Using Roth Retirement Accounts To Avoid Taxes In Retirement

Co-produced with PendragonY

In the U.S., there are, broadly speaking, two foundational types of retirement saving accounts. Various provisions of the tax code set up versions of these two basic types based on other parameters. For instance, employers are typically able to offer their employees what are called 401(k) plans, and most people are familiar with IRAs (Individual Retirement Accounts). Non-profit groups can offer their employees 403(b) accounts. Each of these account types comes in two basic flavors separated by how contributions and withdrawals are treated by the tax code. All these accounts shield the account funds from taxes on capital gains while the funds remain in the account.

The first type, and the more traditional one, allows for contributions to be made pre-tax. This means that making contributions to the account reduces one’s taxable income by the amount of the contribution. When assets are withdrawn during retirement, the withdrawals are taxed as ordinary income and those tax rates apply. Traditional 401(k) and IRA accounts are typical of this type of account.

The second type has contributions coming from after-tax income. Withdrawals are then tax-free. Most people have heard of the Roth IRA, but there are also other types of Roth accounts, like an employer-sponsored Roth 401(k). For direct contributions, there are income limits on who can contribute. However, one can get money into these types of accounts by first putting cash into the pre-tax versioned account and then doing a conversion. You just have to pay the taxes on the amount converted.

Which type of account is best from a tax perspective depends very much on the tax rates at the time of contribution versus the tax rates at the time of withdrawal. If you expect your tax rates to be higher when you retire, contributing to the Roth type account is the better option.

It Is Not Quite That Easy

While it sounds fairly easy in theory to determine which account type is better in terms of taxes, in practice it isn’t quite that simple. Several factors make the calculation more complicated.

The first thing that makes this calculation more complicated, is the structure of the U.S. tax code. The first dollar of taxable income isn’t taxed at the same rate as the last, for most individuals. Meanwhile, your first dollar of income isn’t always part of taxable income.

Why does this make things more complicated? Because the dollars you contribute to a retirement account are the last dollars earned. If the contribution is pre-tax, those dollars would have been taxed at your highest marginal rate. But when you make withdrawals, not all of that money is taxed at the highest marginal rate. So even if you have the same top rate in retirement as you did when working, your retirement account withdrawals will likely be taxed at a lower effective rate than your contributions would have been taxed.

The second wrinkle is because the federal government wants to collect its taxes. So while they were willing to delay collecting in order to help folks save for retirement, the federal government does want those taxes eventually. Traditional retirement accounts (which have a balance built on pre-tax contributions) have what are called RMDs (Required Minimum Distributions). These are scheduled so that the retiree will withdraw enough each year to progressively reduce the account balance based on the average life expectancy for their current age. This has the effect of increasing the percentage of the account balance that must be withdrawn each year.

RMDs do not apply to Roth accounts. Since the government already collected taxes on the funds contributed to the Roth accounts, and because the withdrawals are tax-free, the government doesn’t require you to withdraw funds from the Roth type accounts while you live.

How do RMDs complicate one’s retirement planning? Typically, you set up a withdrawal plan to pull out enough money to cover your expenses. But if you have been very good at saving and have had good returns, you might have a very high portfolio value. At some point, RMDs may be larger than your actual expenses. RMDs can even move you into a higher tax bracket. While the RMD might not initially be a big deal, it does require planning on what to do with the extra cash. And depending on what you do with them, these extra withdrawals can push you into a higher tax bracket as well.

And finally, Medicare does impose a surcharge on your premiums if you have taxable income above a certain level. While the surcharge of $80.40/month at the first threshold might not seem like much, it is an extra expense that gets you no additional benefits and can be like a slow leak from your assets. The surcharge increases progressively with higher income levels.

Time To Do Some Math

For some, keeping all of their retirement funds in the traditional pre-tax contribution-type retirement plans will work best. For others, getting everything in the tax-free withdrawal retirement plans works best. For many, some combination of the two is what works best. There are a lot of variables in making that determination. Each investor will need to run their specific numbers to find out. However, all of us can learn from working through an example case.

Let’s start with a single retiree, retiring at 67, who has determined that their retirement budget will result in their AGI (Adjusted Gross Income) being $90,000 a year. This is just below the threshold for incurring the surcharge on Medicare premiums. Let’s further assume the retiree takes the standard deduction ($12,550) and gets a Social Security Benefit of $3,000 a month ($36,000 a year). So bottom line, to meet their budgeted expenses, they will need to take $71,950 out of their IRA (it can be any of the various pre-tax contribution retirement accounts, but for simplicity, we will just call it an IRA). Based on the current tax brackets, just over $20,000 of the IRA funds will be taxed at only a 12% rate, while most of the rest will be taxed at a rate of 22%. Only about $4,000 will be taxed at the 24% rate. If before they retired, this person had an AGI of $120,000, it can be seen that the top marginal rates will be the same both before and after retirement, but the effective rate during retirement will be much lower than the rate that would have been charged on earlier contributions to the tax-deferred IRA.

With that $120,000 of AGI before retirement, this person had $44,925 of room before being pushed into the 32% bracket. And now in retirement, they have $74,925 of room – however, they only have $1,000 of room before the Medicare premium surcharge hits (at $91,000 of income for an individual filer).

How much trouble will RMDs give them? This very much depends on how large their portfolio is. Continuing with our example, if they have a portfolio bigger than $1.853 million, then right at age 72 RMDs will force them to take out more than needed, and enough to trigger that monthly surcharge on Medicare premiums. By the same token, if the portfolio value is smaller than $864,000 then RMDs won’t force withdrawals great enough to trigger that extra Medicare premium until about age 90.

Which Types of Investments Benefit From Roths or Traditional IRAs

Not all stocks reap the same benefits from retirement IRA accounts. When deciding what to hold in a pre-tax contribution retirement account versus a tax-free withdrawal account, yield and the potential for capital gains are two important considerations. Here are just a few general ideas and examples:

Traditional IRAs

Since the traditional retirement accounts have RMDs, you want investments that will pay you a lot of cash and not have big share price appreciation. CEFs tend to pay out most of their total return as distributions, so they are well suited for being in a traditional retirement account. As it happens, our top pick for 2022 is Oxford Lane Capital (OXLC). With its very high yield, it will produce lots of cash so the investor will have little need to sell its shares to cover RMDs.

Roth IRAs

Stocks with a higher likelihood of share price growth and more modest yields work better in Roth retirement accounts because there is never a need to withdraw funds for RMDs (and possibly have to sell shares). Enviva Partners, LP (EVA) is a stock we recently recommended. With its conversion to a C-Corp in 2022, it has the potential to generate some share price gains as it draws the attention of more investors. Its more modest 4.5% yield also means it won’t generate as much cash. This won’t be a problem in an account without RMDs. And with its conversion to a C-Corp, any concerns over UBTI go away.

Taxable Accounts

Many stocks pay ordinary dividends. These dividends are taxed at ordinary income tax rates. There are tax benefits from holding them in a retirement account either because the dividends will never be taxed or since withdrawals are taxed at ordinary income levels anyway, they do not suffer any disadvantage from being held in a retirement account. Other stocks pay qualified dividends, which are taxed at capital gains rates that are lower than ordinary income rates. Antero Midstream Corporation (AM) pays a dividend that is partially qualified. Most of the rest of the dividend is designated ROC (Return of Capital) and so is not taxed when paid but is taxed at capital gains rates when the shares are sold. This is a good example of a stock to hold outside of a retirement account so that the investor gets the full tax benefit.

Final Thoughts

As income investors, we follow within High Dividend Opportunities our unique methodology which we call the Income Method. Portfolios following the Income Method aim to produce an income stream to be used to pay expenses in retirement. So, it is a fairly easy method to figure out when RMDs might begin to impact your portfolio and cause you to withdraw more than your dividend income. Take the inverse (1/X) of your portfolio yield and then find the nearest value in this table. For instance, if your portfolio has an average 7% yield, the inverse is roughly 14.3. So at age 86, RMDs will force you to take out more than your dividends.

You can do the same if your portfolio is large enough to generate more dividends than you need to cover expenses. Say, for instance, you only need to take out 6% to cover your expenses. Taking the inverse, this means you won’t have to pull out more than you need until you hit 83.

Before hitting age 72, you can convert funds from your traditional IRA to the Roth IRA and thereby lower future RMDs. Although taxes will be due on the conversion, depending on your income needs and portfolio size, this could save you money later on.

Planning ahead not only on how you invest, but also where you place your investments can help reduce your tax burden and also allow you to enjoy more income overall. Every dollar you save is equal to a dollar you earn when it comes to income vs. expenses.

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Final Notes: The IRS Uniform Lifetime Table referenced in the article is from current IRS publications. New tables which are updated for higher longevity are effective January 1, 2022, and result in lower annual RMD amounts. However, the IRS has yet to publish the updated tables in a new Publication 590-B. (A 3rd party source has the new rates here).

HDO is preparing another article to be published in a couple of weeks, that will cover 2022 rule changes for retirement accounts. Click the “Follow” link to be notified about our future articles.