November 5, 2020
Are You Ready to Make Work Optional?
We've all heard that it's best to save for retirement by using "before-tax dollars" - money deducted from your income to be deposited into retirement accounts in order to reduce your taxes. This practice was based on the assumption that while you are working, you are in a higher tax bracket than when you stop working. While this was not a bad concept, it's not a one-size-fits-all solution.
At age 70 1/2 (for those born before July 1, 1949), or 72 (for those born after June 30, 1949), you are forced to withdraw money from your retirement accounts and pay taxes on it, even if you don't need it. This holds with it, the possibility to push you into a higher tax bracket than when you were working. In the end, you still pay taxes on the amount you deposited AND the earnings. Is there a better way to save?
In 1998, the Roth IRA was born. The difference here is that although there is no deduction on the deposit into a Roth, the earnings grow tax-free! Since there is no immediate tax benefit to this strategy, Roths didn't gain the respect they deserved at first.
Enter the Tax Cuts and Jobs Act of 2017 which took effect for the 2018 tax year which lowered tax brackets and widened the taxable income range between each bracket. In addition to that, as of 1/1/2010, congress relaxed restrictions, allowing anybody to convert some, or all of their money from their IRA to a Roth IRA. The amount converted is taxable, but all of the earnings are indeed, tax free which also extends to beneficiaries for 10 years following death.
From a tax standpoing, converting IRA money to Roths allows you to use retirement money more efficiently. You pay taxes on your retirement money when YOU want and when it is in YOUR best interest, not when you are forced to. While this strategy might not be recommended in EVERY instance, in many cases, it is an excellent strategy.
A large component of strategy in financial independence is how you spend assets. The optimal order is: After-tax dollars, IRA, or pre-tax dollars, then Roth IRA dollars. This order will use your more tax-efficient bucket first, and likely leave some of your Roth IRA to be passed on to the next generation. This is a tax-free gift that your children or grandchildren should be grateful for! The exception to the concept of spending your Roth money last is if you are getting pushed into a higher tax bracket by taking a lot of your money from the pre-tax bucket. This can be offset with some non-taxable (Roth) income.
Social Security is also an important component of financial independence to look at. You can claim social security at 62 (for a reduced benefit), 66 (if born before 1954), 66 + 2 months - 67 for birth years 1955-1960 or later for Full Retirement Age (FRA) benefit; and age 70 for Delayed Retirement Credit (DRC), or increased benefit. Married couples should take a look at their Social Security as a team. Since the survivor benefit is the largest of the two Social Security incomes, the spouse with the highest earnings history should wait until age 70 to apply for benefits. For this reason, holding out for more money is not the ONLY reason to delay Social Security benefits. The survivor benefit is also a very important reason.
The SECURE Act changed a few rules which are important to look at, namely the change in when the first RMD must be withdrawn. Under this act, the required beginning date is April 1 following the year after reaching age 72. Another aspect important to look at is if you end up working past 70 1/2. A person age 70 1/2 or older can contribute up to $7000 in 2020 as long as there is earned income.
With all that said, here are four steps you can take to know you are ready to make work optional:
1. Analyze your income sources: Pensions, Social Security, and rental or passive income.
2. Take inventory of your retirement account balances: 401k, 457, 403b, IRA's, Roth IRA's, SEP IRA's Simple IRAs, and annuities.
3. Take inventory of your non-retirement account balances: brokerage statement, savings accounts, government bonds, other investments
4. Business owners - have a business valuation.
In summary: It's always good to have a plan in place to make sure your future is secure to allow you a simple and elegant life. We are here to help you work toward financial independence, so please contact us for a financial consultation, or to update your financial plan.