Saving Too Much in a Retirement Account is no Laffer Matter?

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In the past few weeks, some politicians have created quite a buzz with proposals designed to increase taxes on the rich and redistribute those dollars to the less affluent masses. One of the ideas that has received quite a bit of publicity is raising the top marginal income tax rate from its current 37% to as much as 70% on high income recipients.

Almost certainly, this and other tax proposals will receive increasing attention as the campaigns for the 2020 Presidential Election shift into gear. As talk of raising income tax rates increases, you may also hear about economist Arthur Laffer, or more specifically, his Laffer curve illustration (Exhibit 1). Laffer is a “Supply Side” economist that suggests that there is an optimal point of taxation, that once exceeded, results in less taxes being collected due to the disincentive of working more to earn less.

Exhibit 1.  The Laffer Curve shows the hypothetical relationship between tax rates and tax revenue.

Exhibit 1. The Laffer Curve shows the hypothetical relationship between tax rates and tax revenue.

I’m no economist, but a financial planning issue I recently helped a client navigate may demonstrate that investing in your retirement account is not a Laffer matter.

Ticking Tax Bomb?

The issue in question is for a retirement saver that has a high-end problem, too much money in their retirement accounts. How can that be, you may ask?

While most folks planning for retirement worry if they have saved enough, occasionally some may have saved so much that their retirement account becomes a ticking tax bomb. This is due to the requirement to take withdrawals, known as a Required Minimum Distribution (RMD), from your retirement accounts once you reach age 70.5. It is Uncle Sam’s way of finally getting you to pay taxes on some of that income that you have deferred.

For most people, starting in the year that you turn 70.5, you will take an RMD based on the previous year-end balance of your tax deferred retirement accounts divided by your life expectancy. The IRS publishes a Uniform Lifetime expectancy table that provides the divisor for the calculation (Exhibit 2).

Exhibit 2.  IRS Uniform Life Expectancy Table

Exhibit 2. IRS Uniform Life Expectancy Table

My client, who is in her early 50’s, has been very successful. She has significant assets in her taxable as well as her tax-deferred accounts. She recently had asked me to project what amount of income she could start taking from her accounts if she stopped working now. Using my financial planning software from MoneyGuidePro®, I was able to model the impact of withdrawing various amounts from different account types over a wide range of market conditions, complete with illustrations of what her remaining assets may look like in future years.

While reviewing some of the detailed cash flow data, I noticed her taxable income spiked starting in about 17 years. The big increases were due to the RMDs. She has a Traditional IRA, a Solo 401(k), and a Cash Balance Defined Benefit plan that is currently worth about $5,000,000. If you hypothetically grow that amount by a 6% average return (consistent with her allocation) for the 17 years until she is 70.5, she would have about $13,500,000 by 2036. Divide that balance by the life expectancy from the Uniform Table (27.4), and you can see that her first year projected RMD would be just under $500,000!

That would be in addition to her other sources of income such as Social Security and from her taxable investments. Remember that the main benefit of saving in a pre-tax retirement account is that you defer income when you are in a higher tax bracket to a time when you are in a lower tax bracket. In her case, it appears that she likely will not be in a lower tax bracket when it’s time to pay the Uncle. Like I said, this is a high class “problem”, but one that can be planned for.

Pay Uncle Sam Now

The strategy we came up with was to begin withdrawing funds now to “fill up” her lower tax brackets. For example, her taxable income this year projects to be only about $100,000. That leaves about $60,000 in the 24% tax bracket until she hits the 32% threshold of $160,725 for a single filer. (Exhibit 3)

Exhibit 3.  2019 Tax Rates

Exhibit 3. 2019 Tax Rates

Since she doesn’t need the extra income to pay current expenses, she is doing a partial Roth IRA conversion so that the future growth of the $60,000 is tax-free. At that same 6% hypothetical growth rate we used to project her future RMD estimates, the Roth IRA would grow to around $1,700,000 over the next 17 years if she continues converting $60,000 per year. That ultimately would reduce her RMD by a little over $60,000 per year.

We also have started optimizing where she holds certain investments. We are shifting her fixed income investments into the tax deferred accounts while placing more non-income producing growth investments in her taxable accounts. We are placing her more aggressive investments into her tax-free Roth IRA. This should result in her tax-deferred retirement accounts growing slower than her taxable and tax-free accounts, and make her RMDs more manageable.

With respect to Mr. Laffer, if the top tax rates keep rising, it may be increasingly more beneficial for successful retirement savers to withdraw more retirement savings sooner and paying the government now versus later. But Mr. Laffer may still get the last laugh though, as this strategy ultimately results in paying the government less taxes.

Does the thought of future taxes bring tears to your eyes? Get in touch to discuss your plan.