Ask Liz Weston

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Saving Money

Q&A: Retirement can bring some complex tax questions

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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

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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: There’s a big difference in various kinds of bonds

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Dear Liz: My mutual funds and IRA are mostly in stocks with very little in bonds. I’m thinking I should have more in bonds, but just don’t know how much I should transfer from the stock funds and which bond fund to pick. Are they all the same?

Answer: Just as with stock funds, bond funds have different compositions, fees and investment philosophies. There’s a fairly big difference, for example, between a rock-solid U.S. Treasury bond and a “junk” or low-rated bond.

There’s also a difference in fees between funds that are trying to beat the market (active management, which is more expensive) versus merely matching the market (passive management, which is less expensive and typically offers better results).

The ideal asset allocation, or mix of stocks, bonds and cash, also varies depending on your age and risk tolerance. There are a variety of asset allocation calculators on the web you can try, or you can consult a fee-only planner.

Another option is turn the task over to a target date retirement fund, which manages the mix for you, or a robo-advisor, which invests according to computer algorithms.

Whatever you do, keep a sharp eye on the fees you’re charged. The average bond fund had an expense ratio of 0.51% in 2016, according to the Investment Company Institute. There’s little reason to pay much more than that, and ideally you’d try to pay less.

Q&A: How to avoid outliving your retirement savings

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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: Saving for retirement can’t wait

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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: How to build a cushion against all those pesky expenses

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Dear Liz: We’re both retired and live on retirement checks. When expenses exceed our income, we draw from savings, but the balance is going down fast due to a new air conditioning unit, real estate taxes, etc. How do we put that money back and build a cushion in the checking account so our savings isn’t used to cover us month to month?

Answer: You need an emergency fund for truly unpredictable expenses, but you also should have a bunch of savings “buckets” to cover less regular but still predictable expenses. These would include property taxes, insurance, home repairs, car repairs, vacations, medical bills, holiday expenses and any other bill you face regularly but not monthly. You can track these buckets in a spreadsheet or set up separate savings accounts for each goal. Online banks typically let you set up multiple savings subaccounts for free.

Here’s how it works. If your next property tax installment is due in six months and you’ll owe $3,000, you transfer $500 a month into the property tax savings account to cover that bill. If you’re planning on a vacation in nine months, divide the expected cost by nine and transfer that amount to savings each month.

Estimating some costs can be tricky. You often can use last year’s spending as a guide, or seek out authoritative sources. Edmunds.com’s True Cost to Own feature, for example, can help you estimate repair and maintenance costs for many vehicles. With home repairs, Consumer Reports can help you calculate how long various systems tend to last and how much they cost to replace, which will allow you to save accordingly. Or you can just use the rule of thumb to put aside 1% of your home’s value each year into an account to cover maintenance and repairs.

You may not always guess correctly, but setting aside something throughout the year can help you meet these big expenses as they arise without having to dip into your emergency fund.

You may discover that you can’t set aside enough to cover these less regular expenses and still pay your monthly bills. If that’s the case, you may not be able to afford your current lifestyle and may need to trim some costs.