King & Wood, P.A.

Should You Have a Roth or Traditional 401(k)?

“The 401(k) was built on a simple idea. Set aside money from each paycheck to save for tomorrow and get a tax break today. Many workers now have another option: Save the tax break for tomorrow, too.”

The Roth 401(k) is a relatively new retirement savings tool funded with after-tax money and tax-free growth. It’s like the Roth IRA but with an additional benefit: workers may save significantly more than possible in an IRA, and often, there is a company match. A recent article from The Wall Street Journal, “Roth v. Traditional 401(k): Where to Put Your Money for Retirement?” examines the options.

Roths aren’t the best choice for everyone. Deciding how much to fund a Roth versus a traditional retirement account requires calculating your current spending, future taxable income, and some other unknowable factors—like life expectancy. Despite the choice's complexity, it offers the ability to reduce lifetime tax bills and leave more money for retirement and heirs.

The money withdrawn from a Roth can be tax-free, so it’s excellent for supplementing taxable income during years when retirees would otherwise be pushed into higher tax brackets. Starting in 2024, Roth 401(k)s will be exempt from the required distributions with traditional accounts. Roths can be left intact for heirs, although the accounts must still be emptied in ten years.

The best candidates for Roths are those who anticipate they’ll be in a higher tax bracket in retirement than now, which fits younger workers with years of raises ahead of them. For mid-career earners, it can be hard to tell whether they’ll be in a higher tax bracket during retirement. Some sources of retirement income, including Social Security and pensions, can provide some estimates of benefits. It’s still difficult to accurately predict the investment returns used to determine retirement account withdrawals.

How to decide? Start by comparing your current tax rate and the rate you expect to pay in retirement. For younger earners, the math favors the Roth. Some experts say once a person moves out of the 12% bracket, it’s best to start dividing savings between a Roth and a traditional 401(k). One rule of thumb: add 20 years to your age and put this percentage of money you are saving for retirement into a traditional 401(k), with the rest in a Roth.

If someone retires at 60 and their taxable income falls, it can present an opportunity to convert a traditional IRA or 401(k) savings into Roth accounts at a low tax cost.

Another tactic is the mega-backdoor Roth conversion, which can allow high earners to build a nest egg of tax-free retirement savings without giving up traditional 401(k) contributions and the tax breaks from making them.

Other reasons to consider Roth contributions? Your tax rate is likely to stay the same. To move a large amount into a Roth, big savers might want to contribute to a Roth while working and look for opportunities to convert money while temporarily in a lower tax bracket.

If you think tax rates will increase, as when many tax cuts enacted by Congress in 2017 are scheduled to expire, the Roth is a good way to protect from higher tax rates in retirement.

If you want to leave your 401(k) to heirs, they will have ten years before they need to empty the account, with no tax consequences. The tax-free nature of a Roth withdrawal, IRA, or 401(k) makes it well worth considering.

Reference: The Wall Street Journal (September 2, 2023) “Roth v. Traditional 401(k): Where to Put Your Money for Retirement?”

Should I Have a Roth IRA?

“Roth individual retirement accounts allow you to pay income tax on your retirement savings upfront, so you won't be stuck with a tax bill in retirement when you can least afford to pay it.”

Roth IRAs are powerful retirement savings tools. Account owners are allowed to take tax-free distributions in retirement and can avoid paying taxes on investment growth. There’s little downside to a Roth IRA, according to a recent article “10 Reasons to Save for Retirement in a Roth IRA” from U.S. News & World Report.

Taxes are paid in advance on a Roth IRA. Therefore, if you are in a low tax bracket now and may be in a higher bracket later, or if tax rates increase, you’ve already paid those taxes. Another plus: all your Roth IRA funds are available to you in retirement, unlike a traditional IRA when you have to pay income tax on every withdrawal.

Roth IRA distributions taken after age 59 ½ from accounts at least five years old are tax free. Every withdrawal taken from a traditional IRA is treated like income and, like income, is subject to taxes.

When comparing the two, compare your current tax rate to what you expect your tax rate to be once you’ve retired. You can also save in both types of accounts in the same year, if you’re not sure about future tax rates.

Roth IRA accounts also let you keep investment gains, because you don’t pay income tax on investment gains or earned interest.

Roth IRAs have greater flexibility. Traditional IRA account owners are required to take Required Minimum Distributions (RMDs) from an IRA every year after age 72. If you forget to take a distribution, there’s a 50% tax penalty. You also have to pay taxes on the withdrawal. Roth IRAs have no withdrawal requirements during the lifetime of the original owner. Take what you need, when you need, if you need.

Roth IRAs are also more flexible before retirement. If you’re under age 59 ½ and take an early withdrawal, it’ll cost you a 10% early withdrawal penalty plus income tax. Roth early withdrawals also trigger a 10% penalty and income tax, but only on the portion of the withdrawal from investment earnings.

If your goal is to leave IRA money for heirs, Roth IRAs also have advantages. A traditional IRA account requires beneficiaries to pay taxes on any money left to them in a traditional 401(k) or IRA. However, those who inherit a Roth IRA can take tax-free withdrawals. Heirs have to take withdrawals. However, the distributions are less likely to create expensive tax situations.

Retirement savers can contribute up to $6,000 in a Roth IRA in 2022. Age 50 and up? You can make an additional $1,000 catch up contribution for a total Roth IRA contribution of $7,000.

If this sounds attractive but you’ve been using a traditional IRA, a Roth conversion is your next step. However, you will have to pay the income taxes on the amount converted. Try to make the conversion in a year when you’re in a lower tax bracket. You could also convert a small amount every year to maintain control over taxes.

Reference: U.S. News & World Report (April 11, 2022) “10 Reasons to Save for Retirement in a Roth IRA”

Estate Planning for Couples with Big Age Differences

“Increasingly, financial advisors are working with clients from nontraditional families, which can sometimes require different or additional strategies to protect their assets and achieve their financial goals.”

Seniors who are married to younger spouses have a special situation for estate planning, a situation that’s become more common, according to Barron’s recent article “Couples with Big Age Gaps Require Special Attention.”

This kind of family requires planning for the older spouse’s retirement needs and healthcare costs, while determining how much of the older spouse’s wealth should go to the children from any previous marriages while balancing the needs of a future child with a younger spouse. Beneficiaries for all financial accounts, last wills and all estate documents need to be updated to include the new spouse and child. The same goes for medical directives and power of attorney forms.

Social Security and retirement account considerations differ as well. The younger spouse may begin receiving their own Social Security at age 62, or a portion of the older spouse’s Social Security, whichever is greater. If the older spouse can wait to file for Social Security benefits at age 70, the younger spouse will receive more spousal benefits than if the older spouse claims earlier. Social Security pays the survivor’s benefit, typically based upon the older spouse’s earnings.

Pension plans need to be reviewed for a younger spouse. If the pension plan allows a survivor benefit, the surviving spouse will receive benefits in the future. IRAs have different beneficiary distribution rules for couples with significant age differences. Instead of relying on the standard Uniform Lifetime Tables, the IRS lets individuals use the Joint Life and Last Survivor Expectancy Table, if the sole beneficiary is a spouse who is more than ten years younger. This allows for smaller than normally Required Minimum Distributions from the IRA, allowing the account a longer lifetime.

Families that include children with special needs also benefit from trusts, as assets in the trust are not included in eligibility for government benefits. Many families with such family members are advised to use an ABLE Savings Account, which lets the assets grow tax free, also without impacting benefit eligibility. There are limits on the accounts, so funds exceeding the ABLE account limits may be added to special needs trusts, or SNTs.

A trustee, who may be a family member or a professional, uses the SNT assets to pay for the care of the individual with special needs after the donor parents have passed. The child is able to maintain their eligibility.

For same sex couples, revocable or irrevocable trusts may be used, if the couple is not married. Nontraditional families of any kind with children require individual estate plans to protect them,  which usually involves trusts.

Trusts are also useful when there are children from different marriages. They can protect the children from the first marriage and subsequent marriages. A wisely constructed estate plan can do more than prevent legal battles among children—they can preserve family harmony in the non-traditional family after parents have passed.

Reference: Barron’s (July 27, 2021) “Couples with Big Age Gaps Require Special Attention”

How Will Marriage Impact My Savings for Retirement?

“Does getting married later, have any effect on retirement saving?”

New research from Boston College’s Center for Retirement Research has analyzed individuals’ contributions to a 401(k) plan, before and after marriage.

“Millennials marry later than previous generations. Since marriage is a major life milestone that often marks a line between youth and adulthood, a logical question is how this delay affects retirement saving,” the report states.

Think Advisor says in its April article, “Do People Save More in Their 401(k)s After They Marry?” that at age 30, only 41% of millennials were married, compared with 59% for the late baby boomers.

The report looked at data from the Survey of Income and Program Participation linked to W-2 records on defined contribution plan deferrals, to determine the extent to which marriage affects retirement savings.

The results of the analysis show that people increase both their participation in and their contributions to 401(k) plans after marriage.

In terms of participation, men respond a bit more after marriage than women. The research shows that men have lower participation rates than women before marriage, but they wind up at the same level once married.

After marriage, women increase their contribution rate by an average of 0.8%, compared to only 0.3% for men, according to the research.

Following these results, the research then looks at what this means, if the trend toward later marriage continues. To do this, the research looks at how much retirement wealth accrued in 401(k) plans by age 65 would have been impacted, if men and women married later than they do now.

The analysis assumes a five-year delay in marriage, which is based on the approximate increase that occurred between baby boomers and millennials.

The analysis finds that the effect of delay, while statistically significant in the regression, is small—a 3.1% decline in accumulated assets for men and a 3.4% decline for women.

“While the delay in marriage may be problematic for some forms of savings—delaying homeownership for example—it seems unlikely to make a large dent in retirement savings,” the report states.

Reference: Think Advisor (April 23, 2019) “Do People Save More in Their 401(k)s After They Marry?”

When Do I Cash in My Savings Bonds?

“Whether you got them as a birthday gift from Grandma or bought them through a payroll deduction on your first job, you may own U.S. Savings Bonds that have stopped earning interest.”

The common variety of bonds that were first issued in 1980 are the Series EE Bonds. These bonds continue to be issued today. Series EE Bonds were designed to pay interest for up to 30 years. As a result, any bonds dated 1988 or earlier will stop paying by the end of 2018. Their value will then be frozen—there’s no reason to keep them. Cash them in and put the money to more productive use.

A recent Investopedia article asks “U.S. Savings Bonds: Time to Cash In?” According to the article, prior to the start of Series EE Bonds, a relative might have bought you a Series E Savings Bond. These bonds were issued from 1941 to 1980. They have also stopped earning interest.

Series I Bonds are more recent. First issued in 1998, these bonds pay a combined fixed and inflation-adjusted rate of interest. They’ll accumulate interest for 30 years. Thus, the earliest of them will stop gaining value in 2028.

To see the value of your old bonds, use the Savings Bond Calculator on the TreasuryDirect website. You only need the type of bond, its denomination and the issue date. You can also add your bond’s serial number, but you don’t need to do that to get a value. As an example, a $50 bond issued in August 1982 that cost $25 is now worth $146.90. A $100 bond from February 1984 is now worth $230.64.

If you think you own some old savings bonds, but have lost track of them, you can submit a claim with the Treasury, by filling out Fiscal Service Form 1048, Claim for Lost, Stolen, or Destroyed United States Savings Bonds. Get the form on the Treasury website.

You can also redeem your old paper bonds at most financial institutions.

Remember that your savings-bond interest is taxable by the federal government, but there’s no state or local tax. You can report it and pay tax every year that you hold the bond—or wait until the end and pay the tax all at once. That’s what most people do. When you redeem your bonds, you’ll get an IRS Form 1099-INT that shows your taxable gain.

In certain cases, there is an exception to the taxes. One is if you use the proceeds from bonds issued in 1990 or later to pay qualified higher-education expenses for you or your child. The rules, including income limits, are detailed in the Education Planning section of the TreasuryDirect site.

Reference:  Investopedia (February 21, 2018) “U.S. Savings Bonds: Time to Cash In?”

When is it Worth Incurring a Penalty for Early Withdrawal?

“Many savings and investment accounts come with rules around when you can pull out your money. However, there are exceptions in which the penalty is worth the reward. There are times when you might be able to lessen the consequences.”

You hear it all the time: “early withdrawal penalties apply.” When you have retirement accounts and CDs, it’s usually not advised. However, there are some instances when it makes sense.

CNBC’s recent article, “Sometimes, early withdrawal penalties don't apply”, explains that we dutifully follow these rules to avoid the much dreaded early withdrawal penalty. However, there are cases when the penalty might not apply to you, or times when the benefits outweigh the financial hit. You should remember that these moves should often only be made if necessary, because they place your savings in jeopardy.

Certificates of Deposit. If your CDs are growing at less than 1% a year at a bank, but the bank across the street is offering annual returns of 1.72% on their certificates of deposit, you might consider an early withdrawal, despite a penalty of three months interest. Do the math: you might be ahead financially after three months, at the other bank's higher interest rate.

529 Plans. There's no early withdrawal from a 529 plan—the tax-advantaged account that can be used for education-related expenses. That’s because there are no rules as to when you can use the money. The rules stipulate only what you can use it for, which is just education-related expenses. There’s a penalty, if you use it for other reasons. It’s a 10% tax penalty, as well as income taxes on the account's earnings. In many cases, the family’s no worse off than they'd be in a taxable account. However, you may have to repay the state income tax benefits you received for using the account. If your child does plan on going to college, the withdrawals will leave your savings with less time to compound.

Retirement savings. An early withdrawal from your retirement account is a huge black eye in personal finance. Using an individual retirement account (IRA) or 401(k) plan before the age of 59½ can mean a 10% penalty, income taxes and a depleted fund for your retirement. There are several exceptions to the 10% penalty, eliminating that expense when you withdraw early from your retirement account. However, there's confusion about when the penalty does and does not apply. For example, if you decide to retire at 56, you can withdraw from your 401(k) without any penalty. However, if you roll it into an IRA, you'd have to wait until 59½ to have your money without consequences.

Both 401(k) plans and individual requirements waive the penalty. if you're using the money for serious medical expenses, or if there's a disability or death. You can use your IRA to fund health insurance, if you're unemployed, without penalty. If you're divorcing, you may be able to use 401(k) assets without a penalty.

Reference: CNBC (August 21, 2018) “Sometimes, early withdrawal penalties don't apply”

What Should We Expect When We Hit Retirement Age?

“Your taxes in retirement may be a lot more complicated than taxes while you're working.”

There are a lot of variables when you reach retirement: Social Security checks may or may not be taxed, depending on your income; you'll pay federal income taxes on most retirement plan withdrawals, but there may also be state taxes based on where you live. The tax rates on investments can also vary. The San Francisco Chronicle’s recent article, “Beware of hidden taxes in retirement,” tells us what to expect when we hit retirement age:

Social Security Taxes and Combined Income. Whether or not your Social Security benefit will be subject to taxes, will be determined by "combined income," which is your adjusted gross income (AGI), plus any non-taxable interest, and 50% of your Social Security benefit.

State Taxes. There are 13 states in which you also could owe state income tax. Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia all tax Social Security benefits to some degree. Seven states don't tax income: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. New Hampshire and Tennessee tax only dividends and interest. In other states, your retirement income may be exempt, partly exempt, offset by a credit, or fully taxable. Sales, property and use taxes also vary widely.

Required Minimum Distributions May Mean Higher Taxes. At age 70½, you must start withdrawing money from most retirement accounts. RMDs typically are taxed at your regular income tax rates. If you've been a good saver, these RMDs could be enough to push you into a higher tax bracket.

The Sale of a Home. Selling your home to downsize, free up some equity, or in a move to a new area may generate a tax bill. If you've lived in your primary residence for at least two of the five years prior to selling it, you can exempt up to $250,000 of home sale profit from capital gains taxes (or up to $500,000 for a couple). Any profit above that is subject to federal capital gains tax rates, that range from 0-20%. In addition, you may owe a "depreciation recapture tax," if you took a home office deduction, rented out rooms, or rented out your whole house. The depreciation you took or should have taken over the years, is added back to your income in the year you sell, and you'll pay a maximum rate of 25% on it.

State Estate or Inheritance Taxes. There are 12 states and the District of Columbia that impose estate taxes. Hawaii, Maine, and the District of Columbia use the federal exemption amount. Oregon and Massachusetts may tax estates worth $1 million or more. Connecticut, Illinois, Maryland, Minnesota, New York, Rhode Island, Vermont, and Washington all exempt varying amounts. Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania have inheritance taxes meaning these states can tax people receiving bequests.

Talk to an estate planning attorney, if think you might be impacted because you may be able to minimize taxes with the right strategy.

Reference: San Francisco Chronicle (June 11, 2018) “Beware of hidden taxes in retirement”

How to Budget for Retirement

“Separating financial facts from fiction, will help you budget correctly for retirement.”

After spending years working, bringing in income and saving for the future, you now must spend and manage that money. It’s a big change, and requires a thoughtful approach.

US News & World Report’s recent article, “7 Myths About Finances in Retirement,” says that moving into this new phase of life, can create changes in your finances and lifestyle. For most of us, despite the planning, there’ll still be some surprises when you enter retirement. Here are some of the most common financial myths about retirement, as well as the realities behind them.

1. Medicare covers everything. You’ll be eligible for Medicare the month you turn 65. However, you should remember that there’ll still be ongoing health care expenses. Medicare only covers some services for free. Unless you qualify for Medicaid, you’ll need to budget for costs like premiums, copays, and deductibles. You’ll also need a Medicare supplement plan, which can be affordable but is not free. Note that Medicare only provides some coverage for long-term care. Consider buying long-term care insurance to help pay for additional services.
2. I’ll just need 70-80% of my pre-retirement income. You may discover that you want to spend money on travel, dining, or a new hobby. Because people are healthier and more active today than in past generations, they actually require more money to go out and do what they’d like in their retirement.
3. Taxes are nothing in retirement. Since you’re no longer bringing home a paycheck from working each month, you may assume that your taxes will decrease in retirement. Maybe, but you’ll likely need to plan on paying taxes each year.
4. Downsizing means more savings. A common retirement transition plan includes moving out of the family home and into a smaller place. You might think this means fewer home-related costs, but that’s not always true.
5. $1 million is all I need for a comfortable retirement. For years, building a $1 million nest egg was thought of as a goal for retirement. However, that figure may no longer be accurate, due to longer life expectancies, increasing costs, and active lifestyles. There’s no specific one-size-fits-all amount to save for retirement.
6. I can withdraw 4% each year from my portfolio. This rule refers to the concept of withdrawing 4% from a retirement account each year. The idea is that you’ll be able to maintain a steady stream of income, while keeping the funds sustainable for many years. But again, with increased life expectancy and recent challenges, many retirees are severely underfunded for retirement. Consider withdrawing a lower percentage, such as 3% each year.
7. No need for assisted care. You may believe that once you’ve settled in the home where you want to spend your retirement days, you’ll avoid assisted living or nursing home care, resulting in substantial savings. However, there could also be many expenses to stay in your own place and getting the right level of care. You might save money by staying in your home, but you could spend a lot more on care.

Reference: US News & World Report (April 18, 2018) “7 Myths About Finances in Retirement”

 

Can You Afford to Make These Retirement Mistakes?

“As more and more baby boomers start eyeing the coastline of retirement, thoughts turn from the daily worry over the Monday-through-Friday commute to concerns about how to fund the golden years.”

On a scale of one to ten, how prepared are you for retirement? A five? An eight?

Do you know the amount of money you really need to retire?

Do you understand all the rules concerning your pension (if you have one)? What about your 401(k), IRA, and other retirement accounts in your nest egg? You also need to have a grip on when to claim Social Security benefits. These are some of the issue you need to address in the days and months ahead of your retirement.  However, don’t wait too long to do your research and ensure that you’re making the right moves.

Kiplinger’s recent article, “Retirement Planning Mistakes You'll Regret Forever,” compiled a list of the greatest retirement planning mistakes and how to avoid making them.

Spur-of-the Moment Relocation. If you’re thinking of moving to Arizona or another warm weather spot to get out of the cold, test the waters before you make a permanent move. Consider renting before you buy a home.

Not Saving for Retirement. The single greatest financial regret of Americans surveyed by Bankrate was waiting too long to start saving for retirement. Those who responded who were age 50 and older expressed this regret at a much higher rate than younger respondents. Many people don’t begin aggressively saving for retirement, until they reach their 40s or 50s. While these investors may still have enough time to change their savings behavior and achieve their goals, they’ll need to take action quickly and be extremely disciplined about their savings. Morningstar calculated the amount required to save each month to reach a goal of $1 million saved by age 65. Assuming a 7% annual rate of return, you’d need to save $381 a month if you start at age 25; $820 monthly, starting at 35; $1,920, starting at 45; and $5,778, starting at 55.

Taking Social Security Too Soon. You can start taking retirement benefits at 62. However, you should  consider delaying this if you can afford it. Most experts recommend that you wait at least until your full retirement age–67 for anyone born after 1959–before tapping Social Security. If you can wait until 70, it is even better.

For example, if your full retirement age (when you’d get 100% of your benefit amount) is 67, but you claim Social Security at 62, your monthly check will be reduced by 30% for the rest of your life. If you can wait, it’s an 8% boost in benefits each year between ages 67 and 70 because of delayed retirement credits. Talk with an elder law attorney, because the strategies can differ for couples, widows, and divorced spouses.

Avoiding Estate Planning. It is not just for the super-rich. Estate planning is for you. This is true, even if you just own a car, home and bank account. Your estate plan will instruct who you want to want to get what and who will be in charge of dispersing your money and possessions (the executor). If you pass away without a will, your estate is subject to your state’s probate laws. You should also have a durable power of attorney that names someone to manage your financial affairs, if you become incapacitated. There are also advance directives such as a living will, which spells out the treatments you do and don’t want, if you become seriously ill, and a power of attorney for health care, which names someone to make medical decisions for you, if you can’t make them yourself.

Reference: Kiplinger (February 12, 2018) “Retirement Planning Mistakes You'll Regret Forever”

Widow/Widower Preparation 101

“Among the risks that married couples face in retirement, this one is unavoidable. It’s the risk of becoming a widow or widower.”

According to USA Today’s recent article, “How to prepare financially for being a widow/widower,” the death of a spouse frequently results in a decline in economic status. For example:

• Some income may cease when a spouse or former spouse dies.
• The death of a disabled person’s caregiver spouse may result in financial issues at a very difficult time.
• The surviving spouse may be unable or unwilling to manage the family’s finances.
• The inability to cope with a spouse’s death or terminal illness plays a part in high rates of depression and suicide among the elderly.

There are several things you and your spouse can do to manage the risks associated with becoming a widow or widower. One is talking about money matters together.

First, spouses (especially women) need to know about the household’s finances. This includes where all accounts are located. In addition, it’s critical that they know what benefits might be available from employment-based plans, like pensions, 401(k)s, life insurance and medical insurance, and how to contact the appropriate people to access any benefits that may be due.

Figure out if your financial plan will provide enough lifetime income for the surviving spouse. Note that the surviving spouse may have less to live on, if he or she has to spend down assets to take care of the spouse that dies. If, after running all the variables, there’s a shortfall, think about upping your savings, decreasing expenses, downsizing and buying life insurance.

If you’re the higher earner, you might delay Social Security until at least full retirement age (FRA)—or better yet until age 70—if there’s a good possibility your spouse will outlive you, because the surviving spouse collects a higher lifetime benefit based on the primary earner’s benefit.

Investigate whether you have a traditional defined benefit pension plan and select the joint-and-survivor annuity, instead of the single life annuity.  You should also check your beneficiary designations.

Make a list of your employer-sponsored retirement plans, as well as your life insurance plans, bank and credit union checking and savings accounts and titling on real estate. Be sure the credit cards and other accounts are set up so that both spouses have access.

You might also look at long-term care and consider what would happen if one or both spouses needed LTC.

Create or update your estate planning documents. This includes your will, trusts, powers of attorney for financial matters, advance directives, living wills and powers of attorney for health care and physician orders for end-of-life care. You may want to file a “do not resuscitate” or DNR order with your hospital to avoid aggressive attempts to prolong your life. It can also help to prevent incurring large medical bills for the surviving spouse to pay.

Consider planning your funeral arrangements in advance.

Review all of your assets and property with an experienced estate planning attorney and be sure that you understand what is in individual and joint names, and the way it might be disposed.

Reference: USA Today (January 19, 2018) “How to prepare financially for being a widow/widower”