Wednesday, January 13, 2010

IRAs and 401(k)s Aren't Retirement Plans. But a Roth Conversion May Help Your Estate Plan.

It's easy to think of IRAs and 401(k)s as retirement plans. They're not. IRAs and 401(k)s are retirement accounts. They serve as tax shelters to delay taxation of the money contributed to them. However, the amounts that you are allowed to shelter have no particular relationship to how much money you need for retirement. The IRS limits on contributions to IRAs ($5,000 in 2009 or $6,000 if you're 50 or older) and 401(k)s ($16,500 in 2009 or $22,000 if you're 50 or older) are simply the amount you can shelter from taxation. In both the saving phase and the withdrawal phase of your retirement planning, don't confuse tax issues with financial planning. Here's why.

Saving. How much you need to save for retirement may be more or less than the amounts the tax code lets you shelter. You should base your saving rate on a prudent estimate of your life expectancy. That is more easily said than done. Life expectancy is influenced by family history, your personal habits and diet, your occupation, the availability and quality of health care, and a host of other factors. If you dabble with life expectancy calculators on the Internet, you're likely to get a range of estimates as wide as 15 or so years. That's a big difference from a financial planning standpoint. Make the best estimate (meaning most accurate) you can of your life expectancy. Then add 10 years to account for medical advances. The resulting lifespan is probably a pretty safe assumption for financial planning purposes. Save in aftertax accounts if the amount that you can shelter in 401(k)s and IRAs isn't enough.

If all this number crunching is painful, then follow a simple formula: if you save 15% to 20% of your pretax earnings over the course of a 30 to 40 year career and invest it in a diversified portfolio, the amount you save plus Social Security will probably let you have a retirement lifestyle pretty close to what you enjoyed while working. For more details, see

Withdrawals. Once you reach the age of at least 59 and 1/2, you can start making withdrawals from your retirement accounts. At the age of 70 and 1/2, you are required to begin making withdrawals, whether or not you want to. The IRS has no objections if you withdraw your savings faster than required; they get more taxes upfront that way. But at 70 and 1/2, the process of minimum withdrawals begins. The exact amount of your minimum withdrawal will depend on IRS formulas designed to increase sales for antacid manufacturers. But the important point here is that the amount you're required to withdraw may or may not be safe for you to spend. If you have a longer than average life expectancy, save some of the aftertax portion of the withdrawal. Remember that the IRS withdrawal formulas are tax rules, not financial plans.

Avoid withdrawals with a Roth Conversion. One step that may simplify your retirement planning would be conversion of your IRA(s) to a Roth IRA. Traditional IRA accounts may be converted to Roth IRAs in 2010 without any income limitations (which were a problem in the past for many people). Conversion requires paying current income taxes on the amount converted, and you have to consider whether you're prepared to do that. There are lots of arguments why conversion will or won't save you taxes. How this analysis turns out could depend on tax legislation that remains to be adopted in 2010 and you may want to delay the decision whether or not to convert until later this year. But if you don't think you'll need your IRA assets, conversion to a Roth will let you avoid mandatory withdrawals altogether. That way, you can pass the entire account onto your heirs. Paying taxes now, but then letting the account grow on an aftertax basis could provide your heirs with quite a tidy sum. They'll have to make minimum withdrawals, but the withdrawals are tax-free and the remaining balance continues to grow tax free. Thus, converting a traditional IRA to a Roth can be an effective estate planning tool.


OSR said...

I have a feeling that 401(k)s will be regarded by future generations as one of the greatest scams in history. A pyramid scheme with a legally mandated delay in redemptions. Now that's how you play Ponzi.

Leo Wang said...

Most 401(k) accounts are invested in the stock and/or bond markets. In a technical legal sense, they'd be fraudulent pyramid or Ponzi schemes only if their assets were stolen. Millions of investors have taken painful losses because of financial scandals or excessive risk taken by Wall Street firms in order to boost executive bonuses. Not literally a Ponzi scheme, but are we surprised that bankers' bonuses have become politicized?