At what time in your life will your income be higher? Are you young and just starting your job? If so, do you have the kind of education, training, and work ethic that will propel you into a position where you’re earning a much higher income? Does that mean there’s a good chance you could be very wealthy by retirement? Or, are you already at the peak of your career? Are you earning the most you’ll ever earn? We all know that tax codes can change with different government leadership, but if you assumed that the tax codes stayed the same, at what point in your life will you be earning more: now or in retirement? If you are just starting out then there’s a good chance you’re earning less than you’ll earn later in life, and if you save well for retirement all those years you could be in a higher tax bracket in retirement.
The rule of thumb used to determine whether or not to contribute to a Roth now is this: If you’re earning less now, then you would possibly be better off paying the taxes on the money now, meaning you’d want retirement contributions to be “after-tax” going to Roth. But if you’re a higher earner now, then you may be looking to reduce your taxable income now, in which case you’d want to focus on “pre-tax” contributions to Traditional IRA or regular 401(k). If your employer offers Roth 401(k), then you can contribute varied amounts to either or both 401(k) types as long as you stay under the maximum amount permitted by the IRS. Just keep in mind that employer matching (the money your company contributes) will always be “pre-tax” money that you’ll owe taxes on in retirement.
Even if you are at peak income now, it may be useful to have some Roth money in retirement that you can access without paying taxes for large expenses like major home repairs and improvements. If you need a refresher on the taxability of Roth vs. Pre-Tax/Traditional, go back to lesson 24. Then, come back here and roll through this simplified hypothetical scenario[1] that discusses a woman with only pre-tax[2] money.
Hypothetical One
Brenda successfully retired at age 61 with $1.2 million. After talking with her advisor and analyzing the investments that suited Brenda, they decided that her retirement savings combined with the social security she’ll be receiving in a few years would sustain a lifestyle equivalent of $70,000 per year, and that she could “give herself a raise” to $80,000 a year when she turns 67. All of her savings was pre-tax. So, Brenda rolled all of it to a Traditional IRA.
In her first full year of retirement, Brenda took $70,000 from her retirement account. She had to pay income taxes because it came from an IRA. So, she was left with $60,000 to cover her expenses.
In her fourth year of retirement, Brenda only wanted to take $70,000, but, her air conditioning system in her house went out and the entire system had to be replaced . . . a cost of $11,000. She needed to get it from her IRA and would need $11,000 after she paid taxes. So, she had to take a total of $14,500 to cover the cost of the air conditioner. In total that year, she took $84,500 from her retirement account. $71,000 covered expenses and air conditioner replacement, while $13,500 was paid in income taxes.
At age 67, Brenda started taking social security and was receiving $18,000 per year in social security payments. She also gave herself a raise and could live off of $80,000 per year. So, $80,000 – $18,000 social security = $62,000 from her IRA. After taxes, her combined social security and retirement income was $70,100. She decided she would use her excess to buy more gifts for the children and grandchildren and to take an annual cruise.
Remember that with pre-tax money, you’ve never paid income taxes on it. So, the IRS doesn’t get to collect revenue off of you unless you distribute the money from your retirement account. When you reach 70 ½ years old, the IRS becomes concerned that you could kick the bucket, and they force you to start taking distributions called “required minimum distributions” (RMDs). When Brenda turns 70 ½ the IRS uses a table that says she can distribute her Traditional IRA assuming she’ll live another 27.4 years.
Back to the hypothetical. This year Brenda turns 70 ½, her IRA is now worth $1,612,700 because she’s been earning more on her investments than she’s been taking out. She’s required to take at least $58,857.66 from her account in that year so that the IRS can have its revenue from her in the form of income taxes. That’s okay. She normally takes more than that anyway.
Hypothetical Two
In this scenario, Brenda successfully retired at age 61 with $1.2 million. She and her advisor decided she could live off of $70,000 per year and could “give herself a raise” to $80,000 when she turns 76. While working, half of her money was contributed pre-tax, therefore, $600,000 has been rolled to a Traditional IRA and the other half was contributed after-tax, therefore, $600,000, which was in Roth 401(k), has been rolled to a Roth IRA.
In her first full year of retirement, Brenda took $35,000 from her Traditional IRA and $35,000 from her Roth IRA. She had to pay taxes on the portion she distributed from her Traditional IRA. She was left with a net amount of $29,750 from that distribution plus $35,000 from the Roth, which she didn’t have to pay taxes on because she paid them when she earned the money while working. The total amount left to cover expenses after taxes was $64,750. That’s $4,750 more for her to spend than in the scenario where she didn’t have a Roth IRA.
In her fourth year of retirement, Brenda only wanted to take $70,000, but again, her air conditioning system failed and had to be totally replace at a cost of $11,000. She took it from her Roth IRA and didn’t owe taxes. So, that year she only had to take $81,000 from her retirement accounts, She only had to pay $5,250 in income taxes, and had a net amount of $75,750 to cover expenses and the air conditioner replacement. That’s a better scenario than when she only had pre-tax money.
At age 67, she got her social security and her raise.
This year, Brenda turns 70 ½ she still has her two accounts. The value of the Traditional IRA has grown to $806,349. The Roth IRA has grown to $792,820. It’s smaller because she took the $11,000 distribution to cover the air conditioner in year four.
Remember, the IRS requires the distribution (RMD) at 70 ½. It’s required from the Traditional IRA. It’s not required from the Roth IRA because the IRS collected revenue off that money when it was earned while Brenda was working. At age 70 ½, the IRS assumes she could distribute the money over the next 27.4 years. Brenda is required to take at least $29,428 from her Traditional IRA, but that’s okay because she takes more than that anyway. In the year Brenda turns 70 ½, she is satisfying her RMD by taking out more. She’s taking $31,000 from each account now, receiving $18,000 from social security, paying income taxes in the amount of $7,350, and living off of $72,650 per year.
What you should have noticed from the two hypotheticals is that Brenda, our imaginary retiree, paid less in taxes during retirement when half of her money was coming from a Roth IRA because she’d already paid taxes on that money when she earned it.
The other thing you may have noticed was that there was less total money distributed from her accounts in year four when she had to replace the air conditioner. It was lower in the second scenario because she didn’t have to take out extra to cover taxes. The whole emergency expense was covered from the Roth.
So, if you’re trying to determine whether you need Roth money or pre-tax money, you should consider when your income will be higher and what large out-of-pocket expenses you might have in retirement (because it may be more beneficial to cover those out-of-pocket expenses from a non-retirement savings account or a Roth).
I try my best to stay apolitical. That is, I don’t like to discuss sides of politics with clients and potentially alienate them. However, I do like to discuss facts and figures. Sometimes those can help us all to be better prepared. Obviously I’m about to say something that could sound political. Please stick with me.
Price Waterhouse Coopers does a survey each year[3] [4] and they use good methods and a large number of people (sample size). They call it the PWC Employee Wellness Survey. According to the most recent survey, conducted in 2017, only about 53% of Baby Boomers feel confident that they will be able to retire when they want. That’s a huge improvement over prior years. You can Google the survey yourself and see the results. But, it’s still not good enough. What’s worse is the amounts they’ve saved. 30% of Baby Boomers have saved less than $50,000. Only 17% have saved over $500,000. 52% said they were planning to delay retirement. I’m not 100% sure how their survey shows 53% planning to retire when they want and 52% planning to delay, because you can’t have 105% of Baby Boomers. You can only have 100%, but perhaps some people have already delayed and are now on track for a new target retirement date. Of these figures, the number that concerns me most is that 30% have saved less than $50,000, and three-quarters, about 75% have saved less than $500,000.
According to the most recent census data, there are approximately 76 million Baby Boomers. They make up about 24% of our population in the US. If 75% have saved less than $500,000 that means 57 million people are about to become old and unhealthy with a high potential for inadequate retirement savings. You might be one of the people who talk about working forever, but sometimes your brain or your body won’t let you. At current interest rates, you might be able to draw an income of $25,000 – $30,000 per year off of a $500,000 investment account and have it last until the day you go to the Great Beyond.
But what about Social Security? According to the Social Security Administration[5] [6], the average payment per month in 2018 is $1,404. That’s $16,848 for the year. If you have $500,000 saved you might be able to afford a $41,848 per year lifestyle. Maybe. Possibly. If you have less than that saved, then let’s hope you have another source, like a pension or a kid who became a surgeon who’s willing to help with your expenses. I’m not trying to beat anyone up. I’m driving home a point about a generation that has under-saved and is now aging and retiring.
Right now you’re wanting me to get to that point I promised you earlier. Part of the point is that people aren’t saving enough to survive without Social Security, and they definitely can’t live on $16,848 a year, which is the average annual Social Security payment right now. You see? Without Social Security, a retiree with $500,000 in retirement savings must live off of $25,000 to $30,000 a year. Without the retirement savings, the retiree must live off of $16,484. In the absence of one, the other is not enough. When combined, they make a livable amount. So, what bridges the gap for ALL those people who haven’t saved at least $500,000? Social programs . . . government benefits.
I’m not taking a side here. I’m saying that the majority of Americans and lawmakers are eventually going to have a very hard time saying “no” to a bunch of elderly unhealthy people that need shelter, food, and health care. Many advisors share this opinion, even fiscally Conservative ones. It’s just a fact that we have an aging population with very little savings. As a result, many advisors give the advice that we should all assume we’ll have a higher tax rate in retirement than we have right now. But, that paints the whole picture with one color and one brush. Maybe we’ll all figure it out in time, before this becomes a crisis.
In case you missed that point, in all the doom and gloom over the last few paragraphs: It’s very possible that tax rates could be higher for all of us in the future. So, when deciding how much to put in a Roth, you may want to take that into consideration. It’s take it or leave it—up to you.
[1] This hypothetical doesn’t factor in the possibility of tax rate changes, which can happen when different politicians take office. It also doesn’t account for inflation or the possibility that she gets cost of living adjustments to her social security benefit.
[2] The author is not a tax advisor and this is not intended to be tax advice. If you have questions about your taxes or the tax treatment of retirement accounts you should visit www.irs.gov or contact a tax advisor.
[3] PricewaterhouseCoopers LLP. Employee Financial Wellness Survey. April 2017. https://www.pwc.com/us/en/private-company-services/publications/ assets/pwc-2017-employee-wellness-survey.pdf (Accessed April 16, 2018)
[4] The author and this book are not endorsed by nor have any financial interest in or from PricewaterhouseCoopers LLP. The source is believed to be reliable.
[5] Social Security Administration. 2018 Social Security Changes Fact Sheet. https://www.ssa.gov/news/press/factsheets/colafacts2018.pdf (Accessed April 16, 2018)
[6] The author and this book are not endorsed by any government agency. The data used is directly from the original source and is believed to be reliable.
