By Brian Bruggeman, CFP
If you find yourself nearing retirement after decades of diligent saving, it becomes very important to plot out an effective withdrawal strategy — and even more so when there are multiple retirement plans to factor into the equation. In this article, we’ll discuss key considerations related to a pension, 401(k) plan, and nonqualified retirement plan.
The most complex distribution decisions tend to involve pensions. Investors often look at different payout possibilities and wonder whether it would make more sense to take the pension only on their life and receive a higher dollar figure, or apply 50% to their surviving spouse for a reduced amount, or perhaps allocate 100% of the surviving benefits to their spouse.
It’s important to note that a pension is generally one of the safer assets a retiree or near-retiree can have, potentially even safer than bonds. It may be the least risky part of your portfolio besides Social Security. Accordingly, I don’t recommend essentially flipping a coin about whether you, as the pension holder, or your spouse will live longer. For most married couples without liquidity needs or significant differences in health, I usually suggest the 100% joint-survivor option.
Furthermore, with complicated scenarios where the pension is accompanied by a defined-contribution plan, it makes sense to diversify risk. For instance, if you have $1 million in your pension and $2 million in your 401(k), the 100% joint-survivor option represents the safest choice because it provides a floor, along with Social Security, and as much risk diversification as possible.
Where it gets trickier is with the Social Security leveling options that many pension plans provide. Corporations don’t typically offer inflation adjustments on pension payouts, so what Social Security leveling options do is essentially front-load a recipient’s benefit statement.
For example, one of my clients retired at age 60 and wasn’t going to receive a cost-of-living adjustment (COLA) on her pension. I was able to show her that if she chose the Social Security leveling option, she would be paid about two-and-a-half times her life amount for six years, at which point she could receive full Social Security benefits and her pension payment would fall to about 60% of her original single-life amount.
Depending on the scenario, you could effectively trade a pension with no COLA for Social Security with a COLA. The overarching concept is that all of the options available for a given pension are equal from an actuarial standpoint — it’s just a matter of deciding which one best matches your individual circumstances.
In terms of a 401(k) plan, the “mega backdoor Roth” is really the best tax-planning option available to anyone who isn’t self-employed. It works by taking advantage of a little-known rule that allows substantially more money to be put into a Roth IRA if those funds are being rolled over from a 401(k).
For 2021, total contributions to traditional IRAs and Roth IRAs can’t exceed $6,000 for people under age 50, or $7,000 for those who are 50 or older. Furthermore, if your modified adjusted gross income exceeds $140,000 as a single filer, or $208,000 as a joint filer, you can’t directly contribute to a Roth IRA at all. However, the backdoor option essentially enables high earners to make indirect Roth contributions.
The process starts with contributing to your 401(k), where the current annual contribution limit is $26,000 for individuals 50 and over. Let’s say you earn $200,000 a year and make a maximum $26,000 contribution to your 401(k) plan. If your company offers a 6% match, that adds another $12,000 for a total of $38,000.
Current law then allows additional 401(k) contributions so long as these are after-tax funds and the total contributed amount doesn’t exceed $64,500. So, in the example above, $26,500 could still be contributed after your initial $26,000 allocation and the $12,000 employer match. The process is then completed by either rolling that additional $26,500 into your Roth IRA or converting the after-tax funds inside of your 401(k) plan.
If you have the money, it’s very appealing to make this conversion because any growth on the after-tax contribution amount would be in a Roth. Conversely, if you put the additional $26,500 into your 401(k) but don’t convert it to a Roth, and that amount doubles, then the $26,500 of gain would be taxable income when withdrawn from your 401(k).
Moving on to the third type of retirement account, nonqualified plans are classified as such because they don’t adhere to Employee Retirement Income Security Act (ERISA) guidelines. Primarily available to highly compensated individuals, nonqualified plans can differ significantly from one plan to another. But one unifying characteristic is that these plans typically can’t be rolled over unless they are sponsored by a nonprofit or governmental entity.
Generally speaking, a nonqualified plan should be one of the first buckets of money you decide what to do with in retirement. This is due to the limited rollover options available and often-strict limits on how long money can remain in the plan after you separate from employment. Another key aspect of nonqualified plans is that contributions can generally be deducted, because technically these are at risk of being forfeited or liable to a company’s creditors.
When you take distributions from retirement accounts, the two primary considerations are optionality and tax efficiency. In lining up the first pot of money and how much to withdraw, you should focus on the tax treatment and try to avoid just deferring taxes into the future. The goal is rather to minimize your and potentially your heirs’ lifetime tax bill. And remember, any decisions that you make for one retirement plan will likely impact each of the other plans as well.
About the author: Brian Bruggeman, CFP®, CTFA
Brian Bruggeman, CFP®, CTFA, is vice president and director of financial planning at Baker Boyer in Walla Walla, Washington. He has over 10 years of experience in financial services and expertise in estate planning, individual income tax, behavioral finance, portfolio construction, retirement planning, financial technology and financial industry practice management. Brian works with high-net-worth and ultra-high-net-worth individuals, high-earning young professionals and business owners. Throughout his career, Brian has focused on helping clients remain confident as they work through complex financial decisions.
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