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Retirement and Uncle Sam – It’s not about what you make but what you keep!

Lisa Saxton, CFP (headshot)

Smart diversification includes account types, not just the assets within

“Death, taxes, and childbirth!  There’s never any convenient time for any of them.”

– Margaret Mitchell, Gone with the Wind

There are so many things we would tell the younger version of ourselves; eat better, exercise more, spend more time with family, and of course, save more.  Over the years, I have encountered many retirees ready to embark on their journey to financial freedom, beginning distributions from their portfolio, which consists entirely of 401(k) and IRA dollars.  The newly retired have done a great job of funding their 401(k) plans over the years, which can lead to a nice nest egg as they cross the finish line.  Assuming a thirty-year-old saved $1,000 per month at 7% over a thirty-year career, they would have $1.2 million at retirement!  Monthly distributions from their IRA begin (the new paycheck), and every dollar that leaves the account is taxable at ordinary income tax rates.  Consequently, if this newly retired couple needs $100,000 per year deposited into their bank account for living expenses, they might need to distribute as much as $150,000 from the IRA so that the IRS and state can receive their share, depending upon where they live.  Ouch!  Wouldn’t it be nice to have more control over taxes in retirement?  Younger self: save more to different types of accounts with different tax treatment as you contribute and, more importantly, as you distribute in retirement.

Essentially, there are three types of accounts that you can save to: taxable, tax-deferred, and tax-free (Roth).


When saving and investing, you might consider opening a taxable account in either your individual name, in the name of your trust, or jointly with a spouse.  This type of account is funded with after-tax dollars, often from the proceeds from a sale of a business or rental property, a bonus, or simply through monthly contributions.  Each year, the realized gains or losses as well as any income from the account are reported on an IRS Form 1099.  Unlike qualified retirement plans, the taxable account has no penalty for withdrawals prior to age 59 ½; therefore, this type of account can be useful when saving for other, non-retirement goals.  A taxable account can also be quite beneficial in retirement since gains on the sale of any shares are taxed at long-term capital gains rates, which are currently much lower than ordinary income tax rates.   In addition, this account can be extremely tax-efficient by allowing the losses on any investments to be harvested for tax purposes, as these tax losses offset gains in the future, creating a nice bucket to distribute from in retirement.

Tax-deferred –

Tax Savings Today

Probably the most commonly used account for retirement savings is a 401(k) plan, which is often rolled over to an IRA at retirement for investment flexibility.  Contributions to the plan are made through payroll deductions, which reduces your taxable income today, and the growth on the contributions is tax-free.  Sometimes, there is even a company match (free money!)  Tax-deferred growth and free money are incredible components to wealth accumulation; however, as mentioned previously, every dollar that is distributed is taxed as ordinary income.  In addition, once you are 70 ½ there are required mandatory distributions, even if you don’t need the funds!  Wouldn’t it be nice to supplement this account with the aforementioned taxable account, as well as the “holy grail” of retirement accounts: the Roth?

The Roth –

Tax Savings in Retirement

A Roth IRA is an individual retirement plan that bears many similarities to a traditional IRA. The biggest distinction between the two is how they’re taxed.  Contributions to a Roth IRA do not reduce your taxable income, but they still grow tax-free, and distributions are tax-free.  Tax-free growth and distributions in retirement sound fantastic; so, how do you get dollars into this type of account?  There are essentially five ways:

  1. Roth IRA Contribution

If your income meets certain thresholds, you are permitted to contribute into a Roth IRA.  For 2019, a married couple filing jointly with an adjusted gross income (AGI) of less than $193,000 can contribute the full amount.  If their AGI is between $193,000 and $203,000, they can make a partial contribution.

  1. Roth Conversion

You can convert all or a portion of your IRAs to a Roth IRA.  The amount converted will be taxed at ordinary income rates in the year of conversion; however, once converted the amount grows tax-free.  Hence, it might make sense to convert a portion of an IRA, so long as it doesn’t push you into too high of a tax bracket.  In the past, the IRS allowed you to undo, or “recharacterize,” all or a portion of the amount converted until the tax filing deadline.  You would be able to say, “oopsie,” and send the converted amount plus any growth back to the IRA; however, effective January 1, 2018, a conversion cannot be recharacterized.  Therefore, it is important that any conversion be carefully evaluated before implementing.  For example, a conversion might reduce any health insurance premium subsidies under Obamacare, disqualify a student for financial aid under FAFSA, or increase your Medicare premiums.  Or it might be that you underestimated your income, and the conversion just doesn’t make sense given your current and projected tax-bracket.  Conversions typically make sense in two scenarios: where the tax on the conversion will be at a lower rate than the expected tax due in retirement, or when your income for the year is lower than normal (say because a spouse retired, switched to part-time work, etc.)  For example, one of our clients that converted IRA dollars in 2018 was a high-earning engineer who decided to take a year-long sabbatical from work to travel the world, prior to making a career change.  It was a great year to convert a portion of his high value pre-tax IRA to a Roth IRA, which is now growing tax-free for his retirement.

  1. Back-door Roth

If you are unable to contribute to a Roth IRA because of the income limits, and you have not established any IRAs with pre-tax dollars, you might consider a strategy called the “back-door” Roth contribution.  When you have no pre-tax IRA balances, you can make a non-deductible IRA contribution and then convert the contributed amount to a Roth IRA, paying zero taxes.  There are no income limits on making a non-deductible contribution to an IRA.  Now, why do I say you must have no pre-tax IRA balances?  If you have pre-tax IRA balances, those values must be included at the time of conversion when calculating the taxable amount.  That means that the non-deductible contribution will be partially taxable and create a whole heap of other tax issues that you don’t want to mess with.  The best solution would potentially be to convert your pre-tax IRA balances to a Roth first, and then implement the back-door Roth strategy for future contributions.

  1. Roth 401(k) Contribution

Some 401(k) plans allow after-tax (or Roth) employee elective deferrals, meaning that the employee contributes money that has already been taxed but enjoys tax-free compounding.  Withdrawals of contributions and any growth are tax-free in retirement.  For 2019, total employee elective deferrals to the plan (pre-tax and Roth combined) are limited to $19,000 ($25,000 if age 50 or older).  Many clients ask us, “Should I be saving to the traditional 401(k) or the Roth 401(k)”?  Well, it likely depends on your income, and it doesn’t need to be one or the other.  It might make sense to contribute a portion of your elective deferral to traditional 401(k) and a portion to the Roth 401(k).  Bear in mind that any employer matching contributions are always made on a pre-tax basis, even if you’re making Roth contributions to the plan.

  1. After-tax 401(k) Contribution

A lesser-known way to get money into a Roth bucket is through after-tax 401(k) contributions (not to be confused with the above Roth employee elective deferrals), for plans that offer this feature.  For 2019, the IRS permits 401(k) contributions from all sources of up to $56,000 ($62,000 if age 50 or older).  If after-tax contributions are permitted, a 55-year-old employee might elect to defer their employee contribution of $25,000 to the traditional 401(k), so they receive an income tax-deduction, receive an additional pre-tax employer match of $17,000, and elect to save $20,000 into the after-tax bucket ($25,000 + $17,000 + $20,000 = $62,000).  Over a five-year period, the retiree would have a total after-tax bucket of $100,000 ($20,000 x 5) that can be rolled into a Roth IRA, while the investment earnings on the after-tax contribution is rolled into a traditional IRA.  The $100,000 that moved into the Roth IRA now grows tax-free and distributions are tax free!

Many investors are familiar with the importance of investment diversification among stocks, bonds, and other asset classes.  It is also important to diversify the types of accounts that hold your investments, as some provide tax benefits today and others in retirement.  In our earlier example, if our retiree that needs $100,000 to live on had more than just an IRA available, they could distribute $75,000 from the IRA to remain in a lower tax bracket, with the remaining funds coming from a taxable or Roth account.  Having a mix of account types can provide benefits as you are saving today, control over taxes in retirement, and provide additional strategic flexibility in managing your assets.

This commentary is provided for general information purposes only, should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.

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