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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.