Kevin Michels, CFP®, EA
Rule-of-Thumb Regarding Pre-Tax and Roth Retirement Accounts
The common rule-of-thumb regarding pre-tax retirement accounts (Traditional IRA & 401k) and Roth retirement accounts is if you are in a higher tax bracket today than you will be in retirement, save in a pre-tax account. If you are in a lower tax bracket today than you will be in retirement save in a Roth account.
Initially, this makes sense. The most optimal benefit comes from receiving a tax deduction when your tax rate is highest.
For example, if you’re in the 33% tax bracket today and will be in the 25% tax bracket in retirement, it makes sense to get a 33% deduction today (contribution to pre-tax) instead of a 25% deduction during retirement (tax-free withdrawal on a Roth).
Hence, the popular advice: If you are in a higher tax bracket today than you will be in retirement, save in a pre-tax account. If you are in a lower tax bracket today than you will be in retirement, save in an after-tax account.
However, like most rules-of-thumb, this doesn’t and shouldn’t apply to all situations.
I’m specifically referring to high earning couples and individuals following this rule-of-thumb, who diligently max out their pre-tax accounts through their working years and eventually hit the magic age of 70 ½ only to be hit with a giant tax bomb in the form of required minimum distributions (RMDs).
The fact is, saving in a pre-tax account is simply deferring income to the future, eventually it will have to be recognized and taxed, and if you continue to “kick the can down the road” long enough it can end up doing more damage than simply recognizing the income now.
Required Minimum Distributions (RMD)
A quick run-down of RMDs:
The year in which you turn 70 ½ the IRS requires you to begin withdrawing a certain percentage of your money held in pre-tax retirement accounts. It’s the IRS’ way of forcing you to recognize the income you have deferred so the IRS can collect the taxes you owe them.
Roth IRAs are not subject to RMDs since contributions are taxed up front (Note that Roth 401ks are subject to RMDs but this can simply be avoided by rolling the Roth 401k into a Roth IRA which is a non-taxable transaction).
To calculate your required minimum distribution, the IRS provides a table called the Uniform Lifetime Table (if you own an inherited IRA or your spouse is more than 10 years younger than you, you will use a different table) that provides a factor based on your age. Your year-end account balance is divided by the factor to determine your required minimum distribution.
The first year RMD will be roughly 3.6% of your account balance and will increase incrementally each year thereafter.
For example, if you have $500,000 in your pre-tax retirement accounts your first year RMD will be $18,248.
“RMD Tax Bomb”
The “RMD Tax Bomb” is created when an individual or couple saves so much in their pre-tax retirement accounts that they are required to withdraw more from their account than they actually need.
Three negative consequences occur when this happens:
- Taxable income increases which subsequently increases your tax liability
- Tax-deferred growth is halted and maximum compound growth isn’t realized
- The longevity and amount of retirement capital decreases
For example, consider the financial situation of the Smith’s. Mr. and Mrs. Smith both age 70 have accumulated $2,000,000 in pre-tax accounts. In addition to their retirement savings they receive $100,000 in fixed income payments each year (between social security, pension plans, and rental income). They only need $150,000 to live comfortably in retirement which means they only need to withdraw $50,000 from their retirement accounts.
Unfortunately, the Smith’s first year RMD totals $72,993 which is almost $23,000 more than they actually need.
This additional $23,000 creates an additional tax liability of roughly $6,345, which isn’t devastating but is definitely unnecessary. In addition, the extra $23,000 the Smiths are forced to take out doesn’t realize the compound growth that could have taken place over the years. In this case, at 6% over 25 years, that $23,000 could have turned into $98,700.
The next year the Smiths are forced to withdraw $25,600 more than they need, creating an additional tax liability of $7,200. In addition the extra $25,600 the Smiths are forced to take out doesn’t realize the compound growth that could have taken place. In this case, at 6% over 24 years, that $25,600 could have turned into $103,600.
Each year that passes the Smiths are forced to take out increasingly more than they need creating additional tax liabilities and foregoing large amounts of compound growth. After 25 years of this process repeating, the Smiths have withdrawn $1.6 million more than they need, creating an additional tax liability of roughly $500,000 and missing out on compound growth of over $3.1 million.
Now assume the Smith’s decided to split their savings throughout their working years and have saved up $1,000,000 in pre-tax retirement accounts and $1,000,000 in Roth retirement accounts.
Although the Smith’s gave up half the deductions they could have had during their working years they have effectively reduced the amount of their savings that are subject to RMDs giving them much more flexibility and freedom on how much they withdraw during retirement.
Like the first scenario the Smiths are planning on withdrawing $50,000 from their retirement account at age 70. Their first year RMD only totals $36,500 giving them the flexibility to withdraw the $50,000 they actually need or less if they want to. No additional tax liability is assumed and every penny the Smiths don’t need will be allowed to stay in the account and take advantage of compound growth.
By splitting up their contributions between pre-tax and Roth retirement accounts the Smiths end up with about $3.3 million more in their retirement accounts at age 95.
Having made the point that splitting up contributions between pre-tax retirement and Roth retirement accounts is a good strategy for those in high tax brackets, it does not apply to everyone and every situation.
This example doesn’t take into account the possibility of investing the additional tax deduction received for contributing everything to a pre-tax retirement account each year. It also doesn’t take into account year-to-year changes in expenses, inflation, and investment growth which are inevitable.
However it’s critically important not to choose where you save your retirement funds based on rules-of-thumb such as only saving in a pre-tax retirement account if you are in a higher tax bracket today than you will be in retirement. Or only saving in an after-tax retirement account if you are in a lower tax bracket today than you will be in retirement.
A more comprehensive approach using actual financial planning software is required to determine what is best for each individual and couple.