Insecure About Social Security? Use a Roth IRA Now to Maximize Benefits Later
If you're getting close to retirement, your emotions probably seesaw steadily between angst and anticipation.
Retirement is supposed to be exciting and/or relaxing. But with market wobbles and uncertainty about Social Security's solvency, it may be tough to put aside worries about whether you'll have enough money and focus instead on having fun.
If you're afraid retirement won't live up to expectations, you aren't alone. According to the Transamerica Center for Retirement Studies' most recent retirement survey (from April 2019), the most frequently cited retirement fear for people is outliving their savings/investments (48%), followed closely by the concern that Social Security will be reduced or cease to exist in the future (44%).
Higher Taxes on the Horizon?
I wish I could say those fears are unfounded and that everything will be OK. But the truth is that for years, the two former public trustees of the Social Security and Medicare trust funds have issued a joint message to the public warning that these programs are facing substantial challenges. Their 2018 letter cautioned lawmakers to take seriously the increasing urgency to repair financing shortfalls. And, it stated, "Americans can no longer afford to indulge the myth that Social Security and Medicare are best safeguarded by leaving their benefit and tax schedules alone."
Of course, lawmakers are reluctant to touch the issue. They want to be re-elected, and if they cut benefits, there will be an uproar. But eventually, they'll have to tweak something to deal with those shortfalls. And when they do, I believe there's a strong chance they'll get that money by taxing retirees' required minimum distributions at a higher rate.
Changing Your Retirement Strategy
I know. For years, financial professionals (myself included) have been advising pre-retirees to pile up their savings in tax-deferred investment accounts like 401(k)s and IRAs, with the idea that their tax rates would likely be lower in retirement. But that's not necessarily correct anymore. I know couples who are in a higher tax bracket than they've ever been because they retired with two pensions, two Social Security checks and two healthy 401(k)s.
My advice to them now is to convert that 401(k) money as quickly as possible to an after-tax Roth account in exchange for tax-free distributions down the road.
Yes, they'll pay taxes on the money as they convert it. But if done right, they may be able to minimize their tax burden now and later. Many experts believe taxes could be significantly higher in the future, and my goal for our clients is to get rid of our partner (the IRS) as soon as possible.
See Also: 3 Reasons to Convert an IRA to a Roth
An Example to Show How a Roth Can Help
Let's say I have married clients who want to retire at 60. If they can get $6,000 to $7,000 a month in income with no debt and their house paid off, that's doable.
I'd have them wait to take their pension benefits until they're age 70 -- and wait on their Social Security, as well, when they're eligible for those payments. Instead, I'd have them pull $100,000 out of their 401(k)s in their first year of retirement. With the standard income tax deduction of $12,000 each, they'd be at $76,000 -- which would keep them well under the $78,950 limit for a 12% tax rate. Any money they didn't spend on living expenses, I'd want them to convert to Roth accounts that year, and the next year, and so on, systematically.
In a perfect world, I'd like them to convert every dime to their Roths by the time they reach age 70.
Even if they need more income, the math is still manageable for many couples. If they're married filing jointly, they can make up to $168,400 a year and stay in the bracket for a 22% federal tax rate. Let's say they pulled $192,400 out of their 401(k)s. The $24,000 standard deduction would bring them down to $168,400. If they needed $80,000 or $90,000 to live, they could put the difference between that amount and $168,400 into their Roth accounts.
If they continue emptying their tax-deferred accounts and building their Roths every year, when they reach age 70½, they will have reduced the amount they need to take in RMDs or they may not even have to take RMDs at all. Should tax rates go up -- as I expect they will -- they won't get dinged by a higher tax bill. Any withdrawals they take from their Roth will be tax-free, as long as they've had it for at least five years. They'll get the maximum benefits from Social Security. And they won't have to worry about triggering a higher Medicare bill by going over the income threshold (which currently is $170,000) because of high RMDs. This of course, depends on your financial situation, so not everyone will have the same outcome.
The Moral of the Story
You've worked hard for your nest egg. By including a Roth account in your retirement plan, you can be sure Uncle Sam won't take a bigger chunk than necessary should lawmakers set their sights on the money sitting in tax-deferred investment accounts.
If you're worried about the future of Social Security, and you think there's nothing you can do about it, there is. This is a specific strategy that can help you avoid paying taxes on RMDs and maximize your Social Security benefits at the same time. And now is a good time to get started, thanks to the low tax rates set by the Tax Cuts and Jobs Act of 2017, which are scheduled to sunset at the end of 2025.
Remember that everyone's case differs, so consult a financial professional or your CPA before making the final decision on what's best for your situation.
In fact, if you're a married high-income couple with no heirs I probably wouldn't convert it all. What is the point if you're leaving the rest to your favorite charity, because they'll receive all of it tax free.
Kim Franke-Folstad contributed to this article.
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