The Advantage of Having Several “Buckets” to Draw From in Retirement

Only having retirement savings in a 401(k) can restrict retirement planning

By Jon Aldrich

I have seen it a lot over the years in my time as a financial planner and advisor. I have a client come in that has done a great job of saving through the years, but virtually all of their retirement savings are in a company 401(k) or similar type plan. They are now near retirement age so there is not a lot of time to save in other accounts, but if I had worked with them several years prior, I would have recommended that they consider diversifying their savings into other accounts to give them more flexibility when it comes to generating the income they will need in retirement, especially when it comes to managing the amount of taxes they pay in retirement.

The issue arises when someone has saved up, say $2million in their 401(k) and maybe now that is rolled into an Individual Retirement Account (IRA) and they need to start drawing on it for the income they need to live on in retirement. Let’s assume they need $80,000 a year after-tax in addition to their Social Security income which is $55,000 before Medicare deductions and they do not have any taxes withheld on their Social Security. This situation will put them squarely in the 22% marginal Federal Income Tax bracket. Since they don’t really have other sources to pay the tax due from the $80,000 they need from the IRA, they will need to have more taken out of the IRA to pay the taxes for the year. Thus, they will need to draw $95,000 from the IRA and have $15,000 of Federal taxes withheld to cover the tax bill of $14,867 based on these assumptions to get the $80,000 net cash they need each year.

Since they live in Illinois, none of their Social Security or IRA income is taxed, which is nice. But if they live in a state that taxes these sources of income, they will have additional taxes to account for on a state level as well from the IRA distributions.

Now, let’s assume that another couple comes to me and has $1million in their IRA, but another $250,000 in a Roth IRA and $750,000 in an after-tax brokerage account. If they have the same $80,000 net cash needs, we can get creative and pick and choose from these 3 “buckets” consisting of an IRA, a Roth IRA and an after-tax account. Let’s also assume the after-tax account generates $24,000 of interest and dividends of which half are taxed as “qualified” dividends from stocks and half are non-qualified dividends from bonds and cash. Let’s also say the account generates $10,000 a year in long-term capital gains.

This second couple could take just $40,000 from the IRA and the rest of the cash needed from the after-tax account and/or the Roth IRA which will have no taxes associated with it. Total taxes would roughly be $7,900 for Federal and about $1,500 for Illinois due to interest, dividends and capital gains taxes on the after-tax account. This totals $9,400 as they are still in the 12% Federal tax bracket and is about $5,400 less than the couple that only had an IRA to choose from. The taxes could be paid from the after-tax account so they don’t have to take additional funds from the IRA to pay for taxes.

When the Required Minimum Distributions (RMDs) start once the account owner turns 73, a larger IRA will also have larger RMDs to take as the IRS wants to collect taxes on these funds that have been deferred for many years. Roth IRAs and after-tax accounts do not have to take RMDs.

I am not saying to stop saving into your 401(k) plan through your working years, you still want to do this to grow retirement savings tax deferred for many years and to get the bonus of a company match along the way. But you should give some thought to saving in a Roth IRA and into after-tax brokerage accounts as well. Also, you don’t want to forget to have an ample amount in savings as well to cover unexpected expenses that arise.

Some other benefits to having retirement savings in an after-tax account in addition to your 401(k) or IRA are:

Accessing Funds Before Age 59 ½ - If you need to access funds prior to age 59 ½, you will pay a 10% penalty if you take from a 401(k) or IRA in addition to any income taxes due unless you qualify for a hardship distribution.

Secure Act 2.0 Made IRAs a Less Attractive Asset to Leave to Heirs – Recent legislation has made 401(k)s and IRAs less attractive for children to inherit by requiring them to empty the accounts within 10 years of receiving them. Prior to Secure Act 2.0, IRAs could be left to children or grandchildren and they would be required to take the funds out over their potentially much longer life expectancy. This was known as a “Stretch” provision since they could stretch the payments out over their lifetimes. Having to empty a large IRA over 10 years can potentially push beneficiaries into higher tax brackets. Assets in after-tax accounts would qualify for a “step-up” in basis at the death of the owner and can be passed to heirs without any income tax as the tax-cost basis, would “step-up” to the market value at the date of death.

IRMAA – Income Related Monthly Adjustment Amounts – IRMAA does not refer to your favorite aunt that makes awesome peach cobbler. IRMAA refers to the increases in Medicare Premiums you may pay if your income gets above certain levels. If you have large IRAs, the larger RMDs you need to take can potentially push you up into higher income levels and the possibility of triggering much higher Medicare premiums in retirement.

Many 401(k) Plans Have High Fees and Limited Investment Options – Although I see plenty of great low-cost 401(k) plans with decent investment options, I also see many high-cost plans with limited investment options. Thus saving in your own Roth IRA or after-tax account, you can have an unlimited array of investment options to choose from.

Benefits to Having Funds in Roth IRAs:

Never Taxable – Amounts in a Roth IRA are put in after-tax, so they can grow tax-free and are never taxed once they are withdrawn. Even if you just put in a few thousand dollars and it grew to several million over the years, not one penny is taxable. It is a beautiful thing to have a source of tax-free funds in retirement. Also, amounts taken out do not count as income as well. This is helpful for avoiding income related surcharges, such as IRMAA.

No RMDs – Roth IRAs are not subject to RMDs once the owner turns 73. When they are inherited by children or non-spouse beneficiaries, they must be withdrawn by the end of the 10th year after inheriting, but there is no tax to the beneficiaries.

Can Get Contributions out Before 59 ½ Without Penalty – If you do need to get money from a Roth IRA prior to reaching 59 ½, you can take the amounts contributed out (but not any earnings). If the Roth has not been open for 5 years, you would need to qualify for a hardship distribution. After it is open for 5 years, you would not need to meet the hardship qualifications to access contributions.

Conclusion:

Although I highly encourage people to continue to save in 401(k) and other employer sponsored retirement plans, you should also be considering saving into other investment vehicles such as Roth IRAs, after-tax investment accounts, high-yield savings accounts and even sometimes, low-cost non-qualified annuities. By having a plethora of different types of accounts to choose from in retirement, you can really do some wonderful tax planning and have a lot of flexibility in determining how much taxable income to generate from year to year.