One of the most popular retirement plans is the beloved 401(k). This allows participants of the plan to make pre-tax or Roth contributions during their earning years. Also, employers generally will match contributions up to a certain percentage, giving the employees a major incentive to contribute. As of March 31, 2018, 401(k) plans held an estimated $5.3 trillion1 in assets.
The “good old days” of pensions are gone, and it’s up to the employee to take on the responsibility of his or her own retirement. It’s not uncommon for us to see a large 401(k) or IRA balance when someone is nearing retirement. If you have done a good job saving (early and often) and achieved a modest investment return, it’s probable that this would be your largest asset on your statement of financial position.
At age 70 ½ the IRS does require a minimum distribution on those pre-tax retirement accounts. The major benefit of the pre-tax contribution is that you can avoid the federal and state income taxes that are due during your prime earning years. You will pay them later. However, the U.S. tax system is progressive, so you ideally won’t pay as much tax because your income will be less than it was during your earning years. This is where the opportunity lies.
Above is an example of a person’s total tax cost in dollars across the vertical axis. Along the horizontal axis is their age. This picture will look different from person to person as everyone’s situation is unique. The point is to show the “opportunity valley” in the middle. This is where the income has been shut off at retirement. The significant drop illustrates a period of time before Social Security and/or IRA/401(k) distributions. The valley will be longer if you retire early or delay Social Security and IRA/401(k) distributions. The valley could be looked at simply as an opportunity to pay less in taxes for a while. Another financial planning strategy would be to convert some of those IRA/pre-tax 401(k) dollars into a Roth IRA. This would allow you to pay taxes in the year you convert. This makes more sense when your tax situation is low.
Essentially, you are putting yourself in the driver’s seat and choosing when you will pay taxes on the IRA. If your projected taxes are higher in later years and future tax law is a relative unknown, why not take control of the controllable? When you withdraw the Roth IRA, the entire withdrawal will be tax-free. That is assuming you are over the age of 59 ½ and waited 5 years from conversion or converted to a Roth IRA that had been open for 5 years.
For this strategy to be really beneficial, you would need to have a sizeable Roth IRA and/or after-tax investment accounts in place to fund those retirement years before your Social Security and IRA/401(k) distributions begin. This approach couples well with a person who wants to delay Social Security to the maximized benefit age of 70 years old. Because the Roth IRA is tax-free on withdrawals, this can make an excellent estate planning tool to pass along to heirs. Would you rather that they inherit a fully taxable account or a completely tax-free account? It’s worth repeating that each person’s financial plan is different. But if you have most of your liquid wealth in pre-tax retirement accounts, it’s wise to review what financial planning opportunities are out there for you. At Foster Group we keep the focus on helping our clients plan and invest, so they have the opportunity to accomplish their goals in every climate.
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