By Andrew Crowell
Research estimates that as many as 10,000 boomers are entering their retirement years every day. While many, if not most, are excited about tackling their wish list of retirement activities, many are also fretting about whether or not their accumulated savings will be sufficient to carry them across the finish line. Decades of diligent saving during their working years may now be followed by decades of retirement living. This means that those hard-earned dollars will likely need to stretch further than in past generations.
We've all heard about the benefits of stretching for our physical health, particularly as we age. Research shows that regular stretching improves mobility, flexibility, balance and energy. Now that we're living longer, it is also important to point out that stretching our retirement assets can be just as critical for our financial health. A retiree can accomplish this "financial yoga" through careful planning and understanding of all available income streams, all the while balancing cash flow needs with tax sensitivity. Often, this means strategically choosing to take less from retirement accounts that would generate taxable income upon withdrawal in order to allow these sheltered assets to have additional time to compound without the tax impact. Most of us are familiar with Required Minimum Distributions, or RMDs: at age 70½ the IRS tells a retiree how much they must withdraw from their retirement accounts. This continues for the remainder of the saver's lifetime. Not only do RMDs deplete the balance of the account, but they add to the taxable income of the saver at the time of the distribution.
Thankfully, there are several powerful savings vehicles available to investors that can help them stretch their retirement accounts, providing greater flexibility and longevity. The key to successfully stretching assets is pre-planning and strategic decision-making during working (accumulation) years. The following are strategies investors could consider when thinking about stretching their assets.
RMDs: Traditional vs. Roth IRAs
Most savers are aware of the differences between Traditional IRA/401(k) accounts and Roth IRA/401(k) accounts. While there are many distinct differences that should be carefully discussed and reviewed with an accountant prior to making decisions, a key distinction is that traditional accounts are funded with pre-tax dollars whereas Roth accounts are funded with post-tax dollars. This means that savers in a traditional retirement vehicle get a current tax year benefit in addition to long-term compounding without the impact of annual taxes. Distributions from a traditional account are taxed as ordinary income the year in which they are taken. By contrast, Roth contributions are post-tax dollars, so they do not provide a current tax year benefit, but these accounts also accumulate without the impact of annual taxes. Moreover, qualified distributions from these accounts are completely tax-fee. A simplistic way of thinking about Roth contributions is that you are pre-paying the taxes by funding the account with post-tax dollars, so you can remove that uncertainty and tax expense later when you withdraw.
There are numerous free calculators available online to help savers decide which type may be best for them from a savings perspective; however, there is another important difference that should be considered as part of that evaluation, and most calculators fail to incorporate it. Traditional IRA accounts have RMDs whereas Roth accounts do not. This means that an investor who reaches age 70½ does not have to take funds out of their Roth account unless they want or need to. The IRS no longer dictates when, if ever, they must dip into their Roth. This means that, provided they have other income streams to use, they can let these Roth funds accumulate indefinitely. Purely for illustration's sake, imagine that an investor lives to age 80 or even 90-an additional 10-20 years. Growing without the impact of annual taxes or RMDs, these Roth funds have the potential to double, or even more than double, during these years.
Pre-planning during the accumulation years is key. Choosing which annual contribution path (traditional versus Roth) is critical. Saving early and often in a Roth account - if that is the optimal strategy for the saver based upon their needs, income level, taxes, etc. -- is important to growing a substantial Roth balance. However, there are both income and contribution limits to these accounts that preclude many from taking advantage of this benefit. For tax year 2018, couples who are married and filing jointly are unable to contribute to a Roth if they make $199,000 or more. So, does that mean this account option is completely closed for higher net worth families? Surprisingly, no.
The Back-Door Roth IRA
While the new Tax Cut and Jobs Act of 2017 did not remove the adjusted gross income qualification limits for Roth contributions, it did continue to allow a valuable "back door" Roth opportunity for higher income families by expressly allowing conversion of traditional IRA assets. This means that higher income families still have the ability to store away nuts for winter in a Roth. It's important to note that any conversion of retirement assets should be thoroughly evaluated with an accountant or tax expert since the conversion of pre-tax traditional contributions to post-tax Roth contributions will create taxable income in the year in which they are done. However, investors can work with an adviser to strategically plan out how to spread the tax burden over multiple years by converting in stages, and if income fluctuates widely from year to year, they can take advantage of lower income years for potentially larger conversions, as they may be in a lower than normal tax bracket. While this is not a new strategy, it was expressly preserved in the 2017 tax law when many had expected the back door to be slammed shut.
Health Savings Accounts
Another strategy which savers and higher income families might be able to benefit from is to open a Health Savings Account (HSA). HSAs are special accounts for individuals who participate in high-deductible healthcare plans. Participants in these accounts can contribute pre-tax dollars up to the annual specified limits. The annual family maximum contribution for 2018 is $6,850. Two additional added benefits of HSAs are that qualified distributions for healthcare expenses are not taxed and the account does not have any RMDs. Thus, an HSA account can provide a triple benefit to the saver. The tax-free nature of the qualified distributions and lack of RMD make these accounts similar to Roth accounts and can therefore be another valuable source of retirement account stretching.
Qualified Charitable Distributions
Let's assume, for example, that a saver still has substantial traditional IRA/401(k) balances that they were unable to convert to Roth contributions. There are still tax-efficient strategies for these balances once RMDs begin. The Tax Cut and Jobs Act made permanent Qualified Charitable Distributions (up to $100,000 annually) for IRA owners 70½ or older. Assuming the saver has philanthropic intentions and uses some or all of their RMD to make a Qualified Charitable Distribution (QCD) to their designated charity, the donated portion will count toward the total RMD but will not be treated as taxable income when it is distributed. While the donation cannot also be deducted on their tax return when it is given, it will still reduce the saver's adjusted gross income and therefore result in tax savings. The IRS has specific rules around how the QCD needs to be made, but this is yet another example of how thoughtful planning in the distribution phase can help to stretch hard-earned savings.
Many savers diligently plan ahead and contribute thoughtfully to their retirement accounts during their working years, researching investment options and maximizing employer matches. But many of these same savers don't spend enough time planning their distribution strategy for when it comes time to use these assets. Thanks to some newer account choices, those savers have additional choices about what type of bucket to save in, and the vehicle they choose can have a dramatic effect on their ability to stretch savings in retirement. Whether retirement is decades away or right around the corner, improved financial health and agility is possible, but only with advance preparations.
About the author: Andrew Crowell is vice chairman of wealth management at D.A. Davidson & Co. D.A. Davidson & Co. is not a tax adviser. Before investing in any IRA, consult with your personal tax adviser about the specific tax consequences and advantages of your situation.