I’m 50 with $800K Saved: Avoid the RMD Trap and Save Big on Taxes in Retirement

Troy: Welcome to part 2 of I’m 50 with $800,000, Can I Retire at Age 60, and How Much Can I Spend? Now in this video, what we’re going to do is explore the decisions that you could make in that period from age 50 to 60 with your 401k. Specifically, should you put money into the traditional part of your 401k or the Roth part of your 401k? When you put it into the traditional side, you get a tax deduction today, that money grows tax-deferred, or as I like to say, tax-infested. When you get to retirement, you take it out. Whenever you take a distribution, you have to pay income taxes. Of course, what I call the tax risk is the uncertainty about what taxes may be in the future.

Again, we’re spending $3 billion a day almost just on interest of the national debt. There’s some concern about taxes possibly being higher down the road. Now, when you put the money into the Roth part of your 401k, then you pay taxes at today’s rate as that income is earned. Then it goes into the Roth part of your 401k, it grows tax-free, and it’ll be tax-free forever. We’re going to explore the different decisions that you could make and the impact that they have on your future retirement. Potentially looking at some of these scenarios.

Now in the last video, which is part one of this series, and again, the title is I’m 50 with 800k, Can I Retire at Age 60? We explored a multitude of financial planning considerations. We didn’t delve too much into tax like we’re going to in this video, but a lot of different financial planning considerations. I encourage you to watch that video if you have not already. If you just are curious about taxes, this video is going to be very powerful for you as well. I encourage you to watch both of them because we’re trying to lift the curtain. We’re trying to provide some visibility into the impact of the decisions that you’re making today, how they impact your retirement.

Okay, so a quick refresher for those who did not watch the video and those who simply don’t remember, which is probably most of you. We had age 50, husband and wife, wanted to retire at age 60. Now at age 60, they wanted to spend $75,000 as a baseline spending level. That’s after-tax money. Then an additional $25,000 for the first 10 years of retirement. They had $800,000, $700,000 of which is inside the 401k. $100,000 is outside in a taxable brokerage account.

What we’ve done now is we fast-forwarded, before we get to the tax software, 10 years. Then we’ve taken these values and put them into the tax software so we can perform the analysis. A couple of things I want to show you here. First, what we’ve done is just a real simple conservative average rate of return here. Now I say conservative because many of you may be watching this and say, “Troy, the stock market returns 10% or 12% or something like that.” True, it has done that historically.

Importance of Tax Diversification

Most experts today forecast the stock market to have a little bit lesser performance over the coming years. Now, the accuracy of those predictions I’m not going to get into. What I am going to tell you is from a planning standpoint, we would much rather be a little more conservative than a little bit more aggressive. Because if we average 8%, 9%, 10%, well, guess what? The plan is going to be that much better. I don’t want to plan at 9% and then we return 6% and then have a conversation with you in 10 years. Say, “Hey, you know what? We didn’t hit those targets that we had projected 10 years ago. Instead of spending this, now you have to spend that.” That’s not a good conversation to have.

Pretty conservative investment returns here. What I want to show you is because of inflation, now we come over here. This is Tim and Jane YouTube. $75,000 as the base spending goal because of inflation is now $96,000 a year. Just a simple 2.5% inflation rate. That $75,000 in today, 2024 dollars, you’re actually going to need to spend $96,000 to have the same purchasing power in 10 years. The go-go period, the 10 years where we’re going to spend $25,000 in today’s dollars, that’s actually $32,000 here. We went through that in pretty good detail in the previous video, but I just want to point that out because it’s important.

Now, the only other thing to point out here is the 401k contribution. Tim was making $100,000 a year at age 50. He was going to put 20% into the 401k. That’s $20,000 plus get a 4% match. $24,000. Then that’s increasing as the income increases over the years. This is what the 401k contribution is. Now, we’re going to look at this two different ways in the tax software. The first is that money goes into the pre-tax traditional 401k side. Then the second scenario, if it goes into the Roth. All we’re trying to do is to create that visibility so we can fast forward 10 years into the future and say, “If I made this decision and did it this way, this is one potential outcome versus doing it this way.”

Now, here we are. It’s 10 years later. This is the scenario where all of the money went into the tax-infested 401k, the pre-tax, where you get a deduction while you’re working, but you have to pay taxes later in life. All we’ve done is taken the balances from the other software and dropped it into here, and then made them 10 years older. Now, what we’re also going to do here is look at the next 20-plus years of retirement and the overall impact that those decisions from age 50 to 60 had on the future of their retirement.

401k, the traditional side, $1.709 million. The taxable brokerage account, $136,000. No more money went into the brokerage account because it was the liquidity pool. It was pretty conservative. We just had it 100% fixed income. Just a conservative rate of return in the hypothetical case study here. We had $700,000. We put 10 years of contributions into it, and a fairly moderate to conservative, let’s say, investment return. We now get to $1.709. All of that money is inside the 401k.

At the risk of beating a dead horse here, if they want to go on a vacation, if they need to buy a car, if they want to help their son or daughter out, if they want to do any type of withdrawal, they are at the mercy of whatever the income tax rate environment is in the future. You want to pull $50,000 out? Great, you can pull it out, but you’re going to pay income taxes at some unknown future rate. That’s what we call tax risk.

Now, here’s a scenario where instead of putting those 401k contributions into the traditional side, Tim and Jane put it into the Roth part of their 401k. $1.32 million inside the traditional part, still $136,000 in the taxable brokerage, but $376,000 inside the Roth 401k. Now, I made this point in the last video, but it’s worth repeating. If you’re doing this and you do not have a Roth IRA outside of your 401k, there’s a five-year aging rule that applies. It is recommended that you open up a Roth IRA, which is separate from the Roth 401k.

This is an employer-sponsored plan. Your IRA is an individual retirement plan. You can do that at any discount brokerage firm online. The reason you do that is because when you retire, you roll this money into the Roth IRA, and that Roth IRA needs to have been established for at least five years in order for you to withdraw earnings from that account without any type of taxable event. That’s the one caveat here. It’s the five-year rule. It can be fairly complex, just like most things in the Internal Revenue Code. Talk to a CPA. Do some research online. I do encourage you, if you’re going this route, make sure you open that Roth IRA so you can get that five-year window rolling.

Required Minimum Distributions (RMDs) Overview

What we’ve really done here in preparation of retirement over this 10-year period by contributing to the Roth 401k as opposed to the traditional is we’ve simply created choices. We’ve diversified our tax bucket. When you go to make withdrawals, now you have choices. If taxes happen to be really high, well, we can still pull some out of the 401k because we’re going to bring that down, and then we can manage how much goes into the lower buckets. The tax-free Roth IRA, maybe we’re going to pull out more from that account to meet our needs, goals in retirement.

We can manipulate where we’re getting our income from. What that does is that puts you in control of what goes on your tax return. That’s the number one thing to really take away here is that we’ve created some tax diversification. Now, we have choices of where we can withdraw income from in retirement. Let’s say these were two separate people entirely, and they came into our office, and we sat down, we went through the process on the first visit of getting to know each other. Our team does all the analysis they do in between the first and the second visit, and they came back for the second visit.

What this is showing over here, I want to avoid this right now. What this is showing is based on the tax analysis of having all of the money in the 401k. This is the traditional 401k contribution plan. What we would see is if they follow the conventional wisdom advice from that point forward, because, remember, all of the money is inside the 401k. They did not diversify their tax buckets. They could withdraw the amount of money that they were planning on withdrawing. Isolate as much as possible. We deferred Social Security till age 70 in both of the scenarios we’re going to look at.

Ending value upon passing away is $2.696 million, the total value received of all income plus the asset balances projected at the end of life. That’s what the total value is. We have about $2.7 of ending value, and over the course of retirement, they’re going to pay about $700,000 in estimated taxes. This is the base strategy here of all the money being in the traditional 401k. Now, this one looks exactly the same, except this is the Roth 401k. Instead of putting it in the pre-tax, we put it into the Roth. Here we see, one, the total value has increased about $800,000.

What that is, just to explain a bit further, is it’s the sum of all the income that’s projected to be taken plus your ending asset balance. As you put those two together, it comes up with total value. That does include social security strategy because that’s part of your overall retirement value, making the right social security decision. To make it simple, let’s just focus on the ending value. 3.475 last 30 years from 60 to 90, and taxes $336,000. A significant difference in tax savings from the Roth contribution strategy inside the 401k versus the pre-tax strategy of putting money into the 401k.

Tax Risks of Large RMDs

Important concept here is that this is an apples-to-apples comparison, but what we’re doing is we’re extrapolating identical variables out over a 30-year period. Of course, there are assumptions in here, but the portfolio returns, the income withdrawals, everything is the exact same except the character of their accounts, how much money they had in IRAs, Roths, and taxable brokerage accounts at their retirement date. Those are the only variables that are different.

What is the cause? Why does someone who puts money into the pre-tax part of their 401k end up paying more in taxes than the person who puts money into the Roth part of the 401k? Keep in mind here, what we’re doing is we have two identical scenarios and we’re comparing them over a 30-year retirement. When you put money into the Roth 401k, you pay taxes at that time. From age 50 to 60, you’re paying taxes. This analysis is looking to see what happens from age 60 to 90. While you’ll pay more taxes putting money inside the Roth 401k as opposed to the pre-tax, in that accumulation phase, once you get to the distribution phase in retirement, that’s what this analysis is showing.

Now, why is that? Why would there be such a stark difference in taxes paid and also ending value? It’s pretty simple, really. When you have a large sum of money inside your retirement account and your future required minimum distributions exceed your income needs, because, again, you have social security, you have your required minimum distributions, you end up a lot of times taking a lot more income than you necessarily need, paying taxes on income that you don’t need. That ends up creating more taxes paid over time, more taxes paid over time, and less ending value.

It’s really, it comes back to this problem with required minimum distributions. It’s an increasing percentage that you must start taking at either age 73 or 75, depending how old you are today. When you combine those increasing distributions with your social security income and any other income sources you have, oftentimes, you end up having a lot more income than you necessarily need, getting pushed into much higher tax brackets in the future, which can result in you paying more taxes. Ultimately when you pay more taxes in the future, you have less in your account balances.

Now, for the tax rates in this comparative analysis, we’re simply looking at post-Trump tax cuts or the Tax Cuts and Jobs Act. That expires or sunsets at the end of 2025. We’re looking at the tax environment as we know it today, as the law is currently written. These are not overly aggressive tax rates. These are not conservative tax rates that we’re using. We’re simply using what the law will be in a couple of years based on current environment.

Some of you are probably wondering what this blue box is over here. In both scenarios, we have the base strategy, which is if you follow conventional wisdom. These two different people, they come in to see us. We’re going to do a base case analysis of their tax situation based on their spending needs and their account balances. Of course, the composition of those accounts, Roth versus pre-tax. Over here is now what we would recommend if this person came in to see us, it’s not something that’s static and it’s just, here you go. It needs to be managed on an ongoing basis and analyzed and looked at, but we would ultimately recommend if this was where you were coming in, and this is the path that you were following. This is the path that we would want you to get going along.

What this would involve would be taking money out of the traditional part of your retirement accounts and converting it over to Roth, to the tax-free part. Oftentimes, we’re going to end up converting this money over to Roth to help you save taxes over time. Now, if we do that, again, look how much the– it’s not the end of the world. If you’ve done this and this is where you are, a lot can still be done to help you pay less tax over time and increase your account balances over time. Look at the big difference here. If you continue down this path, you’re still spending $736,000 in taxes versus $285,000.

This would be a dynamic strategy where we’re targeting certain tax brackets over time, but all is not lost if you’re in this situation and you’re already 60 or 65 or 68. This is just what this would be. Now, the pre-optimized is what I’m going to call this because we optimized your tax diversification leading up to age 60. This was the analysis of the base case. If this couple came in to see us, there’s still some work that can be done here. Estimated $400,000 in increased ending value, but $120,000 of less taxes paid, so there’s still some work to be done there. Obviously, this person is far better prepared to withstand any tax storms that may be coming on the horizon.

Scenario 1: Pre-tax 401(k) Contributions

I mentioned required minimum distributions, and this is a huge part of retirement planning. Sometimes I’ll talk about trying to reach a point of equilibrium, and what I mean when I say that is based on our projected spending goals. Let’s say we want to spend $100,000. How much do we have in Social Security, other income sources? What’s the gap then between those fixed sources of income and our spending goal? That’s the point of equilibrium. If we can target getting our retirement account to that point where our required minimum distributions, the amount we’re forced to take out, fill that gap.

Now, why is that important? Because we don’t want to be in a situation where we’re forced to take a whole lot of income out of our retirement accounts in a period where taxes could be really high. It’s inefficient to have more income distributed than you actually need when you have to pay taxes on it, plus that tax risk component where you may be paying a lot more than if you just simply got it done today or at some point previous or prior to here in the future.

I just want to show you, this is all the money inside the pre-tax 401k. This is an estimated amount of required minimum distributions in the future. For this couple, they were 50 today, 2024, so their required minimum distribution starting age would be 75. We can simply see here, $73,000 is the estimated starting RMD. That goes on top of all of the other income that you have. You can clearly see as it increases over time, it gets up to almost $150,000 a year of a required distribution.

Impact of RMDs on Social Security Taxation

You’re probably not going to be spending that much money, so it becomes inefficient when you add on to the fact that your Social Security and other income sources are there for you. Not to mention, the tax code is like a net. When you have these massive IRA distributions, what it tends to do is to drag all of your other sources of income into a state of taxation. Your dividends, your capital gains, your Social Security, having these forced IRA distributions taxed at what’s known as ordinary income rates or income tax rates can have this domino effect where other sources of income are now getting dragged into a state of higher taxation.

Just to compare the Roth 401k contribution scenario, we see here are required minimum distributions, but they’re starting at about an estimated $32,000. They get up to about $54,000, so 20, 30, 40, 50, 60. This is a much more manageable situation, even if the RMD is in excess of the gap that you need to meet your spending goal. Now, because this is the base case that we’re looking at, there is no further tax planning. I want to point out that even in this scenario and the other one, we would most likely tackle some of the infestation of the retirement accounts, all that taxation built up in there, between ages 60 and 75.

In the real world, we would optimize this even further. Now, I want to put some numbers behind the concepts that I’ve been sharing with you. It starts here, really, with the adjusted gross income. We see 70 through 74, very modest adjusted gross income. Then all of a sudden, in 2039, it increases to 150. That’s because required minimum distributions kick in. This is the base case of the pre-tax 401k contribution plan, not the one where they put it into the Roth.

Scenario 2: Roth 401(k) Contributions

First thing to point out is in order to reach the spending goal, they only need to pull out $18,000 from the IRA. That goes on the tax return. Then the $88,000 of Social Security goes on to the tax return. You do the little provisional income calculation, but only $21,000 of that Social Security income is subject to tax. Now, go back to what I said a few minutes ago when I mentioned that the Internal Revenue Code, it’s like a net, where when you have big required minimum distributions, it essentially drags other sources of income, potentially, into a state of taxation.

Here, they’re not forced to take these big RMDs. They’re just simply taking what they need. That allows them to still benefit from the preferential treatment from a tax standpoint of Social Security. Now, fast forward over here, once they have to start taking RMDs, 73,000 is the RMD but what it’s done now is it’s dragged 85% of the Social Security income into a state of taxation. This is where you start to get into trouble with these big RMDs is it causes other sources of income to be taxed.

Now, what if there’s means testing in the future with Social Security? Okay, someone who has 150,000, maybe you don’t keep all your benefits. I don’t know, but that is a concern of mine that I have from a planning standpoint. We don’t want to be vulnerable to what I call tax risk. When politicians start to change the tax code and go after certain segments of the population, the question is are you potentially vulnerable to that tax risk in the future?

A final comparison of the Roth contribution 401k strategy. Everything is the same here except we get to 2039 age 75 when RMDs kick in and because the IRA account balances are smaller, we have only a $32,000 IRA distribution and taxable Social Security of $42,000. That has reduced about $30,000 of taxable income. The AGI, adjusted gross income, is now $75,000. Any additional distributions that are needed could come from the Roth which does not increase your Social Security taxes, does not increase your Medicare taxes, does not increase your investment income taxes.

How Roth distributions avoid increasing Social Security and Medicare taxes

Roths are a really cool tool in that they are exempt from dragging other forms of income into a state of taxation possibly. Now, again, as a reminder, this is not the optimized plan. This could actually be lower. This is just the base case. Remember we were looking at those two couples as separate people coming in to see us at age 60. What does their path look like if they just follow conventional wisdom? Now, this could be optimized further but for apples-to-apples comparison and to keep this video reasonable length of time, I just want to show you the base case.

Visibility. That is the goal of what we try to do with these videos. That’s the goal of what we do from a planning process, and really this is what it’s like on a visit with us for our clients. I hope hopefully that this created some visibility for you to help identify should you put money into the Roth part of your 401k, should you not, and most importantly what does the impact of that decision possibly look like down the road.

Now, let me be very clear, we are not advocating one way or the other because many of you have income that is in the 40, 50, 60, 70,000 dollar range. Some of you have income that’s 100, 200, 300, 400 plus. The decision to put money inside the pre-tax or Roth also needs to take into consideration your tax consequences today. This is not about providing advice of what you should do. This is simply trying to provide visibility and education into the impact of some of the potential decisions that you can make.

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