According to recent articles like this one and this one, $3 million is the number people feel they need to have for retirement.  More than 7 in 10 investors stated they would need between $3 million and $5 million to retire.  This is while the median retirement savings is $55,000 for a 55-60 year old and the average (skewed by high savers) 55-60 year old has $199,000 saved.

While I strongly believe that a decent retirement can be had in a low cost of living area for under 1/6 this amount,  I wanted to use the $3 million as an example.  If someone grows their retirement nest egg to $3 million then retires and does a 4% withdrawal or even just the RMD when required, they will end up paying MILLIONS in taxes that they shouldn’t have to.  As I’m writing this I found a recent mainstream news article stating effectively the same warning.

Getting To $3 Million:

Ok how the heck do you get to $3 million?  For the purpose of this conversation we will be talking about a dual earning household with a combined retirement net worth of $3 million.

• They both work full time career jobs with 6% 401K matches after the first year.
• They start out at age 25 combined earing $70,000 per year.
• They increase total income by 3% per year, with final earnings of $197,000 combined at age 60.
• They contribute 15% of gross income to 401Ks
• They average 7% investment returns

This couple will have $3 million at age 60.

By the way, this is a very inefficient method of getting to $3 million, but it is a more likely scenario than the most efficient way.  The most efficient way is to front load retirement accounts with 50%+ of gross pay while working as a teenager and in early 20s while living at home with no expenses.

Although this couple has build a nest egg of $3 million, all of it is in traditional 401K plans that are tax deferred.  The taxes will be due when money is withdrawn from the accounts.   With a Roth 401K/IRA by contrast you pay the taxes in the current year and the money grows tax free forever.

Retire At 60

This couple just retired and plans to take a 4% withdrawal, because that’s the safe withdrawal rate described by the Trinity Study.  This is more than enough money for them to comfortably live off of.  All of their distributions are taxable by the IRS and their state government. At least there is no Social Security or Medicare tax. Here’s a chart showing the first 12 years of their withdrawals, starting age 72 with $4.2 million.

(Age | Year | Income | Start. Balance| Contribution | 401K Match | Withdrawal | End Balance | Return)

Tax Brackets:

For this exercise we will assume that tax rates stay exactly what they are now.  This is highly unlikely to occur.  Our Federal spending, deficit, and national debt have been growing at a massive pace every year.  The only realistic option our government has is to substantially increase taxes.  In the 1980s the top tax rate was 50%, today it is 37%.  I think it is very likely we will see all tax brackets increase by 10% or more over the next 3 decades.

For a married couple the federal tax brackets are as follows:

• Standard Deduction : $27,700
• 10%: Next $22,000
• 12% Next $67,450
• 22% Next $101,300
• 24% Next $173,449
• 32% Next $98,299
• 35% Next $231,249
• 37% Anything over $721,451

It matters deeply when making decisions about 401K withdrawals to understand the order that income comes in.  When you claim Social Security it is automatically your first income,  it is there.  When you have Required Minimum Distributions those also hit the brackets first.  Earned income hits the brackets first. The last money that comes in is elective 401K distributions.

Earned Income, Social Security Income, and RMDs all push elective distributions into a higher tax bracket.   This is why it matters. RMDs will happen at age 72 (73 starting this year).  Social Security income will happen at age 70 at the latest.  The only control you have is then on earned income.

If one continues working, despite having $3 million in retirement accounts, it will prevent elective 401K distributions from being taken to pre-empt the RMD forced taxation at a higher rate and higher total balance amount in the future.

Social Security:

They decide, and wisely so, to take Social Security at 70, allowing for the maximization of their benefits.  At age 70 their total benefit should be 2,825 per month or $33,900 per year each for a total of $67,800 a year. Provided they live to be at least 80, taking Social Security at 70 makes the most sense.

People are living longer and longer.  Sure the average life expectancy in the US is around 77, but many of the risks associated with that number are easily mitigated.  For someone who doesn’t smoke, doesn’t drink, and exercises a couple times a week, the odds of living into their 90s are pretty darn high. The average life expectancy also takes into account people dying at every age, so just living to age 60 means that your individual life expectancy is already higher than the average.

The Social Security income is their income base and will fill up their lower brackets.  2 years after getting Social Security the RMDs start.

RMDs

Starting at age 72 the IRS requires minimum distributions from 401Ks.   By age 72 if all they were doing was removing 4% of their balance each year since 60, their 401K accounts will have grown to $4.2 million.  Social Security and required minimum distributions combined will quickly push this couple into paying a massive tax bill.

Tax law change: Starting this year the RMDs don’t start until age 73 and starting in 2033 they will start at 75. I already did all my math when I found this out, and it barely moves the needle to adjust this by 1 year, so I’m leaving the charts at age 72.

(Note in chart below the RMD becomes the new withdrawal column at age 72.)

(Federal tax dollars were rounded to nearest $1,000 for simplification)

(Age | Year | X | Start. Bal| X | X | Withdrawal | End Bal | Return)

The total federal income tax that this couple would pay from age 72 to age 100 would be $2.6 million.

But wait, that’s not all!  The remaining $2.7 million in the account will be inherited and their heirs will have to pay taxes on that money.  The  account must be emptied within 10 years, and it is still growing! There is no tax efficient way if the 401K is going to 1 individual, to pull the money out.  Assuming the beneficiary works and earns just $50,000 a year, the federal tax burden to withdrawal all of the money from this account would be roughly $800,000. This brings total federal taxation of a $3 million portfolio at age 60 to $3.4 million.

And all of this is if the tax rates stay at the historic lows that they are at right now for the next 7+ decades. This scenario in the spreadsheet is the most conservative, giving the lowest amount of taxes that would be paid. This is also ONLY the federal income tax.  State income tax is levied on RMDs in most US states.

Roth Conversions:

This couple at 72 realizes they are now paying a massive tax bill that will snowball every year as a higher and higher percentage of their growing retirement savings must be withdrawn and taxed each year.  The problem is that the required minimum distributions can not be done as a Roth conversion.  This means that if they wanted to convert any of their balance to Roth accounts that will owe no future tax on withdrawals and have no RMDs they will have to do these conversions in an already high marginal tax bracket. They are STUCK!

The Solution:

At 60 when they quit working they need to do massive Roth conversions every year.  This couple should strive to live off of $80,000 (or less) and max out the current 24% tax bracket.  This would mean taking out $391,000 per year from their 401K accounts.   $80,000 would be for living expenses, $75,000 for federal taxes, $15,000 for state taxes, and the remaining $220,000 would be a Roth Conversion. Yes for this decade their spending will need to be significantly lower than following the general 4% playbook, but still $80,000 a year can be a very comfortable life for 2 people who have no jobs and a paid off house. They could spend more money and reinvest less money and that would be fine.  It doesn’t affect the taxes, just how much money gets reinvested into the Roth IRA.

(Age | Year | Income | Start. Balance| Contribution | 401K Match | Withdrawal | End Balance | Return)

Doing this from age 60 to age 70 they would empty their 401K account completely and have no RMDs. The total effective federal tax rate for maxing out the 24% bracket is 18.9%.

At age 72 rather than having 401K accounts with $4.2 million, their Roth IRAs will have $3.9 million.  By paying their tax before hitting Social Security but after retiring allows them to maximize low tax bracket years.

If instead of spending $80,000 per year they spent $120,000 per year the total at age 72 would be $3.2 million, more than enough to fund a comfortable retirement, especially now that it is all tax free.  $120,000 with no income taxes, no house payment, no jobs, and no minor children is the equivalent for most people of earning closer to $200,000.

It also makes sense to make Roth conversions while they are allowed.  Roth conversions had an income limit up to 2010 when it was removed. Major changes, some good and some bad, have come with the SECURE ACT 1.0 and 2.0.  It is not out of the realm of possibility for them (the feds) to realize that Roth conversions are a tool used by relatively wealthy (top 20%) Americans to reduce their taxes over decades.  They may call this a “loophole of the rich” and eliminate Roth conversions all together.

There is a rule where you must wait 5 years after a conversion to pull money out.  This is relatively easy to work around in this scenario.  Complete the conversions for 1 spouse first, and that spouses Roth IRA will be what is drawn upon between 71 and 75.

Why This Couple Should NOT Have Earned Income:

Remember that any earned income during this time period will work against the goal of emptying the 401K accounts, increases the tax bracket of the withdrawals, and reduces the amount of money that can be taken out.

While sticking to maxing out the 24% tax bracket, if 1 partner in this couple continues working and earns $100,000 per year, that 100% filled up the 0%, 10%, and most of the 12% bracket. They also paid an additional $7,650 in Social Security and Medicare tax.  Effectively what this does is reduces the amount of 401K withdrawals by the amount of earned income, in this case $100,000 per year.  Rather than withdrawing $391,000 per year, this couple could only withdraw $291,000 per year.  At age 70 when they need to start taking Social Security, their withdrawal gets reduced by their total Social Security income of $67,800.

At the end of age 72, on the eve of forced RMDs, they will still have $1.25 million in their 401K accounts.

Just waiting 2 years to quit working would cut the math extremely close, hitting a $50,000 remaining balance on the eve of RMDs.  Keep in mind this is all theoretical based on 7% average annual returns.  The average annualized return of the S+P 500 since 1990 has been 10.16%.  Since 2010 it’s been 12.8%.  The 7% I used is a conservative measure for total value, which means we need to be conservative in the other direction, which is time to get our money out of RMDs.

If from age 60 to 72 they average 12% returns instead working at all is a much bigger problem. In this scenario even maxing the 24% tax bracket with all income being withdrawals, they still have $1.25 million left in the account at the end of age 72. Working just 1 more year at age 60 and earning $100,000 that year would increase the account balance at 72 to $1.6 million. That’s an extra $350,000 that will be subject to RMDs and be pushed into the highest tax brackets.   Please don’t read this wrong and think that working an extra year gained them $350,000 in value.  The increase in account value means the money that is still in the account increased in value, it would have also increased in value in a Roth IRA by the same amount.   The increase of value in the 401K is NOT a good thing.

Why Max The 24% Bracket?

For someone in this scenario with a 10 year window before claiming Social Security, there is not enough time to empty the account before Social Security and RMDs start if only filling the 22% bracket, and certainly not if filling just the 12% bracket.  The 24% bracket is a large bracket, making up $173,000 total.  Reducing the withdrawal to fit into the 22% bracket would just barely cover the gains the account is making and after 10 years the account would be reduced from $3 million to $2.8 million.

The next tax bracket is 32% which is a big jump, and isn’t necessary to fill in this scenario.  Had this couple amassed $4 million by age 60 then this may have become necessary.

The 3.8% Medicare Surcharge Tax:

Unfortunately, following this plan in addition to paying federal income taxes, some of the total income will be subjected to the Medicare surcharge tax.  Currently for married couples their MAGI over $250,000 has this tax levied on it.  For maxing the 24% tax bracket with a total income of $391,000 this would result in $391,000 – $250,000 = $141,000 at 3.8%, or an additional tax of $5,358 per year, bringing the total federal tax bill from around $75,000 to around $80,000. This increases the total federal tax rate from 19% to 20.5%.

But guess what? The same 3.8% surcharge will also be applicable to the RMDs when they are required.

Estate Planning:

At age 71 this couple has $3.7 million in a Roth account and receives $65,000 a year in Social Security benefits.  Assuming they withdrawal and spend 4% every year in addition to their Social Security money, they would take a total of $6.7 million out between 71 and 100, tax free.  There would be $7.7 million left in the account that would pass on to beneficiaries tax free.

Rate of Return Risk:

The world is full of debby downers who preach that even the 4% withdrawal rule is not safe.  These people wore 2 masks while driving alone in their car at 10 miles below the speed limit with a lifejacket on just in case they encountered water.  IF we expected long term diversified stock returns to average under 4% over the next 50 years, not only would it be a strong indicator that saving and investing in paper assets is the wrong method to focus on for retirement, but also that we expect the US and global economy to effectively collapse and we would be better served buying food, medical supplies, and ammunition than stocks and mutual funds.

7% is a good rule of thumb historic average for the S+P 500 over the last 100 years accounting for inflation.  Although the S+P started in the late 50s, a similar index going all the way back to 1926 would have had a total average yearly return of 10.16% and a return of 6.99% accounting for inflation.   There are many paper asset investments that have out performed the S+P 500 over the long run.  Don’t believe me?  The Vanguard Health Care Fund has averaged over 15.41% since 1984.

It is entirely possible that rates of return over the long haul could be 8%, 9%, or even 10%.  Small increases in rate of return can greatly increase the compounding effect of RMDs, especially if drastic action is not taken to remove money from retirement accounts.

An Ounce of Prevention:

The 401K is scary because people think they are practicing delayed gratification, but it is anything but that.  They contribute to a 401K to avoid paying taxes in the current year, but create a massive tax bill in the future.  401Ks may be appropriate for high earners who will have a long duration between retirement and Social Security to transfer funds over to Roth, but for most of us, it is better to do Roth from the beginning.

Another group that it makes sense to contribute to traditional 401K plans is people who are low earners and low savers, which is the majority of the country.  With the average 401K balance for 55-60 years old’s being $250,000 and the median being $55,000,  anyone in this range is better suited to have a traditional 401K and take the tax break in the present, as the total of their Social Security and 401K withdrawals will not create a serious tax burden with RMDs in the future.

88% of employer plans now offer a Roth 401K option, yet only 28% of retirement savers contributed to their Roth option in 2021.  

I am certainly guilty of prioritizing the short term gain of traditional 401Ks. For years I boasted about how I paid no federal income tax.  I’m paying for it now as I realize how much my future RMDs will be and what those tax bills will be.  Starting in 2024 I will be doing Roth conversions.  I’m certainly kicking myself for not doing a conversion in 2020 when my income was down, the stock market was down, and I identified that it was the right course of action.  For this year we will have a large capital gain bill that will put us into the top tax brackets.  I plan to convert all of my traditional 401K/IRA accounts between 2024 and 2026.

For my kids I have had all of them start Roth IRAs.  My oldest who is 20 has been contributing to a Roth 401K at his real job for the past 2 years.

What do you think about this strategy of emptying 401K/IRA accounts to avoid taxation on RMDs in the future?