What You Can Do With Asset Allocation to Lessen Crippling Taxes and Have More Money in Retirement

Troy: On February 2nd, 2023, I posted a video titled, I have 1.7 million. What’s the relationship between IRAs, Social Security, Taxes, and Roth Conversions? Boglenaut recently posted a comment that I thought was very insightful. Comments like this from Boglenaut show that the hard work we’re putting in to communicate these complex retirement planning topics are getting through to you and it’s the thought process that we’re invoking in many of you viewers, is really what makes me proud and I’m very happy to receive comments like this.

Bognlenaut’s Question

Here is comment from Boglenaut. It’s in quotations. It says, “Investing with Humor by Boglenaut” Again, this is the February 2nd, 2023 video that we put out. “Troy, I love your videos and have watched dozens of them. You really fed my confirmation bias to do large Roth conversions in 2023, 2024, and 2025. We have those tax-infested IRAs that you talk about and the conversions won’t kill the beast, but at least start to tame. One thing I have not heard you mention is that asset placement by account type. For example, we put our bond allocation in the retirement account while our Roth accounts are 100% stock. This is one strategy to slow the growth of the future tax liability.”

Before I go into the comment, I want to make sure that we understand the problem.

Setting the Stage: Tax-Infested Retirement Accounts

The general concept is when you have these tax-infested retirement accounts, if we don’t have a plan to remove money from them, either through distributions or taking the money and converting them over to a Roth IRA, those accounts can balloon, can grow, to a much larger amount, and then you’re forced to distribute when required minimum distribution start large amounts of income, which can put you into a much higher tax bracket than you originally thought you would ever be in, but also provide you income at a time in life when you probably could have used that back when you were in your early 60s or mid-60s and enjoyed spending that money.

The thesis that Boglenaut posits here is, “What if I just put all of my bonds inside my retirement account and all of my stocks inside the Roth?” First thing when I started to think about this was, “Well, how much money do you actually have in retirement accounts at this juncture, and also how much do you have in Roth,” because unless you have an amount in each of these accounts that is equal to the appropriate allocation that you should have for retirement, this strategy is probably going to be a little bit out of luck. Let me put some numbers to it.

Let’s say you have $1 million dollars in your IRA and $200,000 in your Roth. If all your stocks go here and your bonds go here, well, you have more than 80% of your money inside bonds and less than 20% of your money inside stocks.

The Potential Consequences of Planning Retirement Out of Order

In the retirement success plan, there’s a reason we put tax planning as step three. Step one is the allocation planning, step two is income planning, and then step three is tax planning.

The first thing I want to bring up here is we can’t put the horse before the wagon. If we set our allocation according to a tax strategy and not according to how much we want to spend, how long we need this money to last, and some of our other key objectives in retirement, we could very well be putting the cart before the wagon. It depends on, again, how much money do we have in each of these accounts. If we have, let’s say, $1 million in Roth and $1 million in IRA, and we adhere to this strategy, well, then we have a 50%-50% allocation, stocks to bonds, and it can work out.

Where it possibly gets out of luck and most likely will get out of luck is this account should be appreciating in value over time much more rapidly than this account. We’re probably going to be taking income from here as well, further depleting our allocation to lower-risk type investments and increasing our overall allocation to higher-risk investments. Whereas we may, in this example, start out 50/50, over the next two, three, four, five years, this account won’t grow as much, we’ll be pulling income out of this account to keep the tax balance low, or the amount of tax infested dollars low, so it could very easily grow to 60-40, 70-30, 80-20.

Now we’re getting older, but our portfolio allocation is getting a little bit out of luck. The concept could be that we rebalance of course, but at some point, we’re probably going to need to add some lower-risk investments in the Roth because this will probably become depleted at some point. Hopefully, this sets the stage or helps you understand some of the potential consequences that could develop over time if we do step three of the retirement success plan before we’ve actually done step one. We don’t want to do task planning before we do the allocation. The allocation should be based off how much income that we need, which of course is step two, generating an income plan.

Planning for Potential Future Changes in Tax Code

The second concept here I want to bring up is future changes to the tax code. While retirement planning, especially tax planning, a lot of times is an arc because it requires assumptions and projections into the future, so we don’t know specifically what will happen, but history tells us that the tax code often changes. Our political system in this country is much like a pendulum and the tax code follows that political pendulum. Republicans get in, they cut taxes, Democrats then take over, they raise taxes and this kind of pendulum goes back and forth.

I don’t want to say safe to assume, but quite possible that this pendulum continues and whenever that pendulum swings back over to the right and we have lower taxes, we could take advantage of greater Roth conversions in the future at that time. Again, understanding that we need to be nimble, we should be flexible. We don’t want to allow the tax tail to wag the dog, so to speak, but starting to look out into the future based on what we know over history can also help guide us when it comes to some of these decisions.

Finding Opportunities in Recession

The number three thing I want to talk about is there is opportunity in recession. We’re always looking for opportunities and what this strategy does here, or what it overlooks is think of 2020, for example, when the stock market was down very significantly over a couple month period, but then also 2022. Whenever we put an allocation together in an income plan and a tax plan for clients, we’re always stress-testing it to see what are the impacts of a recession. If the market historically goes 30% down from peak to trough, what opportunities are there?

One of the biggest opportunities we have is to do Roth conversions when the equity balance is reduced because of a recession or a market pullback. Think about this high level. If we have a million dollars in the retirement account and the account, let’s say, cuts in half to 500,000, well, if we convert prior to the recession $100,000 and the account balance is a million, we have converted 10% of that account to a tax-free Roth IRA.

Now, when a recession hits and let’s just say the account balance drops to 500,000, that same 100,000 now represents 20% of your IRA account balance. We’re paying the same amount of taxes moving that 100,000 over to the Roth, but we’ve proportionately moved a much larger percentage of the IRA over to Roth. Theoretically, when the market rebounds that 100,000 inside the Roth should grow, and now we have a much larger balance inside the Roth IRA.

If we have all of the fixed income inside of our retirement account, we typically do not have the same opportunity to convert a larger percentage of our retirement account to a Roth IRA in a recession.

Factoring Age and Life Expectancy in when Planning for Retirement

The next concept to point out here is age and life expectancy. If we are younger, let’s say 60 years old, well, one, we have more time to do Roth conversions. We can allow those accounts to grow more theoretically by having a higher allocation to stocks because your first required minimum distribution won’t start until you’re 75. We have 15 years to stretch that tax planning strategy out before you’re forced to distribute money out.

Also, life expectancy. This plays into it. Again, not an exact science, but having an understanding of our life expectancy can contribute to this strategy as well. The other concept about age is if we are in our late 50s or early 60s, we probably need this money to last for 25, 30 years, and having the wrong allocation because we’re focusing on tax strategy, could result in pretty bad outcome because the accounts won’t grow nearly as much as they otherwise should.

I want to give you a quick example here. We have a $2 million starting balance, we’re taking 80,000 out per year over a 30-year period. If we earn 7%, the future value is $7.6 million. If we, because we’ve let the tax strategy determine what our allocation is and we haven’t determined our allocation based on our longevity and income needs, let’s say we don’t earn 7%, we only earn 5% over time because of the more conservative allocation, our future value of 7.6 million drops to 3.3 million.

That’s more than $4 million change in value from only a 2% difference in average rate of return. Again, we don’t want to let the tax tail wag the dog. We want to make sure our investment allocation step one is appropriate for our income needs step two, then once we’ve done that, now we build you the tax plan.

Giving to Charity in Retirement

Number five thing to consider here is how charitable are you. Do you plan on giving money to charity?

If so, we can take advantage of what are known as qualified charitable distributions where up to $100,000 of your required minimum distribution can go to charity. You don’t have to pay tax on it, and it does count for your RMD. That could be a strategy where I’m now tying this back, that means we can have more growth in our retirement account because we’re planning ahead.

We know we’re charitable. A good portion of that RMD that we necessarily don’t need we can just do a QCD with, and then we don’t have to pay tax on that. We fulfill our RMD obligation and the remainder balance of that RMD, we can live off as income because theoretically here we have a tax plan that is an appropriate tax bracket that we end up in. I also put DAF here, which stands for donor-advised fund.

If you have non-IRA assets, we could make a contribution to a donor-advised fund which creates an income tax deduction today which can be used to offset any income taxes that you have. I’ve done videos on donor-advised funds. If you search the channel, you’ll find those. Just want to bring up that there are some charitable opportunities if you are inclined to give to charity over time, that we can use to offset potential higher future RMDs.

Conclusion

Concepts, again, we’re trying to communicate how all of these decisions could impact the retirement plan that you actually construct. Investment allocation, income generation, tax planning. Step four is healthcare planning and then step five of course is estate planning, the disposition of those assets and planning for that. Just some food for thought here because when Boglenaut submitted that question, I started to think about all the ramifications and the concepts I wanted to communicate to you when it comes to making sure that we don’t let that tax tail wag the dog.

 

Thanks to @investingwithhumorbyboglen4387 for the great question!

 

Retirement Success Plan Steps mentioned in the video:

Step 1: Allocation – https://youtu.be/eylDPr2GBpA

Step 2: Income Planning – https://youtu.be/Ey3jugfFmJ8

Step 3: Tax Planning – https://youtu.be/v4wspgYn1Go

 

Do you need a Retirement Success Plan that goes beyond allocating funds to truly fit your needs? We can help you create a retirement life plan customized for your retirement vision and legacy. Call us at (877) 404-0177 or click here to fill out this form for a free consultation.