to convert some traditional IRA money into a Roth. That’s because I was trying to stay within my semi-retired 12% tax bracket, so it was really just a drop in the Roth bucket. Now a few months later I’ll have to pay the taxes.
As all these comments to this article show, for some of us in the gray area, it’s tricky balancing short term with the more fuzzy long term and figuring it all out. Will I keep converting every year til RMD time? Probably. Maybe even at a higher bracket. Still learning & researching….
Laura – I think you nailed it with your assessment that Roth conversions are a “gray area” for many. We can’t be certain of future tax rates and brackets which is why I’m hedging my bets and partially filling all three tax buckets of personal savings. I sense you have an even better handle on your options. Your conversions provide future optionality, reduce mandated RMDs and likely enhance the eventual situation for heirs. We can never optimize perfectly without increasing concentration risk or otherwise we should have bet everything on Amazon or Google 25 years ago.
Also use NewRetirement, did a partial conversion to the top of the 12% federal bracket (MFJ) last year, will continue to do so.
Our Roth accounts would ideally go to heirs.
I deeply regret not converting a parent’s traditional IRA to Roth over a decade ago back when they were terminally ill.
Their deductible medical expenses were high enough that there may well not have been any taxes owed, but had there been I would have paid them since I knew I’d be inheriting the account.
Plus it has now grown to several times the balance back then & all RMDs are ordinary income instead of tax-free…$10,000+ this year based on the old lifetime stretch rules, which cuts into the space for Roth conversions.
With over $1 million in tax-deferred accounts, Roth conversions seem like a great way to protect my wife from higher tax brackets when she someday becomes a single widow (her mom lived to 95!). So we’re taking the hit, making Roth conversions and filling a large part of the 24% bracket, which of course is quite close to the 22% bracket. Part of the rationale is that it’s still a lower bracket than the scheduled 25% in 2026.
IRMAA will take a chunk, too, of course, but I think it pales in comparison to the tax savings 20 years from now. We’re also being careful to get close but not go over the nearest IRMAA cliff.
But I wish there was some sort of online calculator to simulate various scenarios and really understand the potential savings, as opposed to giving up the “time value” of money that I might keep a little longer and put to work instead of using it to pay taxes. I have only the vaguest notion of what I’m potentially saving for my wife and heirs.
Ideas, anyone?
I just posted about one online Roth conversion simulator I know about. Should have posted it as a reply to you, sorry.
Interesting, most of the comments here don’t even mention Social Security. I realize that for most HD readers SS is but a trifle and pittance compared to their overall net worth, but for some of us it’s a huge deal and a major pillar of our retirement income. For us, I can assure you that having the bulk of our savings in Roth (vs Traditional) would be a very advantageous thing, and can be very useful in limiting the taxation of our SS benefits (among other things). This is especially true if you have a small pension. This is the primary reason that I would advise those who are mostly in the sub-20% brackets to stick with the Roth, in most circumstances it makes for better tax outcomes in my experience. The idea that most of us will be in a lower tax bracket when we retire is largely a myth, due to how SS is taxed, and is a throwback to the pre-’80’s days when SS was not taxable.
Now, if only I had a time machine, and could go back and have this discussion with my younger self…
The wide range of comments show just how different opinions can be when it comes to saving in traditional vs Roth vs taxable buckets. 🙂 Part of the problem is that no one knows for sure what future tax rates will be. That said, I think many bloggers and people in general seem to be strongly biased toward traditional 401k’s without really having done the math. I always had trouble convincing fellow co-workers to put contributions into a Roth 401k vs a traditional 401k. This is a really complex topic, far more complex than it appears on the surface. But John Yeigh illustrates the potential problem with putting the bulk of your retirement savings in tax-deferred accounts, especially for very high earners. I think one solution is lobby hard for a Roth 401k account if your company does not have one, which I did many years ago in my practice…Thanks for the article, John. I may piggyback on it and write about this issue in the future…
If one is married, one knows for a fact that tax rates will be going up. At some point, one of the married couple will pass and the other will be paying taxes as a single person.
Yes, the decision for savings in taxable, tax-deferred, or tax free accounts is not always clear due to income impacts and tax rate impacts that can change substantially over the long term. For folks in the early career, lower income years, they may not want to max the tax deferred bucket. Tax free Roths probably provide the best savings alternative when worker tax rates are the lowest. For taxable account monies, it may depend whether the savings are invested in capital gains versus income oriented assets. Also, low or high state income taxes before and after retirement may be a factor. For later career workers in their highest earning years, they should have a better assessment as to whether their retirement tax rates will be the same or decrease. But, for someone with a high stock allocation for their savings, the stock market doubling or halving can have a huge and unanticipated impact on likely RMDs and tax rates. Then there’s the 2017 tax legislation which is set to sunset in 2026. Having some savings diversification in each bucket provides flexibilty to manage retirement income and tax planning. There are plenty of tax-related concepts that warrant further discussion.
I think you are making the mistake of focusing on taxes paid in retirement rather than money left to spend after taxes paid. Years of tax free compounding in your 401k more than makes up for being bumped into even the highest tax bracket, when you look at money left after taxes paid. Tax protected accounts should be funded ahead of taxable accounts.
Totally disagree. You are making the mistake of focusing on money left after paying taxes rather than taxes paid in retirement. Years of tax free compounding in your Roth 401k leave you with money that is 100% yours.
Well, the 37% bracket starts at $539,900 for singles, and $647,850 for married filing jointly.
If a retiree has that kind of income, he can just smile and send in the check. Life is good!
While this is an important article because tax diversification can lower taxes and IRMAA charges in retirement, I’d strongly disagree with the author’s comment “In hindsight, we should have increased our taxable savings at the expense of our tax-deferred bucket.”
Unless paying almost zero federal and state taxes in the early work years, it’s going to be generally more advantageous in the long run to invest pre-tax in a 401(k) plan versus saving outside in a taxable account. You not only get much more into a retirement account up front due to the tax deduction, you have decades to benefit from the magic of compounded earnings on those contributions. That said, putting into a Roth account can indeed work better when someone is starting out in the workforce, but you’re not going to do better in a taxable account.
Think of it this way…If you are in the same 25% tax bracket when you are contributing to your pre-tax 401(k) as when you take it out, a Roth 401(k) account will end up in the exact same place as a pre-tax account holding all else held constant. Further, would you rather pay taxes on earnings in a taxable account or receive tax-free earnings and withdrawals from a Roth? Of course, the Roth is better….
In a taxable account, you are also paying taxes on dividends and interest along the way and thus lose the additional tax deferral on that investment growth as well, not to mention potentially being in a higher tax bracket due to earnings, With a 401(k), the contribution is taken out of your paycheck and automatic…Tough to replicate this “behavioral benefit” with a taxable account. Early career readers should prioritize contributions to their 401(k) plan.
My comments are in regards to the 3rd paragraph. When comparing tax rates, always remember its not just the tax rates but all the ancillary taxes that piggyback off of them. IRMAA is one of the largest taxes that comes to mind.
Hi Jim – the primary advantage of tax-deferred accounts are realized when retirement tax rates are lower than working-year tax rates. If retirement income tax rates are the same or higher than working-year tax rates, there is no advantage to tax-deferred plans above the match. There are advantages to Roth alternatives which were unavailable to me. In taxable accounts, investments can be made that capture lower capital gains tax rates rather than the income tax rates for withdrawals from tax-deferred plans. The attached highlights some of the disadvantages of tax-deferred accounts including if tax rates are higher:
https://finance.yahoo.com/news/5-disadvantages-saving-401-k-204904995.html
I disagree. The primary advantage of tax deferred accounts is the tax free compounding over many decades. A lower marginal tax rate in retirement is a bonus, but the main advantage is the tax free compounding. We are not hardwired to easily understand the powerful effect of compounding over long periods of time, but if you run the numbers you will see this to be the case, when compared to a taxable account.
The tax rate at the time of contribution, tax rate of the RMDs and tax rate for capital gains all have an impact. We must pay ordinary income tax rates on tax-deferred RMDs and we are forced to take RMDs. Taxable accounts likely should incur lower capital gains tax rates, and we can adjust timing & perhaps never take the gains and leave it to the estate. These situations are different for every individual and can change significantly over a life time, so there is no one size fits all formula. This is why it is good to have savings distributed across all three tax bucket options. The Roth option is relatively new and offers even better options than my wife and I had available earlier in our careers when our tax rates were lower. In any case, higher savings is always directionally good because it leads to gains – the tax tweaking is secondary.
…and don’t forget about the potential for the step-up in basis at death one has with a taxable account, vs. nothing for the tax-deferred IRA. This can be leveraged to huge advantage under certain circumstances, and is a benefit that no tax-deferred account can even come close to.
You may want to get more aggressive with the Roth conversions before SS and RMDs kick in for two reasons:
#1 – your taxes are going to go up significantly when one of you dies and the survivor has to file as a Single rather than MFJ; thus you need to take full advantage of the larger MFJ bracket that you’re in right now; and
#2 – your heirs will be much happier to inherit Roth IRAs from you than if they get traditional IRAs (because they will have to pay ordinary income tax rates on everything they take out, and those withdrawals have to occur within 10 years after the death of the last surviving spouse). The Roth IRA has the same 10 year distribution rule but of course no tax consequences on those withdrawals by your heirs.
Brian – I agree Roth conversions provide many down the line benefits – no RMDs as well. We are doing lots of Roth conversions already and are constantly restructuring investments and gains to provide as much tax-bracket Roth conversion headroom as possible.
Thank you John, a clear articulation of a very nuanced topic. Yes, in the eyes of many a legitimate “1%er’s problem”, but for anyone looking to improve tax efficiency a relevant discussion. I’m not one to look at hindsight for guidance, because if I knew then what I know now I would have likely made a lifetime’s worth of different choices, but life doesn’t work that way for anyone. Best example is the simply amazing performance of the equity markets, which took traditional stock/bond age-based allocations and reset the bar. So with a look-forward perspective, I thing the topic of “future tax rates” is still unsettled, so I’m in total agreement with your implication that spreading your investment “bets” among the tax-deferred, taxable, and Roth buckets makes the most sense. Like many for whom this discussion is relevant, I’m moderately overweighted in tax-deferred 401k and IRA accounts, but with reading an article like this am glad to find concurrence with a strategy to better address the tax consequences.
>> I’m moderately overweighted in tax-deferred 401k and IRA accounts
I’m strongly overweighted in ROTH and taxable. But I think I’m still going to do ROTH conversions anyway, because I think I’ll probably have enough income (and tax gain harvest taxable once in awhile as I wish) not to touch very much if any of traditional IRA and ROTH. My wife and I both come from long living families, and odds are at least one of us will survive at least to mid 80’s. If so, conversions will let that money run for 2.5 decades, and possibly even leave most of it to heirs. I really don’t care if I don’t save any taxes in the nearer term. Whether conversions make sense all depend on your situation and goals.
Congress could of course change the rules for ROTH, but that might be tricky and in any case I’ll take that chance.
Indeed, no one can predict future tax rates. Likewise, the tax-bracket creep is a function of the amazing nearly four-fold increase in the stock market over the last decade which was never in our plans. However, the stock market may be in the process of some mean reversion at the moment. This all points to the sensibility of filling all three savings buckets with their different tax implications.
Great article John. We are in a similar situation. We maxed out our 401k’s and only opened Roths in the last 4 years. At the time it seemed to make sense, especially the last ten years. My wife and i were in our peak earnings years and had good salaries. It seemed unlikely our retirement income would match our pre-retirement income. And the 24% bracket is so wide (assuming it stays that way) our tax bracket is likely to stay fairly consistent.
The 22% and 24% tax brackets are currently very wide. However, if the 2017 tax legislation sunsets in 2026 as it is slated to do, these brackets will revert to 25%, 28% and 33%.
Tax diversification can be a tricky dribble for those in what seems to be roughly the 85th-95th percentile of net worth. Most people really have no need for anything but a traditional 401k/IRA. They get a tax break up front, and their blended rate at withdrawal is far less than the marginal rate they would have paid to Roth or to save after-tax. I seem to remember the cutoff, where tax diversification can start to make a difference, is somewhere between $150K and $200K of retirement income.
As you note, the exception to this is young workers in the sub 20% tax brackets, who have very good odds to benefit from Roth and after-tax savings (especially if they start saving that young). My sons both have Roth style IRAs for teen and young adult savings.
Anyways, we’re something like 95% tax advantaged and at this point that seems mostly etched in stone. We’ve switched to Roth contributions in our 401Ks (which I think (!) is roughly a 50/50 bet when it comes to probable future tax rates – & the flexibility and our current cash flow make it seem advisable) but the matching contributions are in traditional. When I retire maybe we do some Roth conversions, but it’s kinda like using a teaspoon to bail out the Titanic. In any case, it’s a good problem to have.
RA, can you say more about this comment?
“I seem to remember the cutoff, where tax diversification can start to make a difference, is somewhere between $150K and $200K of retirement income.”
John, thanks for this nice clear article on a complex topic.
I saved in a very different manner, and ended up with more money in a taxable account than in retirement accounts. Unfortunately, the income in the taxable account prevented me from doing any Roth conversions after retiring. When my RMDs start, I’ll be paying IRMAA and NIIT – a nice problem to have, deal with it.
I have a buddy who is retired, age 72, who with his wife has an income of $500K, and pays $200K in tax: “Well, would you rather have $300K left after paying tax, or have an income of $50K and pay no tax?”
>> the income in the taxable account prevented me from doing any Roth conversions after retiring
How so? I didn’t think there were income limits for ROTH conversions.
John I also calculate my buckets: tax-free 48%, brokerage 29%, tax-deferred 16% and cash 6%. Converting to Roth at these rates was too attractive. In addition to Roth I built up cash-value life insurance which is more protected than the Roth $ I believe. So many retirees can’t stand paying taxes today and deferring a larger balance to tomorrow. As you mention the best advice is to take the 401k match and Roth up front.
I am jealous of both your balance and the significant quantity of tax-free.
Many valid points. One thing to consider for many average workers is that saving pre-tax allows them to save more so the balance between saving more pre-tax and less post tax may be a long-term consideration for some.
For my third leg I built up a portfolio of municipal bond funds for tax free additional income when needed. Doesn’t help limit IRRMA though which makes no sense given Roth earnings are excluded.
Excellent advice. It is impossible to predict tax rates 30 or 40 years in the future, and you shouldn’t just assume your tax rates will be lower in retirement. I believe most younger workers should seriously consider Roth and after-tax investments as part of their retirement savings even if they think their tax rates might be lower in retirement. It is usually best to diversify your tax exposure.
Yes, tax rates 40 years out are impossible to predict. However, early career folks with an upward path in career, marriage, or inheritance have a decent likelihood of later higher income and tax rate creep. They maybe shouldn’t max tax-deferred contributions much above the match; however, today many workers have access to Roth alternatives within their 401K plans.