Who remembers their senior year of high school? You’ve completed at least 12 years of school already, perhaps even more with pre-school, and at this point in your life you feel like you’ve learned everything you need to know and you’re just ready to be done. Problem is you have one more year and taking it too easy in that last year, could create hardship in the not-too-distant future. In the same way, many retirees, as they enter their final working years feel those same, “just get me outta here” emotions they felt all those years ago in high school, yet decisions made right before retirement can have some big impacts.
Let’s consider that as a general rule, most individuals have a gradual rising income over their working career. Even young high-income earners can expect that high income to continue to grow into the future. What we’re often faced with a few years before retirement is some of the best income you’ll personally ever see, which allows for some great “catch up” strategies like ensuring all your debts are paid off, including your home, making sure your emergency fund is stacked as strong as you’ve ever had it and putting the final touches (including catch up) on your retirement savings. The purpose of this article is to dive into the realties of how to deal with a retirees retirement savings right before retirement.
To be clear, every situation is unique and your specific situation should be discussed with your financial advisor. Your financial advisor is part of your team, which includes your tax and estate planning professionals that should guide you through retirement and a good advisor, according to Vanguard’s Advisor Alpha Study, can add as much as 3% to their clients return through asset allocation, rebalancing, behavioral coaching, asset location, spending strategy (withdrawal order) and other factors. So, let’s dig into the question of how someone should allocate their retirement savings right before retirement – Roth or Pre-Tax?
Delay Your Roth Contributions
We know the team at Ramsey Solutions tells us that the Roth IRA or Roth 401(k) is the right way to go and we whole heartly believe that, however for some pre-retirees the decision to do a delayed Roth IRA may be more beneficial. What we mean by a delayed Roth IRA is making contributions right before retirement into pre-tax retirement accounts, as opposed to your Roth IRA or Roth 401(k). The reason for this is tax savings, relative to your cost to convert the monies right after retirement. Let’s take a look at an example.
In 2022, a married couple, filing jointly, can earn up to $83,550 while paying 10% and 12% in federal taxes. With their standard deduction in 2022 of $25,900 that could increase their potential income in the above mentioned brackets, to $109,450. Then your rates jump to 22% and go as high as 37%. All things considered keeping your income in the 10% and 12% brackets is a pretty nice strategy. So, let’s assume our client, SAMPLE CLIENT A, who is age 63 and will retire at age 65, is earning $120,000 between himself and his wife. That means that he should be contributing $18,000 towards retirement (Baby Step 4 – 15% of income into retirement). If they would contribute everything to a Roth IRA / Roth 401(k) then they’d have a piece of their income ($10,500) that would fall into the 22% bracket therefore costing them $2,321 in federal taxes on that piece of their wages. However, if they allocated, that $10,550 into their pre-tax accounts and left the balance of their savings in Roth buckets they would have avoided the 22% bracket altogether.
Fast forward two years when SAMPLE CLIENT A retires and let’s assume they would like $70,000 worth of income in retirement. Their income is broken down as follows:
$30,000 – Social Security – Only 85% of this income is taxable so only $25,500 hits their return
$40,000 – Income from Retirement Accounts (assuming non-Roth assets here)
Therefore, their taxable income is $65,500. That means, under 2022 tax laws, they would have $43,950 left in the 12% federal income bracket. Let’s go back to the $10,550 they allocated to their pre-tax account at age 63, if grew at an 8% rate it is now worth $12,373. If we did a Roth Conversion of this money, meaning taking it from the pre-tax account and moving it to the Roth IRA, now that they are retired and their income is lower, we would have to pay $1,484 in federal income taxes. Keep in mind, at age 63 we saved $2,321 in taxes by contributing the $10,550 to the pre-tax side, to keep ourselves under the 12% bracket. Thus approx. tax savings for this person was $837. If they had a higher income, presumably you’d contribute more to the pre-tax side, creating an even larger savings.
This strategy won’t be right for everyone, however those that are above the 12% federal bracket ($109,450 income in 2022 with the standard deduction) and that will dip below it when entering retirement, should be able to see tax savings by executing this strategy. Of course, we always recommend you consult your financial advisor team and your tax ELP team to get specific advice to your unique circumstances.
ROTH VS. PRE-TAX (TRADITIONAL) RETIREMENT CONTRIBUTIONS FOR THE 60+ CROWD
December 13, 2021
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