By Robert Klein, CPA
There are two things you need to do if your goal is to optimize after-tax retirement income:
- Maximize retirement income
- Minimize income tax liability
Although it’s difficult to project what your tax situation will be when you retire (let alone for the duration of retirement), there are certain steps you can take during your working years to reduce your income tax liability throughout retirement. One of the key things that’s often overlooked, especially by younger employees, is minimizing required minimum distributions, or RMDs.
Every time you make a deductible contribution to a qualified retirement plan, you create lifetime RMDs. This is true whether your retirement plan is a traditional 401(k) plan, a 403(b) plan, a SEP-IRA, or a traditional IRA.
Generally speaking, RMDs must be taken from all of your retirement plans beginning by April 1 of the year after your reach age 72. The sooner you start making deductible contributions, the larger the amounts of your contributions, and the more years you contribute to your retirement plans, the larger your RMDs.
Required Minimum Distribution Income Tax Considerations
RMDs are a ticking time bomb. Unless you make nondeductible contributions or qualify for the traditional 401(k) plan company stock net unrealized appreciation (NUA) exception, distributions from qualified retirement plans, including RMDs, are taxable as ordinary income at your regular income tax rates.
RMDs can significantly increase your income tax liability and reduce your after-tax retirement income. In addition to the tax liability attributable to RMDs, six stealth taxes can further reduce your retirement income. This includes increased taxable Social Security, increased Medicare Part B and D premiums, and increased income tax liability for surviving spouses and children. Finally, RMDs are subject to future income tax law changes that can adversely affect the longevity of your retirement assets.
Short of not making contributions to a qualified retirement plan, there are three ways to minimize required minimum distributions:
- Contribute to a Roth 401(k) plan and roll plan assets into a Roth IRA
- Convert a Traditional 401(k) plan to a Roth 401(k)
- Do a Roth IRA conversion
Contribute to a Roth 401(k) Plan and Roll It into a Roth IRA
Contributing to a Roth 401(k) plan provides you with all of the benefits of a traditional 401(k) plan minus the pre-tax deduction for contributions. You can contribute up to $20,500 each year plus an additional $6,500, for a total of $27,000 to your Roth 401(k) plan. The maximum contribution limit increases periodically to reflect higher cost-of-living adjustments.
Other advantages of traditional and Roth 401(k) plans include automatic savings and employer matching contributions if available. Employer matching contributions to a Roth 401(k) plan are required to go into a traditional 401(k) plan, and, as such, are taxable upon withdrawal and subject to RMDs.
A traditional 401(k) plan enjoys tax-deferred growth. Roth 401(k) plan participants benefit from tax-free growth with no current or future taxation of contributions and earnings.
A Roth 401(k), like a traditional 401(k), is subject to required minimum distributions. The start date for traditional and Roth 401(k) RMDs can generally be deferred past age 72 if you’re still working for the employer that sponsors the plan.
You can avoid RMDs for Roth 401(k) plans by rolling them over to a Roth IRA. Contributions and earnings can be rolled over tax and penalty free once you reach age 59-1/2.
While it’s easy to check the box to allocate 100% of contributions to a 401(k) to a traditional vs. Roth plan to realize immediate tax savings, the long-term consequences of this decision need to be carefully analyzed relative to the goal of maximizing after-tax retirement income.
The income tax liability attributable to taking withdrawals from a traditional 401(k) plan is likely to exceed the tax savings from deductible contributions in many situations. Please refer to my September 2, 2016 MarketWatch article, How to Put Some Muscle Into Your Roth 401(k) for further discussion.
Convert a Traditional 401(k) Plan to a Roth 401(k)
If you didn’t allocate 100% of your 401(k) contributions to a Roth 401(k) or your company recently introduced a Roth 401(k) option, you can convert a portion or all of your traditional 401(k) to a Roth 401(k). Conversion amounts are subject to income tax liability at ordinary income tax rates.
Why would you prepay income tax? The overriding reason for doing this is to optimize after-tax retirement income. Given the fact that the current value of converted amounts plus future appreciation are no longer subject to taxation, this is an opportunity to maximize lifetime after-tax distributions from a 401(k) plan to you and potentially your heirs. This can be the case even if you’re in a lower tax bracket in retirement.
The caveat that applies to Roth 401(k) conversions is that you need to have liquid nonretirement funds to pay the income tax liability attributable to converted amounts.
Do a Roth IRA Conversion
The income tax treatment, reason for doing a Roth IRA conversion, and caveat that apply to a Traditional 401(k) conversion are also applicable to a Roth IRA. Once again:
- Converted amounts are subject to income tax liability at ordinary income tax rates.
- Prepaying income tax on converted amounts provides an opportunity to optimize after-tax retirement income.
- Liquid nonretirement funds are required to pay income tax liability attributable to converted amounts.
A Roth IRA conversion, similar to a Roth 401(k) conversion, doesn’t have to be, and shouldn’t be, in most cases, an all-or-nothing decision. You can convert a portion of your traditional IRA accounts to a Roth IRA. I recommend establishing a staged Roth IRA conversion plan when you’re in your 40’s as part of a holistic retirement income plan for most individuals with Traditional IRA accounts.
If your goal is to minimize required minimum distributions, maximize retirement income, and minimize exposure to future income tax law changes that may adversely affect the longevity of your retirement assets, contributing to a Roth 401(k) plan makes a lot of sense. This is especially true if you’re willing to forego current income tax savings available when making contributions to a Traditional 401(k) plan. The potential for increasing after-tax retirement income combined with current historically low-income tax rates makes this more palatable.
Staged Roth 401(k) conversions and Roth IRA conversions also benefit from the low tax-rate environment provided that liquid nonretirement funds are available to pay income tax liability attributable to converted amounts.
About the author: Robert Klein, CPA, PFS, CFP®, RICP®, CLTC®
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC®, is the founder and president of Retirement Income Center in Newport Beach, California. The firm’s motto is Planning, Managing, and Protecting Your Retirement Income™. Bob is the creator of FINANCIALLY InKLEIN’d™, a YouTube channel featuring tax-sensitive, innovative strategies for optimizing retirement income. Bob is also the writer and publisher of Retirement Income Visions™, a blog featuring innovative strategies for creating and optimizing retirement income that Bob began in 2009.
Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies, including fixed income annuities, Roth IRA conversions, HECM reverse mortgages, and charitable remainder trusts, to optimize the projected longevity of his clients’ after-tax retirement income and assets. Bob does this as an independent financial advisor using customized holistic planning solutions determined by each client’s financial needs.