Q&A: Retirement can bring some complex tax questions

Dear Liz: I was in the twilight of my career when the Roth became available, and I contributed the maximum for those few years before retirement. After retirement, I dropped to the 15% tax bracket, so I did Roth conversions of my regular IRA to fill out that tax bracket until I was age 70½. My reasoning was that I would likely be in the 25% tax bracket when I started my required minimum distributions from my IRA, and that turned out to be true.

The scary part is that the tax-deferred money in the rollover IRA has continued to increase each year in total in spite of the required minimum distributions. My tax preparer says he has clients who would be happy with my problem, so I should tread softly with my tax complaints.

One thing I regret is funding a nondeductible IRA for a few years before the availability of the Roth IRA. The nondeductible contributions only represent about 1% of the total. That means I can’t access that money I have already paid taxes on unless I have depleted all of my tax-deferred monies. Do you have any suggestions?

Answer: Absolutely. Listen to your tax preparer. Most retirees would love to have these problems-that-aren’t-really-problems.

You were smart to “fill out” your tax bracket by converting portions of your IRAs. For those who aren’t familiar with the concept, it involves converting just enough from an IRA to make up the difference between someone’s taxable income and the top of his or her tax bracket.

The top of the 15% bracket is $75,900 in 2017, so a married couple with a $50,000 taxable income, for example, would convert $25,900 of their IRAs to Roths. They would pay a 15% tax on the amount converted (plus any state and local taxes), but the Roth would grow tax-free from then on and no minimum distributions would be required.

These conversions can be a great idea if people suspect they’ll be in a higher tax bracket in retirement.

Now on to your complaint about getting back the already taxed contributions to your regular IRA. Withdrawals from regular IRAs are taxed proportionately.

The amount of your after-tax contributions is compared to the total of all your IRAs, and a proportionate amount escapes tax. So if nondeductible contributions represent 1% of the total, you’ll pay tax on 99% of the withdrawal. You’re accessing a tiny bit of your after-tax contributions with each withdrawal.

If you don’t manage to withdraw all the money, that’s not the worst thing in the world. It means you didn’t outlive your funds. Your heirs will inherit your tax basis so they’ll access whatever you couldn’t.

Q&A: Roth IRA offers key tax feature

Dear Liz: In an article that ran in my local newspaper, you stated that, “Roths allow you to withdraw the amount you’ve contributed at any time without triggering income taxes or penalties.” I suggest that you review Pub. 590-B, where you will be reminded that, with some exceptions, withdrawals from a Roth IRA within the first five years will result in a 10% penalty.

Answer: The five-year rule applies only to earnings, not contributions. The IRS publication you reference states on page 30, “You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s).” There’s a helpful diagram on page 32 that explains when a distribution is made within five years of the year in which the Roth is opened, the “portion of the distribution allocable to earnings may be subject to tax and it may be subject to the 10% additional tax.” (Emphases added.)

Retirement distribution rules can be complex and it’s easy to make a mistake. But the fact that people can withdraw their Roth contributions at any time without taxes or penalties is not some obscure facet of these retirement accounts. It’s a central feature.

Unlike regular IRAs, where withdrawals are taxed proportionate to their earnings, a withdrawal from a Roth IRA is deemed to be from nondeductible contributions first. People have to withdraw more than they contributed to face a tax bill or penalties. If they’re over 59½ and the account has been open five years, their withdrawal of earnings will be tax-free and penalty-free.

Q&A: How to avoid outliving your retirement savings

Dear Liz: The wife and I are both 65. We both work, with a combined income of $125,000, of which we spend almost all. We have $550,000 in IRAs and $1 million in other investments, plus home equity of about $500,000. We’ll get $3,800 from Social Security if we start next year but plan to work until age 67. Should we wait until then to claim?

Answer: Both of you needn’t wait, but one of you should — the one who has the larger benefit.

As a married couple, you can get two checks — either two retirement benefits, or a retirement benefit and a spousal benefit that can equal up to half the primary retirement benefit. When one of you dies, the survivor will receive only one benefit, which will be the larger of the two checks you received as a couple.

It makes sense to maximize that benefit by waiting as long as possible to claim so that it can grow. After your full retirement age, which is currently 66, unclaimed retirement benefits grow by 8% each year you wait, until maxing out at age 70.

You have substantial investments that should sustain a comfortable retirement, but plenty of things could go wrong.

The fact you’re spending all your current income is worrisome. If you don’t ratchet back your consumption a bit at retirement, you may draw down your investments at a rate that isn’t sustainable. (Depending on your investment mix, an initial withdrawal rate of 3% or 4% usually is considered “safe,” or the most you should take to minimize the odds of running out of money.)

Even if you do rein in your regular spending, bad markets or unexpected expenses could cause you to exhaust your savings faster than you expect. The longer you live, the greater the odds you’ll run short of money. Maximizing one of your Social Security benefits can be a smart way to ensure you, or your survivor, have more income when you may need it most.

Before you retire, you should consult a fee-only financial planner about the best ways to tap your retirement accounts and claim Social Security.

Q&A: Volunteering can fill a void for unhappy retirees

Dear Liz: I was very disappointed in your response to the reader who was unable to cope with unplanned retirement. The reader has sufficient assets but was unable to manage the loss of purpose. This is common, and maintaining purpose is one of the most important components of a healthy retirement.

You did not mention volunteer work as an option, and that is a shame. There are hundreds of organizations that need volunteers of all skill levels, and they come in every shape and size you can imagine.

There are social services, cultural, civic, social justice, child development, healthcare and senior organizations that exist only because of their volunteers. You can volunteer long term or short term, or even on occasion.

I have just spent the last five months running a series of events connecting retirees to organizations who need volunteers. My own retirement will be completely focused on doing all of the volunteer work I did not have time for while working.

Retirement is an excellent time to make your contribution to the community that helped you along the way.

Answer: Several people wrote in to suggest volunteering was the answer to the reader’s unhappiness with an involuntary retirement. Volunteering may indeed fill her time, but her point was that she found fulfillment in paid work. She rightly warned others that they need to think through what they might lose by retiring too early.

People may get more than paychecks for their labor. They can get recognition, respect, a feeling of achievement and a sense of mission. What they do may be a significant part of who they are — perhaps far more than they realize.

If they give that up without sufficient thought and planning, they may feel as if they’ve gone from a “somebody” to a “nobody” overnight. That can be a terribly hard adjustment that volunteering may not alleviate. Here’s another perspective:

Dear Liz: Your recent writing about considering when to retire and the dangers of a too-early retirement rings a big bell.

I am a psychotherapist who has worked with a number of people who were either considering retirement or who took early retirement. For those who took early retirement, the emotional problems associated with the large amount of both time and space in their lives after retirement, which they never fully considered, have been very surprising and upsetting for them.

To those working every day at jobs they don’t love, retirement seems like a great thing. But the reality of an open, unstructured life can present an array of problems — financial, relational and emotional — for the newly retired.

People should think about this decision carefully because it is hard to re-create a steady job. Or, even better, have a long hard conversation about it with someone close to you or a specialist like me.

Answer: Excellent advice. In addition to traditional therapists, there is a growing field of professionals who combine financial advice with psychological counseling. People can get referrals from the Financial Therapy Assn. at www.financialtherapyassociation.org.

Q&A: How to figure out the right time for retirement

Dear Liz: I hear so much talk about waiting to collect Social Security. What are good reasons to start collecting Social Security at age 62? I recently retired from the military with a monthly retirement of $4,400. I plan to work a civilian job until I’m 62 (eight more years).

I’m in fairly good health now, but decades of military service and multiple deployments overseas put a lot of miles on my chassis. I truly hope I do, but I don’t know if I will live until I’m 80 or 90 years old.

Answer: None of us knows how much more time we have on this Earth. The primary reason for delaying Social Security is to decrease the odds of running short of money if we (or our spouses) happen to live a long time.

Think of it as a kind of longevity insurance because the longer you live, the more likely you are to use up your savings and to rely on your Social Security check for most, if not all, of your income. The wealthier you are — in savings and in pensions — the less important it may be to delay Social Security.

Your military pension provides a substantial monthly check and (presumably) survivor benefits for your spouse. These benefits will rise with inflation. You also have retiree health insurance at reasonable rates. You’re better off than most people approaching early retirement.

Still, your pension may not cover all your expenses and it’s not clear how much you have in other savings. Also, consider that your survivor would get about half (or less) of your pension check if you die first. So you may still want to hedge your bets by waiting at least until your full retirement age of 67 to start Social Security.

In addition to increasing your benefit, delaying to that age means you won’t be subject to the earnings test that can reduce your check by $1 for every $2 you earn over a certain limit (currently $17,040). You may think now that you’ll be ready to stop working at 62, but many early retirees find they miss the stimulation and social contact work provides.

Q&A: When considering retirement, money isn’t the only factor

Dear Liz: You answer many questions about whether people are ready to retire. But there’s one other thing to consider besides money, and this is more important.

Folks need to seriously ask themselves whether they can handle being retired. I know I can’t stand it.

I have more than enough assets, plus a pension, plus healthcare, plus no debts or bills. I’m young and healthy. But I find happiness in work.

Unfortunately, I had to leave my job owing to conditions outside of my control. I now live in a beautiful house at the beach, with all my money and all the things I like to do — and I’m miserable. I’m looking for a part-time job. I live in a small community and there aren’t many jobs, but I’m hopeful to find one.

Tell your readers that it’s not only the advice of a financial planner, but also some good soul-searching that they’ll need, especially if someone is a manager or a highly educated professional. You can’t just give that up and go from full time to no time. At least work part time before retiring to make sure it’s what you want.

Answer: That’s excellent advice. Not everyone derives meaning and purpose from work, but many do, and an abrupt adjustment can be painful. Good luck in your search for a job that gives you a reason to get up in the morning.

Q&A: Don’t jump into early retirement without considering these things

Dear Liz: I am almost 59½. Can I retire at 60½?

I have $570,000 in a 401(k) and $180,000 in an IRA. I owe $253,000 on a condo that would sell for $600,000. I plan to buy a home next year for $400,000 and pay off the mortgage with the proceeds of the condo. Then I would be left with no bills. I will start collecting Social Security at 62 for approximately $1,850 a month.

I had a wonderful job for 23 years but something changed at work and now just going to work is hard on me. Let me know if you think this is doable.

Answer: That depends. How much do you need and want to spend?

Financial planners typically consider a 3% to 5% withdrawal rate as “sustainable.” The rate depends on how long you’re expected to live and your asset allocation, among other factors, but you should err on the conservative side if you expect to retire early.

A 3% initial withdrawal rate would give you $1,875 a month. A higher withdrawal rate could dramatically increase your chances of running short of money later in retirement.

While you might not have a mortgage, you would certainly have other bills, including the cost of healthcare insurance. If your employer is subsidizing your coverage, as many do, you could end up paying a lot more.

And if Congress dismantles or alters the Affordable Care Act, your health insurance could get even more expensive or perhaps hard to find. Your healthcare costs may go down once you qualify for Medicare at age 65, but they certainly won’t go away.

Also consider that taking Social Security retirement early means a smaller check for the rest of your life. If you do run short of money, that check may be your only source of income, and you may curse yourself for locking in the smaller amount.

You certainly shouldn’t bail on your job before you’ve had a fee-only financial planner look at your situation and see if your plans are realistic.

Q&A: Saving for retirement can’t wait

Dear Liz: I have a family member who at 57 has no savings, a house whose value is 58% mortgaged and debt from a family member of $180,000.

This person is just starting a new job that will cover expenses with about $1,000 left over each month. The job offers a 401(k) but doesn’t allow contributions until employees have been with the company for eight months.

This person has paid into Social Security so that will be there (hopefully!) at retirement. What would be the best way for this person to start saving toward retirement?

Answer: Your relative shouldn’t wait to be eligible for the 401(k). People 50 and older can contribute up to $6,500 annually to a traditional IRA or a Roth IRA, which is $1,000 more than the usual limit.

If your relative didn’t have a previous job that offered a workplace plan in 2017, then this year’s contributions to a traditional IRA should be deductible.

Next year, when your relative is eligible for the 401(k), the deductibility of contributions will depend on that person’s income. In 2018, deductibility begins to phase out when modified adjusted gross income reaches $63,000 for singles. If IRA contributions aren’t deductible, after-tax Roth contributions typically are a better deal, but the ability to contribute to a Roth begins to phase out for singles at $120,000 in 2018.

Encourage your relative to save and to delay starting Social Security for as long as possible. When Social Security makes up the majority of one’s income in retirement — as it will for your relative — it’s important to maximize that check.

It’s not clear why your relative has been saddled with a family member’s debt, but any retirement plan needs to include options for paying off, settling or even erasing (through bankruptcy) such a substantial amount. Your relative should talk to a credit counselor and a bankruptcy attorney to better understand the options.

Q&A: Saving for retirement also means planning for the tax hit

Dear Liz: I’m 40. We own our house and have a young daughter. Through my current employer, I’m able to contribute to a regular 401(k) and also a Roth 401(k) retirement account. My company matches 3% if we contribute a total of 6% or more of our salaries. Are there any reasons I should contribute to both my 401(k) and Roth, or should I contribute only to my Roth? My salary and bonus is around $80,000 and I have about $150,000 in my 401(k) and about $30,000 in my Roth. Thanks very much for your time.

Answer: A Roth contribution is essentially a bet that your tax rate in retirement will be the same or higher than it is currently. You’re giving up a tax break now, because Roth contributions aren’t deductible, to get one later, because Roth withdrawals in retirement are tax free.

Most retirees see their tax rates drop in retirement, so they’re better off contributing to a regular 401(k) and getting the tax deduction sooner rather than later. The exceptions tend to be wealthier people and those who are good savers. The latter can find themselves with so much in their retirement accounts that their required minimum distributions — the withdrawals people must take from most retirement accounts after they’re 70½ — push them into higher tax brackets.

That’s why many financial planners suggest their clients put money in different tax “buckets” so they’re better able to control their tax bills in retirement. Those buckets might include regular retirement savings, Roth accounts and perhaps taxable accounts as well. Roths have the added advantage of not having required minimum distributions, so unneeded money can be passed along to your daughter.

Given that you’re slightly behind on retirement savings — Fidelity Investments recommends you have three times your salary saved by age 40 — you might want to put most of your contributions into the regular 401(k) because the tax break will make it easier to save. You can hedge your bets by putting some money into the Roth 401(k), but not the majority of your contributions.

Q&A: Why tapping retirement cash early shouldn’t be done lightly

Dear Liz: I’m reaching out on behalf of my father, who does not know how to write emails. He was wondering if he pulls his money out of his IRA, how much will he get charged? Also, how much would he be able to give to his granddaughters without being charged?

Answer: Withdrawals from IRAs and most other retirement accounts are taxable. The tax bill will depend on his tax bracket and whether his contributions were pre-tax (deductible) or after-tax (non-deductible). If he withdraws money before age 59 1/2, he also may face tax penalties. A premature withdrawal can easily trigger a tax bill of 25% to 50%. Once the money is withdrawn, it also loses all the future tax-deferred returns it could have earned.

If he gives the money to his granddaughters, it’s unlikely he would face an additional tax bill. He would be required to file a gift tax return if the amount exceeded $14,000 per recipient in a year, but he would only have to pay gift taxes if the total amount he gives away in his lifetime over that limit exceeds $5.49 million.

Clearly, taking money out of a retirement account is a big deal and something that shouldn’t be done lightly. At the very least, your dad should consult a tax pro who can estimate the bill he’s likely to face. He’d be smart to consult a fee-only financial planner as well so he understands the potential effect this withdrawal could have on his future standard of living.