Projections are fun, right? We all love those pretty charts showing how much our savings could be worth in the future. In fact, we just did a post on that last week. It’s an important part of being confident that you have enough to retire on and can support yourself.
Over the last week, Mr. Need2Save recently shared specific details about our projections and assumptions for Goals 2 and 3 of our primary retirement saving strategies. We tend to be a little conservative about projections because there is so much uncertainty and time between now and then. The main thing is that we don’t want to run out of money.
At the Need2Save house, we don’t always agree on what the right assumptions are to use. However, this leads to healthy analysis and discussions about different scenarios and it also helps to read what other bloggers are doing as a sanity check on our plans as well. We always appreciate your comments and input as it helps us to refine our plans.
If you tend to be fairly conservative too, is it possible to eventually have too much money saved in your pre-tax retirement accounts?
How can you end up with too much money?
By too much money I mean that you are ultimately forced to take out more than you need for your current living expenses and end up paying super-high income taxes. For some super-savers, it is possible to do so well with your investments that your tax rates actually go UP not DOWN in your retirement withdrawal phase. I don’t know about you, but I don’t want to pay more in taxes than I already do.
It’s all about those nasty Required Minimum Distributions or RMDs we are always talking about. After you turn 70.5, you no longer get to choose the minimum amount that you pull out each year whether you need the money or not. The IRS requires that you use one of their methods to decide the amount to withdraw. If you don’t take enough, you face hefty excise taxes on the amount you should have taken.
Join us for some fun with RMD numbers…
What would that actually look like? In Mr.Need2Save’s posts last week, he projected that under certain scenarios, it’s possible we would still have $2,500,000 or more at age 70. If that turned out to be true, what would our RMDs look like when we turned 71?
- The year we turn 71, if we had $2.5M in our pre-tax retirement accounts (401k and tIRA), our RMD would be approximately $94,339 for the year.
- The next year when we are 72, our RMD would be approximately $97,656 for the year.
We used FINRA’s RMD calculator (which you can access here: http://apps.finra.org/Calcs/1/RMD)
The above numbers are not too far from what our projected withdrawals would need to be to support roughly $60,000 a year in today’s dollars (including inflation of 2% a year). That doesn’t seem too bad, but continue reading for why this is more than we likely need.
What if our balance was more like $3,000,000?
- At age 71, we’d need to pull $113,207 (3.92% replacement rate of return)
- At age 72, we’d need to pull $117,187 (4.070% replacement rate of return)
- At age 73, we’d need to pull $121,457 (4.22% replacement rate of return)
As you can see, even if your initial rate of return replenishes about the amount you take out – your RMDs will continue to go up each year because you get older.
It doesn’t matter if your required cost of living is much less than your RMD. Under this scenario, our RMDs would probably outpace what we would prefer to withdraw for living expenses. Why is that? Well, we will hopefully have Social Security benefits coming in. We’ll also have other non-retirement fund assets we could use, and I also have a small pension that I could be collecting if we don’t take a lump sum. In addition, we are likely to still have some taxable investment dividends, interest and the like.
You have to calculate your RMD annually to be sure you factor in the current balance at the time plus your age. Unfortunately, it’s not a one-time and done calculation. Sounds like a lot of work, ughh 🙁
In Today’s Dollars
Let’s imagine that we were age 71 this year and we did have $3,000,000 in our pre-tax retirement accounts. A good situation to be in, right? As shown above, according to the FINRA RMD calculator, we’d have to take out the minimum of $113,207 from our account for the year.
Our Hypothetical Tax Picture at Age 71 (using current 2017 projected tax tables and omitting other possible taxable income like dividends & interest for simplicity)
In this scenario, our federal tax bill is around $28,000. That is a significant sum. It leads us to the fundamental question of whether investing these funds in pre-tax accounts turned out to be a good idea after all those years?
We are currently fortunate enough to fall in the 33% federal tax bracket so a reduction from 33% to 25% seems like a good deal for us on the surface. However, during many of our working years we contributed to our 401(k)s when we were in the 15% and 25% tax brackets. Of course we have all those tax-free earnings that piled up over the years. But it appears that we would actually be paying a higher federal tax rate after we turn 70 than when we were in our 20’s and 30’s.
Here’s a fun chart showing how our federal income taxes have changed over the last 19 years (at the time of this post, we weren’t finished with 2016 calculations yet).
If you look at our actual Effective Tax Rate (the grey bars), we paid much less than our top Federal Tax Bracket (the pink bars). Many people focus on the highest tax bracket that you fall in, but due to the nature of how the U.S. tax system currently works, you get to deduct certain portions of your earnings and due to the bracketing of the leftover taxable income, only a portion of your earnings are taxed at your highest rate. When you collapse all your taxable income after your deductions and credits, you get the Effective Tax Rate. If you use a software like Turbo-Tax, they do the math for you and show your Effective Tax Rate in your annual summary.
The further apart the Federal Tax Bracket and your Effective Tax Rate are, the more deductions and credits you are enjoying. You can see in recent years the gap between our Tax Bracket and the Effective Tax Rate is shrinking. This is because our income has recently reached the phase-out zone for some exemption and deduction eligibility. The gap during most of the early 2000’s was much larger because we were a one income family with two kids and we received more tax breaks during that time.
We didn’t include State Income taxes in this chart but we can guarantee state tax savings by moving from a state with income tax to one without in retirement. We currently pay an effective tax rate of around 8% in Maryland State and County Income taxes, but during the same period as above, it’s been as low as 4% after deductions and credits.
Would We Really Have That Much?
We plan to start taking taxable distributions around age 59 1/2 or 60 when we are no longer subject to the 10% early penalty. We will take at least the amount to fill up our tax-free space each year (the total of the standard deduction and personal exemptions mentioned above). There is a high likelihood we would need to take much more than that out for our living expenses and travel plans prior to age 70.
Deciding when to file for Social Security benefits will take a lot more analysis but by the time we are 70, it will be a sure thing.
So many possibilities! It makes your head spin, right? This is one of the reasons we called the decade between 60 and 70 the Decade of Big Decisions.
As Mr.Need2Save previously showed, even at just 5.5% growth rate before age 60, and a modest 4% growth rate after age 60 (assuming we use a slightly more conservative investment approach beginning in our 60s), it is still very feasible we’d have $3,000,000 at age 70.
Back in 2007, the IRS estimates that there were over 1,000,000 people in the U.S. with ‘Personal Wealth’ between $2M and $3.5M and 832,000 people with even higher Net Worth. This was over ten years ago. That’s a lot of Americans, don’t you think? They weren’t all named Gates or Buffet.
What About Inflation?
If we estimate that we need $60,000 to live comfortable and happy in today’s dollars, we would need around $98,436 at age 71 and $132,482 at age 85 if inflation held around 2%.
Above, we projected that our RMD could be as much as $113,000 at age 71 so when you add in our projected Social Security Benefits and account for probable taxes, the net income of over $138,000 is definitely more than we need in today’s dollars. About $40,000 more even before we account for other income sources like dividends and interest in our taxable accounts.
Again, just fun projections. Will inflation stay consistently flat? No. Will tax rates change? Yes. Will our health care needs go up? Most likely, yes. Will some of our other living expenses go down? Probably.
The one thing this does show, is that clearly our Social Security benefits will not likely cover our future needs so it’s a good thing we have those retirement accounts!
So what would we do?
Could You Give Some of the RMD to a Charity?
Yes. Under current rules, a Qualified Charitable Distribution (QCD) does count as part or all of your RMDs if you are age 70.5 when the distribution is made. So if you find yourself in a position where you really don’t need the money for day-to-day living expenses, you could exclude up to $100,000 in charitable donations. Plus, if you are married, your spouse can also have a QCD for another $100,000. We could donate up to $200,000 of our RMDs if we wanted to to avoid paying taxes on the withdrawals.
For more information, see IRS Publication 590-B.
This seems like a great way to reduce the portion you need to pay taxes on and give to those charities which you believe deserve your financial support. We will certainly be keeping this in mind for future planning at any income tax bracket.
It’s Not an Issue If You Don’t Live ‘Till 70!
All the planning, worrying, stressing and projecting in the world will not give you the answer about how long you are going to live. Shoot, we may not make it to 70 anyway, right?
Remember to take care of your physical and mental health to give yourself a better chance of reaching your 70’s and 80s!
What About When One of Us Dies?
Since the majority of our retirement assets are in pre-tax retirement accounts (401(k)s and tIRAs), this money would just be left to the living spouse to continue to draw from. This would exacerbate the issue of having more money than needed since the cost of living for one of us would be less than the needs of two people.
If we both died, than taxes are no longer an issue for us. We also aren’t worried about Inheritance taxes because the sum of all our assets would still likely be under the Inheritance Tax limit ($5.45M Federal, but about 8 states still have Inheritance Taxes). Our leftover retirement account money would be split between our two sons as inherited IRAs. Another days post topic will be tax advantages of certain assets and accounts upon death and related concerns for non-spousal beneficiaries.
This would be a really great problem to have at age 71. It may offer us a chance to give away more money to charities which appeals to us. Simply put, I’d rather donate the extra money to a worthy organization of our choosing than send it to the IRS.
We could also ‘gift’ money to our loved ones along the way. For example, if we wanted to give money to our sons before we die, they could each exclude up to $14,000 in gifts a year from each of us (2017 limit). So we could give them a total of $28,000 a year without effecting their taxable income. Since we have two kids, we could give away $56,000 a year tax-free between them if we wanted to. This wouldn’t reduce our taxable RMD income though but it is an important part of estate planning strategies for many aging parents.
In our early 70’s, our sons will be in their mid-40’s. Maybe they could use that gift money to fund their own early retirement or pay for college for our grandchildren? Why not gift some to our nieces and nephews, too? That may feel pretty nice.
For more information about Gift Taxes, see IRS Publication 559.
Have you thought about this? What would you do with the extra income if this happens to you in your late retirement years? Do you have big plans for your leftover assets when you die?