The Power of Zero, Revised and Updated
Page 4
Tax-Deferred Bucket: The Ideal Balance
So, after going to such great lengths to pooh-pooh the tax-deferred bucket, is there ever any scenario in which you would want to have money in these types of accounts? Let me answer that question in two parts.
First, whenever your employer is offering you free money, it’s always wise to accept it. Free is good. For example, if you make $100,000 per year and your employer gives you a dollar-for-dollar match for up to 3% of your income, contribute $3,000 but not a penny more. If your employer is willing to give you $3,000, take it! You just can’t beat a 100% return on your money in that first year. As a rule of thumb, you should always put money into your 401(k) up to the employer match, but nothing more.
Some worry that by stopping contributions to their 401(k), they’ll lose out on tax deductions. This is true, but you have to remember that the purpose of a retirement account is not to give you a tax deduction, it’s to maximize your retirement distributions at a point in your life when you can least afford to pay the taxes—in retirement. Remember that during your working years, you generally have more deductions, more surplus cash with which to pay the tax, and (at least in the near term) historically low tax rates. In retirement, all those deductions will have been phased out, taxes will likely be substantially higher, and there will be less money to go around.
Second, there are legal ways to get money out of our 401(k)s and IRAs in retirement without paying any taxes at all. Let me illustrate this with an example. A 50-year-old married couple planning to retire at age 65, absent any other tax deductions, could claim a deduction. As previously discussed, they would get the standard deduction: $24,000. Because the IRS indexes this $24,000 to keep up with inflation (3% historically), these deductions would actually be closer to $37,000 by the time this couple retired in 15 years at age 65.*3 That means that they could receive income from any number of taxable sources up to $37,000 without paying taxes. Now, that’s my idea of the perfect investment! Get a tax deduction at the outset, don’t pay taxes as it grows, then take it out tax-free. You simply can’t beat it!
So, how much can you have in your tax-deferred bucket without foiling your own attempts to reach the 0% tax bracket? Your tax-deferred balances need to be low enough that by the time you start to take RMDs at 70½, your distributions are equal to or less than your standard deduction ($24,000 in 2018). Let me give you another example: John and Susan both just turned 70½ and have $500,000 in their IRAs. If all their other deductions have been phased out (which is likely), they could distribute from their IRAs an amount equal to their standard deduction without paying tax. Remember, in 2018 this amounts to $24,000.
At age 70½, their RMDs would be 3.65% of their $500,000 IRAs, or $18,250. Because their deductions of $24,000 are greater than their distribution ($18,250), they wouldn’t owe any tax on their RMDs!
If, on the other hand, they had $1,000,000 in their IRAs, their RMDs (at 3.65%) would be $36,500—far greater than their deductions of $24,000. In this case, it would be impossible for them to be in the 0% tax bracket. What’s worse, that $36,500 is all provisional income and, when added to one-half of their Social Security, could cause up to 85% of their Social Security to be taxed at their highest marginal tax bracket.
On the other hand, if they only had $100,000 in their IRAs at retirement, their RMDs would be $3,650. With $24,000 of claimable deductions, $20,350 would go unused!
While it might take a bit of math to figure out, there is generally a perfect amount to have in the tax-deferred bucket by the time you retire. In short, you want RMDs at age 70½ to be equal to or less than whatever your deductions happen to be in that year (which is $24,000 in today’s dollars).*4 In most cases, if you contribute only up to your employer match during working years, your 401(k) balance will be at or below this ideal amount by the time you retire.
To determine if your tax-deferred balances are already too big, you must calculate the number of years until retirement, your contributions, employer match, and the rate of growth you anticipate on your investments. If your balances are too big, you’ll need to employ some of the shifting strategies we will discuss in the next chapter. A good tax-free retirement specialist armed with the appropriate software should be able to help you determine the ideal balance in this bucket today and, if necessary, identify strategies to help reposition any surplus into the tax-free bucket.
In summary, the tax-deferred bucket has a number of different pitfalls that can hinder your efforts to reach the 0% tax bracket. When used in the right amounts and under the right circumstances, however, it transforms into the perfect stream of tax-free income and makes a valuable contribution to your 0% tax strategy in retirement.
*1 “Social Security: Calculation and History of Taxing Benefits,” Congressional Research Service, January 15, 2010, http://aging.senate.gov/crs/ss24.pdf.
*2 effective tax rate: the average rate at which an individual is taxed.
*3 This assumes Congress extends the 2018 tax cuts in 2026.
*4 When calculating the ideal balance in the tax-deferred bucket, keep in mind that one-half of Social Security counts as provisional income. Therefore, these balances may need to be adjusted to stay below minimum provisional income thresholds.
FOUR
THE TAX-FREE BUCKET
If you’re like most Americans, you have the lion’s share of your wealth accumulated in the first two buckets—the taxable and the tax-deferred. If that’s the case, don’t despair, because there is a third bucket. Some people call this final bucket tax-advantaged, some tax-preferred, still others tax-exempt, but for our purposes, we will call it the tax-free bucket.
Now, I have to warn you, there are all sorts of investments that like to masquerade as tax-free. I’m here to tell you that to be truly tax-free, an investment has to qualify in two different ways.
First, it has to really be tax-free. I’m talking free from all taxes, including federal tax, state tax, and capital gains tax. We’ve all heard of municipal bonds, right? We’ve been told for years that municipal bonds are tax-free, but do they really meet the definition of a true tax-free investment? It is true that the interest from municipal bonds is free from federal tax, but it’s not always free from state tax. To avoid state tax, you have to buy a bond issued by the municipality in which you live. For example, if you live in Arizona and you buy a municipal bond from California, you aren’t benefiting the municipality in which you live (Arizona), so you would have to pay state taxes. How about capital gains tax? Let’s say that you don’t want to put all your eggs in one basket, so you buy a mutual fund of municipal bonds. Then your mutual fund increases in value and you decide to sell it. In this case, you would actually pay capital gains tax. So, municipal bonds don’t qualify as truly tax-free because they can, in some circumstances, be taxed.
Second, money distributed from a truly tax-free investment cannot count as provisional income. In other words, true tax-free investments do not contribute to the thresholds that determine whether your Social Security benefits get taxed. Not to pick on municipal bonds again, but interest on these bonds does count as provisional income and may cause a portion of your Social Security to be taxed. So, an investment vehicle widely touted as tax-free doesn’t even satisfy the two litmus tests required of a truly tax-free investment.
Now that we’ve defined a true tax-free investment, let’s explore the investment vehicles that do qualify.
The Roth IRA
The Roth Individual Retirement Account (more commonly known as the Roth IRA) is perhaps my favorite tax-free investment because it meets both of the litmus tests I just mentioned. So long as you’re at least age 59½, all distributions from Roth IRAs are free from federal, state, and capital gains taxes. Further, distributions from Roth IRAs do not count as provisional income and, therefore, don’t cause any of your Social Security to be taxed.
Contribution
s to the Roth IRA are made with after-tax dollars, meaning that you do not get a tax deduction at the time of contribution. However, once your money is in a Roth IRA, your dollars grow tax-free and are tax-free upon distribution as long as you’re at least 59½.
Now, like most good things in the financial world, the IRS does put some constraints on the Roth IRA, but this shouldn’t discourage you from participating.
Contribution Limits: Anytime the IRS puts limits on what you can contribute to a retirement program, your antennae should shoot up. A general rule of thumb is the more austere the limitations, the more attractive the investment vehicle. This is the case with the contribution limits imposed upon the Roth IRA. As of 2018, if you’re younger than age 50, the IRS will only allow you to contribute $5,500 per year. If you’re older than age 50, you have a catch-up provision that allows you to contribute $6,500 per year. Compare these limits to those in traditional tax-deferred alternatives. With a 401(k), you can contribute up to $18,500 (or $24,500 if you are over age 50). With a Simplified Employee Pension (SEP), you can contribute an astounding $54,000 per year. By looking at the Roth IRA’s contribution limits relative to its tax-deferred peers, we can infer that there is something valuable and compelling about this account.
Income Limits: Can Bill Gates contribute to a Roth IRA? Actually, he can’t. He makes too much money. Once you approach the $189,000 income threshold for a married couple ($120,000 for singles), your ability to make Roth IRA contributions begins to phase out. How about my children, the oldest of whom is 16? Can they contribute to Roth IRAs? Nope. In order to contribute to a Roth IRA, you have to have earned income. You have to be working somewhere and earning an actual paycheck. (My kids work, I just don’t pay them!) How about retirees living on Social Security and receiving distributions from their IRAs? Nope. They can’t contribute to Roth IRAs because, again, they lack the earned income. Roth IRAs are designed to benefit Main Street Americans who are still earning a paycheck.
Liquidity Constraints: The IRS does allow you to access whatever you’ve put into your Roth IRA without penalty.*1 But to access the growth on your contributions tax-free and penalty-free, your Roth IRA account has to have been open for at least 5 years and you have to be at least 59½. In other words, your Roth IRA shouldn’t double as an emergency fund. Any of the growth on your contributed dollars can’t be accessed until age 59½. If money is withdrawn prematurely, additional taxes and penalties ensue. Further, once money has been withdrawn from a Roth IRA, it cannot be paid back. You will have effectively forfeited your ability to grow the money you distributed on a tax-free basis for the rest of your life. Once you make a distribution, you lose those tax-free dollars, along with all future growth.
If you do a Roth conversion before you are 59½, you have to wait five years or until 59½, whichever comes first, before you can touch the principal without tax and penalty. If you’re already 59½ when you make the conversion, you can touch the principal immediately but have to wait five years before you touch any of the earnings without penalty. Be sensitive to this limitation when planning your Roth conversions.*2
To reiterate, just because Roth IRAs have constraints doesn’t mean you shouldn’t contribute to them. In fact, I would say that because they have constraints you should be contributing to them. Remember, Congress and the IRS only let you have so much of a good thing.
The Math and Science Behind Roth IRA Contributions
In what circumstances should you contribute to a Roth IRA? The answer depends on whether or not you will be in a higher or lower tax bracket when you take the money out in retirement. That’s it. End of story.
You may have heard the argument that Roth IRAs are deficient because you’re contributing after-tax dollars. This argument suggests that since you are contributing after-tax dollars, you aren’t able to contribute as much and, therefore, won’t have as much money over the long term. Let’s use a little bit of math to debunk this financial myth. Again, the only determining factor in whether you should contribute to a Roth IRA is what you think your tax rate will be when you retire. Let me illustrate with the example of twin brothers Gary and Doug, age 35.
Gary is at a combined state and federal marginal tax bracket of 30% and likes the idea of tax deductions, so he opts for the tax-deferred approach. He decides to put $5,000 of pre-tax dollars into his 401(k) each year with no match from his employer. He then lets it grow and compound at 8% for the next 30 years. By the time he retires at age 65, he has $611,729 in his 401(k). Only, he doesn’t really have that much because he hasn’t paid taxes yet. Remember, the only dollars that really matter are those that we can spend after tax, right? Let’s also assume that tax rates when Gary is 65 (suspending disbelief for just a moment) are still at 30%. How much of that $611,729 is left after tax, assuming that he pays 30% tax on all distributions? The answer is $428,211.
Gary’s brother Doug opts for the tax-free approach with his Roth IRA. Because he’s contributing dollars that have already been taxed at 30%, he can now only invest $3,500 per year. He grows these dollars over the same period of time, and then decides to retire at age 65. How much money will he have? Would you be surprised if I told you $428,211? It’s the same as Gary, down to the last red penny!
What’s the moral of the story? If tax rates in the future are the same as they are today, it doesn’t matter which IRA you choose, Roth or traditional. However, if tax rates in the future are just 1% higher, you’re better off choosing the Roth IRA. In Gary’s case, 1% higher taxes means he’s left with only $422,093, in which case Doug wins!
In order to determine whether you should put your money into a tax-deferred or tax-free investment, you have to ask yourself what you truly believe about the future of tax rates. If you think that tax rates in the future will be higher than they are today, then you should invest in tax-free accounts. If you think tax rates in the future will be the same as today, then it doesn’t really matter. If, in the unlikely event, you think tax rates in the future are going to be lower than today, then you should put money hand-over-fist into your tax-deferred account.
So, as you read the headlines and take inventory of our country’s fiscal condition, ask yourself where tax rates are going to be when you retire. Factor in the reality that you will have very few deductions in retirement, and then make your decision accordingly. If you have even the slightest notion that tax rates could be higher, then you’ll have more money to spend in retirement if you invest in a Roth IRA.
Nondeductible IRA: Becoming a Convert
If you have income that exceeds the income thresholds and have been phased out of Roth IRA contributions, there are alternatives. One such alternative is the nondeductible IRA.*3
With nondeductible IRAs, you contribute to the tax-deferred bucket, only with after-tax dollars. Once you’ve made these contributions, you can then convert them to a Roth IRA. Because you’re contributing dollars that have already been taxed, there are no tax consequences upon conversion to a Roth IRA. If you decide to wait until the end of the year before you convert, there may be some taxable gain if the investment grows, but because you’ve already paid taxes on the contributions, the tax you would pay would likely be nominal.
In short, you start out making contributions to the tax-deferred bucket, but upon conversion it ends up in the tax-free bucket. It just requires signing one extra piece of paper—a conversion request.
Limitations: Once again, anytime the IRS leaves an opening like this, you can be sure there are going to be restrictions. Here’s the caveat: even though you’re contributing after-tax dollars to your nondeductible IRA, you may still owe tax upon conversion if you have pre-tax contributions and gains in other non-Roth IRA accounts.*4
Here’s how it works: Let’s say that you contribute $5,500 to a nondeductible IRA and then decide to convert it to a Roth IRA. Let’s also say that you have $200,000 in a traditional IRA. To calculate the tax implicat
ions on your conversion, you must add the $5,500 to your existing $200,000 IRA and then divide the pre-tax amount by the total IRA balance. When you divide $200,000 by $205,500, you get 97%. This is the portion of your nondeductible IRA balance that would be taxed upon conversion. So, 97% of $5,500 ($5,335) will now be taxed at your highest marginal tax bracket. At the 30% rate (24% federal and 6% state), you would owe $1,650 of tax on a nondeductible IRA balance you already paid taxes on! Paying more tax than necessary, of course, runs counter to everything this book hopes to accomplish.
Now, you could have $200,000 in a 401(k), 403(b), or even a 457, and this rule would not impact you. In that case, you could convert your nondeductible IRAs all day long with little, if any, tax liability. But if you have any money at all in a traditional IRA, you may want to think twice before adopting this tax-free strategy.
Roth Conversions: Ditching the Traditional IRA
In the right circumstances, converting from a traditional IRA to a Roth can be a very useful and efficient way to shift dollars into the tax-free bucket. By paying taxes today, you can take advantage of historically low rates while they’re still around. If you still have plenty of deductions, these could help offset the taxes. Lastly, if you’re at the apex of your earning years, you may have plenty of surplus capital with which to pay those taxes.
Roth conversions, however, cannot be undertaken haphazardly. In most cases, the timing has to be just right. Here’s an example. Let’s say that you’re age 50 and have $500,000 in your traditional IRA. Let’s also say that you’re anxious to convert this IRA to a Roth before a precipitous rise in tax rates. So, you decide to convert all $500,000 in one year. Just to make our math easy, let’s assume your tax rate on this conversion is 40% (35% federal, 5% state). You’d owe the IRS $200,000, right? Well, here’s the problem. Do you have $200,000 just lying around that you would love to send to the IRS? Probably not. Some might suggest that you pay the $200,000 tax bill right out of the IRA itself. If you went this route, however, you would incur a 10% penalty for early withdrawal. That’s a $20,000 mistake! Unless you have piles of money languishing in your taxable bucket earmarked for taxes, you may want to postpone conversion until you’re at least 59½.