The Big Retirement Myth

Key Takeaways

• In retirement, the income from an IRA tends to push people into higher tax brackets than they were in while they were working, and their deductions tend to be lower.
• Between the ages of 59½ and 73, before RMDs kick in, you can’t get a penalty for pulling out money from your IRA. So, you’re free to take as much or as little out as you want and control your own tax rates. If you do nothing, the IRA continues to grow, and at 73, when you’re forced to take RMDs, that can push you into a higher bracket. It’s not in your control anymore.
• For your IRA, don’t just take the money out. A great option is a Roth conversion, and you can do a little at a time to use up those tax brackets and move it to tax-free territory. The lower your IRA balance is, the lower your taxable RMDs will be. Ed Slott calls Roth IRAs tax insurance because they are insurance against future higher taxes.
• You often hear that if the market is down, you should consider conversions. If you want to do a Roth conversion, it’s a long-term decision. The market is always going to go up and down. Wait to do conversions till November and December when you have a better projection of what the tax cost will be and you have a better projection of your income.
• For young people, anybody who gets a job should only be doing a Roth 401(k).

Christine Benz: Hi, I’m Christine Benz from Morningstar. Tax and IRA expert Ed Slott thinks one of the big misconceptions people have about retirement is that they will be in a lower tax bracket than when they were working. He is the author of a new book called The Retirement Savings Time Bomb Ticks Louder, and he is here to discuss what he calls the big retirement myth with me.

Ed, great to have you here.

Ed Slott: Great to be here right in the Morningstar studios.

Do Taxes Go Down in Retirement?

Benz: Wonderful. It’s been quite a while since we were in person. We want to discuss this misconception. You say you hear it from so many people about their retirements that they think that their taxes will actually go down, and it does make some intuitive sense because if you’re not working, you have a little bit more control. But can you talk about where people get this idea?

Slott: Well, that’s exactly it. They said, look, Ed. Because I always tell them about doing tax planning. Rates may go up. You may be in a higher rate. “That’s impossible, Ed. Once I don’t have my W-2 anymore, I’ll have less income.”

And I’ll give you a story. I had a client like this, and I was always telling him for years and years. Finally, I’m doing his tax return, and this was for the first full year of retirement. No W-2. So, he is getting ready. He thinks, “Oh, I’m going to get this big refund.” I give him the return. He says, “Ed, how can this be? My income is higher than my best earning years. How can it be?” I said because you never listen to me. That’s why. I’ve been telling him for years. You may think you’re going to be in a lower bracket in retirement, but you keep forgetting about that IRA you had, and you did nothing about it to trim that balance down. So, it was growing and growing and growing. And now, you’re forced to take money out. Now it’s at age 73. It was 70½ a few years back when that happened. But I said, “Now your RMDs are larger, yes, than your largest W-2.” So, that’s on the income side because if you ignore the growing IRA, that’s a tax bill waiting to happen. And people think, “Oh, if I don’t have my W-2.” But they forget the IRA continues to grow and accrue for the government. That’s on the income side.

But on the deduction side, it’s the same thing. Chances are they don’t have deductions anymore for 401(k) contributions. They don’t get any dependent-related tax benefits. They don’t have little kids anymore. They probably paid off their mortgage, so there are no mortgage interest deductions. And now, under the recent law, they’re probably all taking the new standard deduction, not that new, but the last few years we had the raise. So, the income is higher, and deductions tend to be lower. So, they’re in a higher bracket. It’s not even that it’s a higher bracket. Well, it does go to a higher bracket. But the income from the IRA tends to push them into higher brackets than they were working. And when I talk to advisors and consumers that are in retirement, and I tell them that, they said, “Yes, our income is much higher. We don’t know how, but it’s higher in retirement.” So, I talk about doing the planning, getting that balance down, so in retirement, you can have lower income, maybe with Roth conversions, moving it to tax-free vehicles, and getting it out ahead of time.

Tax-Planning Tips Before You Have to Take RMDs

Benz: Let’s talk about some of those strategies. So, an obvious one would be if I’m still saving, that maybe I would favor Roth over traditional contributions. But let’s talk about that sort of postretirement period before the RMDs come online. So, if I retire at 65, RMDs start at 73, that gives me a window to do some tax planning. Maybe you can home in on that for people who are at that life stage, some strategies they should consider.

Slott: I call that the sweet spot, because between 59½—before 59½, you have the 10% early penalty—between 59½ and 73 when RMDs kick in, there are no rules. It’s a free-for-all. I used to tell people, you can’t get a penalty, you can’t do anything wrong, which is like an oasis in the tax law, because this area is loaded with complex tax rules, except for this little sweet spot. You can’t even do anything wrong. You can’t get a penalty. Some people say, what if I want a penalty? Nope, you can’t even get a penalty. So, you’re free to take as much or as little out as you want. You’re free to control your own tax rates. So, you can pull down, use lower brackets as much as you want, and you can say what your bracket will be. If you do nothing, as I said before, the IRA continues to grow. Then at 73, you’ll be forced into whatever bracket it is, because then you’re forced to take a certain amount, and if that pushes you into a higher bracket, that’s what it’s going to be. It’s not in your control anymore.

The key to tax planning is a couple of things. To always pay taxes when the rates are the lowest, which are right now, and to take advantage of low brackets every year. Every year that goes by that you don’t take advantage of these low brackets, you don’t get them back, you don’t get a credit: “Oh, I didn’t use part of my 22% bracket. Can I take it?” No. There are a lot of things you can take advantage of.

Now, I don’t say just take the money out. Well, you could and spend it, but that’s not what most people want. They do a Roth conversion, and that’s a great move. You do a little at a time. Use up those brackets. Move it to tax-free territory. So, what you’re doing is you’re pulling down that IRA balance, which at 73 will be the amount that will determine your RMD, and you’re building up tax-free. I don’t say this is for everybody, but let’s say you took down your whole IRA balance in those years. Now you have it all in a Roth. Well, come 73, your income will be lower because you won’t have any taxable RMDs. I call Roth IRAs tax insurance. It’s insurance against future higher taxes.

So, people also say, well, what if tax rates don’t go up? I don’t see how that can happen, but let’s say tax rates didn’t go up. Your rates will, because even if rates stay the same, if you do none of the things I’m talking about and keep your IRA growing, just by math, it’s going to push you in a higher bracket than your salary did when you were working. So, the idea is to trim the balances down and move to tax-free vehicles. In the book, I talk about Roth IRAs, permanent life insurance, even use it for charitable giving. Although you’ve got to be careful with that. I’m talking about a whole different topic, qualified charitable distribution.

How QCDs Can Lower Your IRA Balance

Benz: Right. Well, do talk about that because I think that’s a good related strategy.

Slott: Well, you mentioned age 75 to 63. You can’t do the QCDs till you’re 70½. So, that doesn’t work. It’s a great provision. But unfortunately, it only applies to IRA owners who are 70½ or older. But if you want to take that just 70½ to 73, there’s a little window if you’re charitably inclined. Any way you can pull that IRA balance down. If you gift to charity anyway, that’s the way to do it. If you could pull that IRA balance down at low rates and with QCD, you’re pulling it out at zero.

Should You Consider a Roth Conversion When the Market Is Down?

Benz: Right. A related question though is you often hear that if the market is down, you should consider conversions. Well, the market has been really good for a while now. Is that potentially an impediment or a reason to at least move slowly with conversions, the fact that balances are elevated?

Slott: I don’t know. I used to say to do conversions a little at a time over the year, kind of dollar-cost average. I don’t say that anymore because the law changed a few years back where if you do a conversion, there’s no undoing it. Remember, you used to be able to recharacterize. So, I tell people now, you could plan out a conversion, but don’t pull the trigger till November and December when you have a better projection of what the tax cost will be, and you have a better projection of your income.

So, let’s say November/December comes around, the markets up or down, it’s going to be one of them. That shouldn’t have an impact. If you’ve decided this is what I want to do, it’s a long-term decision. The market is always going to go up and down. It’s hard to time it. Like with anything, market-timing, it doesn’t really work with a Roth conversion. If you know you should be doing it, probably in those two months.

Why You Should Contribute to Roth Retirement Accounts When You’re Young

Benz: My last question, Ed, is this kind of a generational thing where the younger cohorts will probably come into retirement with more in the Roth column, right? This will be less of a problem for them?

Slott: Oh, yeah. It’s already happening.

Benz: OK.

Slott: No, it will be less of a problem. They have a huge advantage. Imagine if we were able to start with our retirement accounts from dollar one to build all tax-free without having to convert, young people have that opportunity. I tell young people, anybody who gets a job should only be doing a Roth 401(k), plus the matching now on the Secure 2.0 can go into the Roth. I mean, Roth 401(k). Old 401(k) has no RMDs at 73 like they used to. That was new this year for the older workers or Roth IRAs. Nobody really should be making deductible contributions to IRAs or 401(k) because all that is, people see the deduction. They say, well, I’m supposed to do it when rates are high. It’s not a true deduction. I didn’t like the word deduction because it’s an exclusion from income. It’s not a deduction on your tax return. You just pay less on your W-2 for the contribution. But that kind of deduction is not a real deduction. It’s only a loan you’re taking from the government that has to be paid back at probably the worst possible time in retirement.

Benz: So, younger folks, if they’re watching this, you want them to get the message that they should do Roth.

Slott: All Roth. First of all, younger people, and I don’t want to stereotype, generally make less there in their lower earning years. You’d never want to take a deduction when you’re in your low-earning years. Deductions work better when rates are high. So, it’s a wasted deduction that you’ll pay back probably at a higher rate.

Benz: Well, Ed, it’s always great to have you here in person. Thank you so much for being here.

Slott: Good.

Benz: Thanks for watching. I’m Christine Benz from Morningstar.

Watch Don’t Make These Fatal Errors With IRA Rollovers for more from Christine Benz.