By Jon Meyer, CFP®
Key Takeaway: Power funding a retirement plan through your law firm leads to options when you want to hang it all up. But it can also lead to a tax time-bomb. Knowing your options for the decumulation phase will lead you to different decisions today.
Think before you act. That is an attorney’s role in the face of big decisions. It is the role of someone who must consider all options and plan for every possible scenario for one’s client. All that thinking often leads to a better outcome though. It is the attorney’s job to help the client understand the long-term ramifications of short-term decision-making.
And that is the thinking that needs to be applied to your personal retirement. Without it, you can create a tax problem you never saw coming.
The default for many attorney’s is to save the maximum they can into their retirement plan at work, with the firm also contributing a large chunk for the employer side of the plan. This can lead to very large 401(k) balances at retirement. Having all your money in your retirement plan has a long-term ramification.
Retirement accumulation is simpler than retirement decumulation. When you are accumulating, you are trying to do so in the most tax advantaged way; therefore, retirement plans through employers are attractive. In the decumulation phase, however, there is the conflicting elements of spending and rising tax brackets. If you get to retirement and all your money is in retirement plans through work, then you have no control over your tax bracket; every time you pull money out to spend, you are taxed. Sometimes we call this the tax time-bomb.
The more attractive method to decumulate assets is to have money in a normal brokerage account, Roth IRAs (tax-free) and health savings accounts (HSAs are also tax-free when used for health care spending in retirement). There is no rule as to how much, but I would suggest 50% of your assets should be in these locations, and 50% in your retirement plan at work. Most likely, you will have a majority of your extra savings in standard brokerage accounts.
The reality is many will not get to this 50% mark. Life is expensive, and you must have a good time along the way. The key is focusing on it as soon as possible; too many people wait until they are 60 to finally look at their assets for retirement. Ideally, thinking about this in your mid-30s or early 40s gives you the best chance to get to the number I suggest. But even if you can amass only 20% in accounts outside your retirement plan, it will help a lot in controlling the tax bracket in retirement.
The reason this is an issue is that tax brackets change as your income goes up. For example, assuming a married couple filing a joint return in 2019, if your taxable income was less than $78,950, you would pay taxes in the 12% bracket. For every dollar you go over that, you pay in the 22% bracket, up until $168,400 where it changes to the 24% bracket. While many will spend more than $78,950 in the year, if we can control it so that taxable income of $78,950 comes out of your retirement plan, and then other spending comes out of the brokerage/Roth/HSA accounts, you can conceivably stay in the lower tax bracket (note that capital gains rates would be between 15% and 23.8% federally; state taxes are unique to each state).
Getting money into other types of accounts is also an option if you retire prior to 70 ½ and use the intervening years to withdraw money from your retirement accounts (whether directly to deposit into a brokerage account or through Roth conversions). In doing this, the goal is to pay taxes at the lower rates prior to getting to age 70 ½ when rates likely go up.
Tax rates tend to jump at 70 ½ for many people because they must start Social Security at 70 (if they have not started it yet) plus they must start taking required minimum distributions (RMDs) from their retirement accounts. Thus, higher tax brackets are often attained for the rest of their life. RMDs are based on life expectancy; on average, you will be required to withdrawal approximately 3.5% of your account each year. In other words, that’s approximately $35,000 withdrawals on every $1 million you have in retirement plans. Based on how many law firms fund retirement plans, attorney’s can retire with multiple millions in retirement accounts, which leads to the tax bracket issue in retirement.
Law firms are doing the right thing by encouraging large contributions to retirement plans. Yet assuming that is enough can be bad advice. Attorney’s must look forward to the longer-term ramifications of pre-tax accounts and develop a game plan for how they will save elsewhere to decumulate in the best manner possible. It’s probably the same advice you would give a client.
Jon Meyer, CFP®, is Chief Operating Officer and Investment Manager for BGM Wealth Partners. Outside of work, he is busy raising his four children and training for his next marathon.
The opinion of the author is subject to change without notice and must be considered in conjunction with relevant regulation, as well as subsequent changes in the marketplace. Any information from outside resources has been deemed to be reliable but has not necessarily been verified. Each individual has unique circumstances to which this information may or may not be relevant. Under no circumstances will this information constitute an offer to buy or sell and it does not indicate strategy suitability for any particular investor.