Paul Winkler: All right. Welcome to “The Investor Coaching Show.” Paul Winkler, talking about the world of money and investing. We have some big stuff going on. Anne and Ira are here with me.
So MarketWatch has a little advice column, right? The question came in: “I am 60 and plan to retire in March. I have $113,000 in my 401(k) and no other savings, but I’ll get an early retirement of nine months salary. Should I get a pro to help me?”
It’s more like you need to get a pastor to pray for you, if that’s the case. Especially when you look at, well, not only the savings, but you just look at the changes in the tax laws that have just passed.
Anne Sawasky: Yeah, huge.
Ira Work: One hundred changes.
IRA examples
PW: Mind blowing. And some of this stuff just makes absolutely no sense to me whatsoever. I thought we’d spend some time on the show walking through some things and trying to find some clarity out of the mess. There are a few beneficial things for some people.
I had a conversation with a guy today, he’s about 60 years old, and he said, “I remember when 401(k)s came out and I wanted to do that because I wanted to be able to have tax-free income in retirement.” Well, he was actually talking about Roth IRAs, more specifically, when they first came out.
And I said a lot of it’s the difference between your marginal tax rate versus your average tax rate when you pull it out. But a lot of people don’t put the extra money that you should put into the tax savings, in other words, into the IRA, right? You’ve got to put the extra money into the IRA.
Let’s say that you have a $300 tax deduction. Let’s use $1,300 as an example, and you have $300 that you’ll save in taxes. You can go and put $1000 in a Roth or $1,300 in the IRA.
You can’t just put the $1000 in the IRA and get the tax savings and go spend it at Walmart. You want to make sure that you have actually saved that money into the IRA because otherwise this guy would have been completely right.
So what’s going on right now is there’s a huge push on Roth IRAs. Why is this the case?
The government really needs money right now.
They need money right now because they are spending unbelievably and they need revenue right now.
So if they can get you to take more of your retirement savings, pay taxes on it, then put it in the Roth IRA, then they’ll figure out what to do with your Roth IRA 20 years from now, right?
IW: Without a doubt. And that’s always been my concern when people say, “Well, should I convert to a Roth?” I had this conversation with a lot of my clients and it’s about you’re going to pay the tax now, and maybe I’m a little bit of a conspiracy theorist.
PW: You, a conspiracy theorist?
The Possibility of Taxation
IW: I think the government’s going to figure out a way to tax that again later. That’s my concern.
PW: No, that is always a concern.
IW: I mean, look, what did people do back in 1984, a lot of wealthy people put all their money into tax-free bonds.
Why? Because they were very, very wealthy. They could live off of their tax-free interest and not pay taxes.
PW: And the interest rates were a lot higher then.
IW: Until the government came in and created the alternative minimum tax.
PW: That was brilliant.
AS: Brilliant for the government.
IW: Right. But you see, that’s my point.
PW: That’s a great example, Ira.
IW: Another example is this: we had money, and we still have it today, siphoned out of our check to go into this thing called Social Security. Years ago it was tax-free income to those who lived long enough to start collecting it.
Well during the Reagan administration, it was actually signed that Social Security would now become taxable.
PW: Up to 50% at that point in time..
IW: Right. So I’m always leery about doing the backdoor Roth IRAs for those who are ineligible for it because of their income upfront, so they put it into the IRA, they let it grow, then they transfer it over into the Roth, into a conversion and they call it the backdoor.
Investors can be too easily tricked into marketing schemes that aren’t even real investment strategies.
I hate when people come in and say, “Well, I want to do the backdoor Roth IRA.” Well, what irritates me the most about it is that it is just a marketing term. There’s no such thing in the code called a backdoor Roth IRA.
PW: That’s true.
IW: It’s a way that investment advisors and insurance agents have created in order to market something that you don’t think you’re getting or you don’t know about. So they can get you into their office to then move your money into something else, and it’s not a backdoor.
PW: They never explain the aggregating issue, and that’s a problem. You may try to do this and you’ve got an IRA, and when you have that IRA, you have to aggregate all of your accounts.
Then you come to find out when you try to pull off the backdoor strategy that it doesn’t work as advertised. And by then it’s too late.
Fooling Investors
IW: Many things that I see advisors doing irritate the heck out of me because they have investors thinking that there’s something special out there that nobody’s telling them about.
Several years ago I was meeting with a client in Miami, and he said to me, “Ira, we’ve been with you for 20 years now and we love you and we’re not going anywhere. But I just have to tell you, we’ve been having dinner seminars.”
He asked, “Do we need a stretch IRA?” I said, “There actually is no such thing as a stretch IRA.
Some advisors have investors thinking there are special investment strategies no one has told them about.
AS: Estate planning is the same way.
PW: So true.
AS: You have to try to predict what the taxes are going to be, who’s going to die first, and you have to keep looking at it periodically because the laws change.
PW: How many people have bypass trusts that have very little use anymore. I say very little because there are some situations where you might have some use, where it might be okay.
But for the vast majority of people, they did it for a whole different reason. And that reason became obsolete when you had the portability of the unified credit. If you don’t know what we’re talking about, you need an advisor.
IW: Well, another example is Social Security. All these advertisements for if you don’t get it right, you can end up losing hundreds of thousands of dollars worth of income.
It’s just not that plain and simple. It’s not that cut and dry, as you both know.
Lately my thought is, “Well, should I start taking it at my full retirement age, at 67? Or should I delay it until 70?” Because whether I take it at 62, forget taxes and all that, the income, whether I take it at 62, my full retirement age at 67, or delay it until 80, the break even within a few thousand dollars is going to be between 80 and 81.
So I’ve got to bet what is going to happen to me. Am I going to live much further past 80 or 81? I mean, how much more money will I get if I die at 83. Am I going to really get that much more?
PW: You got the joint life expectancy issue, though, with the two of you.
IW: Right.
Income in Later Years
For a lot of people, you’re not necessarily delaying your benefit if you’re a higher income earner, you’re not necessarily delaying your social security because you’re going to live a long time. But it’s a spouse too. So you need to think about that.
You have to look at the difference between your benefit versus a spouse’s benefit. It almost always works out that if one spouse has a benefit that is less than half of the other, taking it early makes more sense.
But that’s off the table if that spouse is still working and their income is high enough where you have taxation of their benefit. Because if they’re above the threshold, which is, it’s got to be closing in on about $20,000 right now, if your income is above that, they take away $1 of your Social Security for every $2 over the threshold that you’re at.
And then there may be no benefit of taking it early. It may be better to wait until their full retirement age, which if you’re born after 1960 or after is age 67. So there are a lot of things to think about regarding that decision more than just a person’s life expectancy.
Well, and one of the other things that I point out to my clients is that if you need the income, there’s only two places to get it.
In most cases today, people need income.
That’s number one, Social Security. Number two, an income stream off of your accumulated assets. So if you decide that, “Well, I’m going to take it out of my accumulated assets.” You are depleting what should potentially go to your beneficiaries. You cannot leave Social Security to anybody.
PW: A lot of people don’t realize the annuity, you’re basically, if you’d use an annuity, those assets don’t go to another generation, unless you have one that does have the ability to have some remainder to it.
And if they do that, they reduce their income so much that it would be ridiculous to even do that. It would be from a standard cost of living too.
What You Believe vs. What Really Happens
Someone this week said, “I believe inflation’s going to keep going. I believe it.” What somebody really believes doesn’t matter as to what’s really going to happen.
People say, “I believe this and therefore because I believe this, I ought to do this as an investment strategy.” And I go, “No, don’t do that. Your beliefs don’t matter at all when it comes down to what you think is going to happen versus what you ought to do.”
What we believe and what we do are two different things when it comes to investing.
But as I thought about it, the interesting point that he made is that I believe that inflation is going to continue on. And let’s say this guy’s, right?
I mean, if this guy’s right and 8% inflation occurs, that means prices double every 9 years. Something that costs $10,000 right now, in 18 years will cost $40,000, right?
This could be a huge, huge problem. Because a lot of people don’t think about that when they’re buying products right now, that they could be making decisions based on things going on right now.
They hear that they have a guarantee. At the end of last year, I mean, what did we hear, all of the research saying, “I think that 2023 is going to be bad.”
I kept yelling at the TV screen, “Recency bias!” Whatever just happened, you think it’s just going to continue on forever.
I saw an article yesterday that said that people think that the stock market’s going to go up 20% this coming year, and some people think it’s going to go up 40% this coming year. Guesses are all over the place, but I want you to see that they are guesses, that’s all they are.
AS: I’m always amazed at how people totally forget that in the late seventies and early eighties, the inflation rate was 18% and interest rates were from 12% to 18%.
PW: And who says we’re not going to get inflation again? I mean, of that magnitude. That can happen.
AS: But here’s the interesting thing, it was short-lived. Since then, we’ve had an average inflation rate of 2%.
Penalties
PW: That’s why diversification is so important. When you make a move because of what you see happening in the moment, you walk away from diversification. That can be a huge, huge problem.
Now I’ve heard negative commentary, which is that you might have people who mess up more often and the IRS hasn’t been good at actually enforcing that.
The concern is that now that the penalty will be lower, they’re more likely to actually enforce it and actually charge it.
IW: I have not ever read anything about the IRS actually imposing a penalty on anybody. Have you actually ever read a news article about how John and Joan Smith failed to take money out of their IRA and had a $15,000 penalty as a result.
PW: No, nor had I heard anybody pay the 10% penalty when they took the money out before, but that doesn’t mean that didn’t happen.
IW: I’m just saying, that would be something that would make news though.
PW: Yeah, the penalty is big.
IW: For an older person.
PW: 50%. That’s true. So you have employers with their matching contributions.
The other interesting thing with these tax laws changes that I thought was interesting, because a lot of you may have Roth 401(k)s out there. And when you have a Roth 401(k), the idea was that, you pay taxes, you put the money into the 401(k), and when the employer did the match, it was always a separate account that was taxable.
AS: Pre-taxed.
PW: It was always pre-taxed, right? Because the employer deducts the contribution.
Social Security and Taxes
They’re saying that you can choose to either have a Roth IRA or do pre-tax, your choice. Who would in the right mind not want the Roth feature and have that money tax-free in the future?
AS: It’s going to be added on as additional income. But they said it is not going to be subject to employment taxes, which is kind of good.
PW: Yet a 401(k) contribution, in general, is subject to employment taxes. Why would the match not? I guess it’s just because it’s a match. Okay. It wasn’t part of your regular income.
Typically you’ll have Social Security taxes on your income unless you’re above the threshold which keeps getting higher and higher.
It’s $150,000 or something around that this year.
After that, you don’t have to pay Social Security taxes. If you look at how much that threshold has increased, in other words, making more and more people subject to Social Security taxes, it has increased way more than the cost of living.
AS: And Medicare, you still have to pay.
PW: Yeah. That goes up to Infinity.
AS: There is no cap. But not on that Roth match for the employer.
IW: One of my concerns is that if I, as an employee, elect to have my contribution matched in the Roth, if I don’t make adjustments to my deductions, I can end up with a surprise next year, having to pay more taxes. So you have to be cognizant of that.
AS: Now see, now this is just of course taking effect right now. So I don’t know if the 401(k)s are going to have to contact everyone and say, “Hey, you have a Roth. Now are you choosing to have the new Roth contribution and therefore we would recommend you change your withholding?”
Be Aware of Changes
PW: I don’t know that anybody is set up for that yet. From what I understand, a lot of companies are having a hard time getting set up to actually abide by the new rules.
This is just something to keep in mind. If you’re a person that does a Roth, you are able to do that. Now there is a negative to it.
There are a lot of really interesting things out there that you probably need to be aware of. For those 401(k)s, there are a lot of weird changes. Employers are able to set up new 401(k) plans and I suppose that the new 401(k) plans have maybe next to no administration costs because they don’t have contribution limits any higher than an IRA, which just seems kind of pointless to me.
PW: If you’re going to have a 401(k), you get people to participate. If you automatically enroll them and then increase the contribution every single year that they’re there, you’ll get people up to saving 10% of income, which is where it caps off from what I’ve seen.
And for a lot of people, it’s not a bad idea to be saving 10 to 20% of income. That’s usually a pretty good place to be if you’re kind of wondering how much to save of your income.
That’s a good way to get there. Just increase at a percent per year, especially for the younger people.
Keep going with saving that income, keep increasing it.
AS: The nice thing with the auto enroll is, you’d actually force people to opt out of it. Most people don’t do that, which means they don’t even really notice it’s coming out and yet it’s building up for them.
PW: So true. Then as you start to increase your contributions later on you learn to live on less, which is a good idea. Then when retirement comes, it’s not a total shock to the system.
Catch-up Contribution
So the other thing that’s going on with some of these Roth IRA 401(k)s is the idea of a catch-up contribution. If you’re over the age of 50, you’re able to put more money into a 401(k) than under the age of 50.
And now they have a second catch-up contribution phase, which is another increase in your early sixties. Here’s the thing that’s really weird. If your income is above a certain level, $145,000, I think it was something like that, you can’t make a catch-up contribution.
So they’re basically saying you have to do a Roth catch-up contribution. If you have a pre-tax 401(k) that does not have the Roth feature, you can’t do a catch-up contribution. And from what I understand, nor can anybody else, if you have one person above that income level, which is insanity.
Catch-up contribution treatment depends on income in employer retirement plans. If wages from the last year are above $145,000, inflation adjusted. So that’s going to change every year, to make it really fun to remember the numbers.
Additional elective deferrals can only be Roth contributions. So you’ve got those catch-up contributions, an additional elective deferral. Not every employer plan has a Roth Catch-up option.
If the employer does not have a Roth option, nobody is allowed to make catch-up contributions. This does not apply to self-employment income because self-employed income is tougher to determine until the taxes are filed because that gets a little complicated.
A lot of people are negatively impacted by this new rule.
AS: I have to believe though, that 401(k) providers will be contacting their employers to change that provision in the plans. Because they’re not going to want to have people not contribute.
PW: Well, but it costs money to make those plan benefit changes too. So, ka-ching.
The 529 Plan
IW: The majority of people out there are using prototype plans, so it’s really fairly easy for the administrator to update the plan. And really I don’t think it costs that much.
PW: Now, so if you’re above those income limits, think about that. You still have the Roth as the only way to do the catch-up contribution.
AS: So they’re really nailing you on the taxes.
PW: They’re nailing people that are paying taxes at a 40% level. So now you have a situation where you might have a ton of tax money that goes the government’s direction because it forces them into Roth’s and that makes a bunch of money for the government.
These changes work in favor of making the government more money, if you’re not careful.
The other thing that’s interesting is the 529 plan. If you’ve had one for at least 15 years, you’re going to be able to move that money over into a Roth IRA.
So let’s say you have a 529 plan, well, previously you had to pull it out with taxes and a penalty unless you used it or changed beneficiaries. Now the negative aspect of being able to move it is that you can’t pull a whole lot of money.
It’s no more than the IRA contribution limits. It’s a very limited amount of money that can be pulled out.
AS: And it’s a total of $35,000 over the lifetime. I read you can actually designate different beneficiaries.
PW: You can change the beneficiary.
AS: Yes. So you could actually do more than 35. Because you could assign the Roth’s to different beneficiaries.
PW: So you’re going to give Roth money away to different people. You just can’t do this for yourself. So the point that’s being made here is that if you have different beneficiaries, the beneficiary of it is the one that gets the Roth money.
Inherited IRA Funds
AS: What I was reading on that though is that they’re recommending, because of the 15-year rule, to set it up right away. Just throw $50 or $100 in there, just to start the clock running.
PW: Then they changed the laws.
IW: But with all of these new changes, one of the things that we have to just really be aware of is it took two years for the IRS to give us clarity on the 10-year distribution of an inherited IRA.
With all these changes, it will take awhile to gain clarity.
So this was just signed in December, and we’re going to have to get a lot of clarity from the IRS about how they are really going to intend this to be done.
PW: Ira, it’s a really good point. When you look at that 10 year rule, if you inherit an IRA and you’re not a spouse, you have 10 years to distribute it. There are a couple exceptions.
If you’re under the age of maturity and you’re within 10 years of the person that owned the IRA, there are certain things that are exceptions to that, but just in general, you have 10 years to get the money out.
And what they figured out is if the person was actually taking required distributions from the account, they were over the age of 72. If they were over that age, they were taking distributions, you have to continue based on their schedule.
And then you continue it for 10 years and then the 10th year, you get to yank the rest of the money out. So that was the rule change right there.
PW: It’s really complicated. So in essence, they are 72, they look at the life expectancy of a 72-year-old, married to a 62-year-old, and they were taking distributions. And now you, the inheritor, even if you’re 40 years old, have to take distributions based on their life expectancy, married to somebody 10 years younger than them.
So it may be 5%, 6%, 7%, 8%, if they’re up to age 90, it might be 10% distribution per year. Well, what will happen is you’ll do that for 10 years, then in the 10th year, if there’s money still left, you get to yank the rest of it out.
The Rules Are Different Than They Used to Be
If they were under that age, you have 10 years, period. You have to pull it all out in 10 years and then take all of those distributions. Well, for a lot of people that’s a ton of taxable income because it may be on top of any other income that you earn.
So that is a far cry different from what I got when I inherited my dad’s IRA. What ended up happening was I got to use my life expectancy.
So I basically get to pull out 4% of the account value every year. And I can do that for my life expectancy, which is super nice.
Ira Work: But under the old rules, an inherited IRA would be depleted somewhere around the age of 85, 86. If you’re 50 when you inherit. I mean, that’s 35 years. Think of the growth that could have happened over 35 years.
And this is an example of the reason why I am cynical about what the government might do. The Trump Tax Act in 2017 lowered all the rates, but they also took away our ability to allow our inherited IRAs to grow.
Now we have 10 years to get that money out. And it only makes sense when you think about the fact that the government needs X amount of dollars to run. They have electricity to pay, they have salaries to pay, they have Social Security, they have Medicare. They have all of these entitlements, and they have to pay them.
IW: It’s called liabilities. So the only way you pay liabilities is to have revenue.
If I cut revenue from my left pocket, I have to have revenue coming from my right pocket.
This is my concern about that. As you know, that backdoor Roth IRA and these Roth IRAs that they’re recommending that everybody fund now, because yes, they’re going to get more revenue now.
The Elephant in the Room
They can figure this out because they can just demand all of this information from the IRS. They know how much money is sitting in inherited IRAs. They know how much money is in traditional or pension plans. They have all this data, thankfully, to these wonderful little devices called computers and the forms that the investment firms send them.
PW: One of the keys, one of the things to take away from all of this conversation, because this can be overwhelming, is you need to diversify not only from an investment standpoint, but also from a tax standpoint. It’s one of those things that we talk about.
Diversify from an investment standpoint and a tax standpoint.
We’re not against Roth IRAs. I like pre-tax, I like Roth IRAs. I like non-qualified accounts because they’re tax based on capital gains tax rates, which have always historically been lower, but not always.
It’s important to look at how we can diversify to protect ourselves from what may be coming.
IW: This big bill that was just signed, 100 changes were made, but they never addressed the real elephant in the room.
PW: Okay. What is the real elephant?
IW: What is the biggest concern that most of our clients face in retirement?
AS: Oh, I think it is running out of money, that they’re not saving enough.
IW: I don’t think that’s it.
PW: Social Security and the funding of it?
IW: Correct. And when you look at your Social Security report, they did not address that at all.
PW: Why would they?
IW: Well, I know why they wouldn’t. Because then they’re afraid,
PW: Well, because they have 10 years before the trust fund runs down, then they’ll do it.
IW: But they should be doing it now. And that’s my point.
A Possibility of the Retirement Age Being Raised?
PW: It would be so much better if they could use time as their ally with this. Yes, that would be good if they would do that. But there are a lot of things that they can do.
If they wait they’re just going to kick the can down the road and they’re going to nail high income people and continue to tax and increase the taxes. They may increase taxes overall on everybody, but that’s politically not terribly popular or raise retirement ages on the younger people.
IW: Right. I think that would be the first one. Because those of us who are fairly close to retirement, I mean, I’ll be 62 next month, so I would actually be able to start taking my Social Security.
PW: Well, this is a good point. Hey, you don’t even have to take distributions from your IRA until 75. Why would it matter if you don’t take your Social Security, your early Social Security age is 70?
I doubt it would be that. But the problem that you run into with that is that you have a lot of people that are in trades that physically are difficult and you can’t do them past the age of 50. I think that’s where that becomes really difficult.
We’re moving toward a service economy where people can work longer and they can stay in the workforce longer.
The exception being some construction and heavy labor jobs, which are becoming fewer and fewer.
PW: Like nursing, would be an example, then we’re going to have a different type of a system for nurses where you can retire a little bit earlier and have a supplement until Social Security actually starts. Is that a possibility?
IW: The full retirement age is 70. They didn’t address that at all. They made all these changes that you may or may not be able to put money away into your retirement account, but they’re not addressing Social Security.
PW: Well, Medicare’s the other huge one. That’s the other huge elephant in the room. When you look at that, that’s more imminent.
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