5 Ways to Fix an Overfunded Retirement Plan

Building a large nest egg fast requires fancy footwork involving a high savings rate and avoidance of taxes. At least that is the conventional wisdom. 

But conventional wisdom has been wrong before and even in demographics such as the FIRE* community where the idea of maxing out retirement accounts is practically a religious belief, cracks are beginning to appear.

Less understood are the benefits of NOT investing in a retirement account. Yes, traditional retirements accounts (tIRA and t401(k)) reduce your taxable income while providing tax deferred growth. But when the money comes out it is all taxed at ordinary rates while a similar investment in a non-qualified account will largely have been taxed at the lower long-term capital gains (LTCG) rate, though without any tax deferral.

Other serious issues arise from fully funded retirement accounts. Once you hit age 70 1/2 you must take a distribution from traditional accounts—the dreaded required minimum distribution (RMD). RMDs reduce your ability to control your tax matters which means fewer potential tax credits, higher Medicare premiums and taxation on up to 85% of your Social Security benefits.

 

A Growing Problem

Recently I was a guest on The FI Show podcast. Cody and Justin did a great job prying solid tax information out of me. Things I think are normal problems to deal with are unheard of by the general public. Except the general public will suffer the consequences. And Cody and Justin knew a good story when they heard it. 

The one issue I brought up that shocked most was the size of the RMD some people will face and the catastrophic tax issues involved as a result. I mentioned I have a few clients looking down the barrel of a half million dollar RMD when they hit 70 1/2. This was shocking news, but it shouldn’t be.

The broad stock market averages in the U.S. (S&P 500, for example) tend to increase about 10% per year on average, or about 7% after inflation. (Stocks for the Long Run by Jeremy J. Siegel)  Depending on the time frame covered skews the averages a bit above or below the stated returns so we will use these numbers loosely for illustrative purposes only. 

This means if you invest $1,000 today in a broad-based index fund you can expect the investment to double in nominal terms in around 7 years and in real terms every 10 years. 

Here is where the problems begin. A common question from clients is how to add even more to their retirement plans to defer taxes. If the client is in the early stages of building wealth this makes sense. But if a client is 50 with $2 million in traditional retirement plans we need to discuss the issues further before adding to the stack.

Remember, a 50 year old will need to start taking required distributions in 20 years. Since, on average, the investment will double every 7 years in nominal terms the $2 million doubles to $4 million, then to $8 million and then to nearly $16 million when RMDs kick in!

While $2 million sounds like a lot—and it is; trying to save a few more tax dollars today can hurt you a lot later. In the example above the RMD the first year exceeds $500,000! There is not a lot of tax planning I can do for you at that point to help you. It’s required! That means control of your tax situation is reduced to the point of Band-Aide solutions, if that. 

Now I understand you might be younger and have less than $2 million socked away. But the earlier you start (I’m talking to members of my FIRE community here) the bigger the numbers get. If, for example, you manage a mere $100,000 in your traditional IRAs and 401(k) by age 30 and never drop another dime into those accounts and the market just performs average you get 40 years of compounding growth, or almost 6 doublings! 

Visualize the growth. From $100,000 to $200,000 to $400,000 to $800,000 to $1.6 million to $3.2 million to almost $6 million! (Remember we get just shy of 6 doublings.) 

Six million is a smaller problem than our first example, but still an issue. And it assumes you never defer another dime into your traditional retirement accounts.

 

5 Ways to Avoid RMD Problems

Whenever I consult with a client I have to make clear my advice will consider “all years” rather than just “this year”. If my advice saves you money this year but increases your taxes the next or some future year, the benefit is less than it appears up close. 

Traditional retirement plans are just such an example where “all years” planning is so important. A few million in a traditional retirement account with generate adequate RMDs to cover a very ample lifestyle. The drawback is the increased taxes on Social Security benefits and taxes on the RMD at ordinary rates.

Solution 1

After a certain point (your facts and circumstances will determine that point) it is better to fill your Roth IRA or use the Roth feature of your 401(k). Yes, the Roth gives you no up-front tax deduction. But, the earnings growth is NOT deferred; it is TAX-FREE! 

RMD issues don’t plague the Roth investment the way it does traditional plans. Roth distributions are also tax-free which add flexibility to tax planning in later years. This makes the job for a future Wealthy Accountant working with you to save you money easier. (I assume I’ll retire at some point, if only because I forget to breath one day.) 

Also where traditional retirement plans are a tax nightmare for beneficiaries when you die, the Roth is a much more pleasant experience. 

I’m perplexed when people show reluctance in filling a Roth investment. The tax deduction today in minor compared to the future taxes avoided due to the tax-free nature of Roth growth! Remember, this thing tends to double every 7 or so years. A 25 year old dropping a mere $5,000 into a Roth can expect somewhere around $500,000 at age 70! That means $495,000 tax-free dollars. I’m sorry, I can’t find you a better deal than that. (Not legally, at least.)

Solution 2

There also seems to be a fear amongst some when it comes to investing in non-qualified (non-retirement) accounts. To these people there is something sacrilegious about not getting a deduction and paying taxes as you go. And I can’t understand why.

Think of it this way. When you take money from your traditional retirement plan, the one you got a deduction for up front and enjoyed tax deferral on the gains, you pay tax at ordinary rates which currently top out at 37%. And state taxes can add more.

But your non-qualified plan also enjoys a lot of tax deferral! Index funds are by design tax efficient. This means they are not trading a lot to get incremental gains at the expense of extra taxes. This also means most index funds throw off few capital gains, hence a de facto deferral. Only dividends are currently taxed and most of these are qualified and taxed at LTCG rates. 

The highest LTCG tax rate is 20%. And many will pay 0% tax on LTCGs. (In 2019 a joint return can have income up to $78,750 before LTCG are taxed. And the 20% rate doesn’t kick in until your reach $488,851.) 

Because a lot (most) of your gains are deferred anyway with an index fund and the tax rate is lower when you do sell (compared to traditional retirement accounts) and there are no RMDs or early withdrawal penalties, non-qualified accounts should play a central role in the portfolio of most investors.

The deductible retirement account investment is not the default.

Keith’s Rule 76: If investing in a deductible retirement account doesn’t provide additional tax benefits outside a simple deduction it is probably not worth it.

This means that dropping money into a 401(k) at work needs matching to offset the future losses from higher taxes and RMD issues. It also means you need to consider if a contribution to a traditional retirement account will provide larger credits elsewhere (Education Credits, Saver’s Credit, Earned Income Credit, Premium Tax Credit, et cetera). 

It’s not always a simple calculation. An IRA deduction might not work while profit-sharing in your business might. Facts and circumstances play a vital role. 

Solution 3

Once you reach age 59 1/2 you can start taking money out of your retirement accounts without tax penalty. This makes a lot of sense if you retire early, even if you don’t need the money.

Your income level will determine if this works for you.

By the time you reach 60 you may either have retired or slowed down to part-time or accepted a less stressful, lower income profession. As a result your tax bracket might be zero or something close to it.

With the standard deduction for joint returns now $24,000, many will have ample room to move money from retirement accounts early. If your income is comprised of LTCGs only there is an opportunity to move some money from retirement accounts tax-free.

Remember, joint returns enjoy tax-free LTCGs up to $78,750 of income. If you take a $24,000 distribution from your traditional retirement account and have another $40,000 of LTCGs you would pay zero tax. The standard deduction would cover the retirement distribution and your income would not exceed $78,750 so your LTCGs would also be tax-free.

Solution 4

Some of you are hyper-savers and started maxing out retirement accounts at a young age. Now you have $1.5 million and you still haven’t reached the ripe old age of 40. Your RMD issues are going to be huge even if you stop adding to the pile now.

Your reasoning for building such a large nest egg at a young age was so you could take time to be with family and travel.  Enter Section 72(t) of the Tax Code.

Section 72(t) says you can withdraw money at any age from your traditional IRA without penalty if you follow a few rules.

1. Distributions are based on IRS tables. The larger your account balance and the older you are the more you can access under 72(t).
2. Once started, you must take the same distribution each year for at least five years or until you reach age 59 1/2, whichever is later. (There are some rules that allow for increasing your distribution each year based on inflation.)

Distributions under 72(t) are taxed as ordinary income without penalty. 

Warning! If you fail to continue taking the required 72(t) distribution for 5 years or until age 59 1/2, whichever come later, all prior distributions under 72(t) are subject to penalty.

Section 72(t) is a powerful tool in tax planning for early retirees. Since your income is lower you effectively get tax-free, or nearly so, distributions while also enjoying potential tax-free LTCGs.

Solution 5

Sometimes I have to pull out all the stops to protect my client. That is why I consider it vital to keep RMDs below a certain threshold if at all possible.

The reason I mentioned on The FI Show podcast a few clients I have facing $500,000+ RMDs is because I lose all control in tax planning with these clients. Which begs the questions: At what level of RMD do I retain at least some control?

Glad you asked.

The answer is: $100,000.

Here’s why.

Under current tax law I can have my client elect to have up to $100,000 of her RMD sent to a charity of her choice and not include it in income.  

This is more important than you think! The ability to not include up to $100,000 in income allows me to potentially access a large sum of LTCGs are low or no tax. It might also allow fewer Social Security benefits to be included in income. 

This strategy allows me to micromanage with the client for an optimum tax outcome. The more room I have to move, the better the magic I can perform.

 

Final Comments

Conventional wisdom is NOT always right! Filling retirement accounts to the brim make for great titles on CNBC and personal finance blogs, but around here we are more interested in workable knowledge. One size does not fit all.

Consider this one last point. A non-qualified account not only enjoys significant tax deferral and lower tax rates on LTCGs, but also opens the possibility to tax-loss and -gain harvesting. Two additional powerful tools in the wealth-builders toolbox.

Always consider your facts and circumstances. I’ve consulted with several thousand clients this past decade and it is rare that any two got exactly the same advice. It is never that easy. Never. The individual is important. You are the most important part of the equation. 

These ideas I shared with you today are only a start. They are the framework to build your financial plan. But the details require the master’s touch.

 

* Financial independence, retire early

 

 

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