For most Baby Boomers, the easiest way for them to accumulate wealth was saving in their qualified plans through work- including 401k and 403b plans, but they also may have had deferred compensation plans that their employers set up on their behalf, or they may have various IRA accounts that have accumulated over the years. As these types of accounts are set up, they usually are put on auto-pilot and reviewed once a year at benefit renewal time or at tax time. Now that Baby Boomers are retiring they could find the distribution stage of these assets getting more complicated. We thought we’d share a few things to think about before you consider touching these assets.
First, not all plans are alike from a tax standpoint. You need to be aware of what you have before you decide to plan a distribution strategy around it. Some plans are completely pre-tax. This means every dollar that was put into the account was deductible to you or to your employer. It also usually means that every dollar in these accounts are taxable when they come out. However, there may be some tax relief from state income tax if the account is a state sponsored retirement plan. The key is to be sure you know.
Some plans may be tax-deferred, and you don’t pay taxes until you take the money out, but they also may have some cost basis to them. Some old retirement plans (pre-1980s and 90s) could be this way, as could non-deductible IRAs. Non-deductible IRAs are IRAs that had money put into them by folks that for whatever reason (usually high income) could not deduct the contribution. However, because they were not deductible at the time, if certain stipulations have been made, they are not typically 100% taxable.
In 1997, the Roth IRA tax law was passed, going into effect for the first time in 1998. At the time, people who fell below a certain income threshold could contribute up to $2,000 per year to a Roth IRA, allowing that money to grow tax-free (with certain stipulations) for retirement. Man, oh man, has this evolved! The income limits have gone up. The Roth 401k and Roth 403b have developed. Further, there is a way to “convert” traditional IRA money to Roth. These accounts can not only be fabulous for tax planning on income in retirement, they can be great college or estate planning tools as well. But you must follow the rules with them!
Beyond tax planning with qualified accounts, retirees also need to think about how to consolidate these accounts and how to invest them. Many times, deferred compensation plans can be rolled over into IRA plans and taxes can continue to be deferred. Cost should be considered carefully, as well as the investment choices, when doing this. Some deferred compensation plans offer guarantees that can help people sleep easier, but may or may not serve their overall planning needs. Consolidating all IRAs could be a mess too, especially if you accidentally cross those aforementioned tax rules. Investing is an entirely different layer to this planning. Go too aggressive and you may need a back-up. Go too conservative and inflation can eat up your assets. Just like a pizza crust and toppings, tax laws and assets can be mixed and matched to some degree (don’t get a meat lover’s toppings on a thin crust- it’s just a waste).
Employer plans and various IRAs may also have different ages at which they are eligible for distributions without penalty. Some plans can be touched as early as 50 or 55. Some you have to wait until 59 ½. Some you can touch while you still are working. Many must have distributions at 70 ½, but not all of them! Further, as we mentioned earlier, Roth conversions are possible. This can be a great strategy when certain circumstances are at play, such as a low-income year or a down market year.
Beyond qualified plans, your other accounts will also come into play. Qualified plans and IRAs can be accentuated or hurt when a retiree doesn’t have a plan for liquidity outside the plans. While this can be worked around, it is more difficult. Tax planning with qualified plans isn’t done in a vacuum, either. Earned income, pensions, social security income and investment income from fully taxable accounts can also be very important factors that need to be considered for the strategy.
The good news is, none of this is rocket science. It’s all about putting the puzzle together correctly for you and then monitoring it for changes you may have personally, or external changes. While we always recommend consulting with your CPA (and we work closely with them developing these strategies), there are clearly a lot of opportunities for phenomenal distribution planning that can help you make the most of your qualified nest egg.