Getting [Seriously] Creative About Creating Retirement Income

This week’s topic comes to us compliments of a reader--let’s call him Carl--who contacted me with what he thought was a brilliant idea. So brilliant, that he was amazed that he’d never read or heard about it before.

Like many baby boomers who are a few years from retirement, Carl has started to explore how he and his wife are going to create the income they’ll need out of the various accounts among which their assets are spread. He’s also convinced that, given the ballooning federal deficit and the deteriorating fiscal condition of Social Security and Medicare, income tax rates are headed higher.

At 56, Carl is about to make what hopes will be the last job change of his career. His 401(k) has a combination of pre-tax and after-tax money in it. Carl’s ground-breaking idea? To roll the pre-tax money in his 401(k) account into Traditional IRA No.1 and the after-tax money into Traditional IRA No. 2. Carl figures that this way he’ll be able to keep the earnings on each IRA separate as well.

Carl’s question for me: Could he instead roll the after-tax money in his 401(k) account into a Roth IRA?

Wow! As a baby boomer myself, I applaud the creativity and energy Carl put into this. Unfortunately, neither approach will accomplish what he hopes: to forever shield all future appreciation on his after-tax money from income tax. Here’s why:

Let’s assume that Carl has a total of $100,000 in his 401(k) account. $80,000 has not been subject to income tax (i.e. it’s pre-tax money) and $20,000 represents additional after-tax contributions he made. Is it possible for him to direct the $80,000 to Traditional IRA No.1 and the $20,000 to Traditional IRA No.2? Absolutely. But his withdrawals will be taxed the same way as if the entire $100,000 were rolled over into a single IRA.

But don’t just take my word for it.

Boston attorney Natalie Choate is one of the foremost authorities on retirement plan distributions in the country. She not only has a thriving practice, she has somehow managed to recently publish the 7th edition of her book, Life and Death Planning for Retirement Benefits, which most financial advisors regard as the “bible” on this complex topic. Choate points out that if and when Carl takes a withdrawal from any of his traditional IRAs, this “will be treated as a pro rata distribution of pre- and after-tax money.”

In other words, Carl cannot simply look at one traditional IRA in isolation, the tax code requires him to aggregate, or add up, all of his traditional IRAs. In order to determine how much of his withdrawal is taxable, he’ll need to multiply the amount by the percentage of AFTER-TAX money in ALL of his traditional IRAs.

To keep things simple, let’s assume the only traditional IRAs Carl will have when he changes jobs will be from his 401(k) rollover:

Traditional IRA No.1: $80,000 (all pre-tax money)

Traditional IRA No. 2: $20,000 (all after-tax money)

If Carl were to immediately take withdraw $10,000 from IRA No.2, the taxable portion would be calculated as follows:

Withdrawal Amount X (Total After-tax Money in All Traditional IRAs/Total Traditional IRAs)= Non-Taxable Portion of Withdrawal

$10,000 X ($20,000/$100,000) = $2,000

Withdrawal Amount – Non-Taxable Portion = Taxable Portion of Withdrawal

$10,000 – 2,000 = $8,000

Notice that Carl would get the same result if he withdrew the $10,000 from Traditional IRA No.1 or if he had simply rolled his entire 401(k) balance into a single traditional IRA.

So, is it possible for Carl to rollover his pre-and after-tax 401(k) assets into different traditional IRAs? Sure. Is he accomplishing what he hopes by doing so? Nope. In fact, he’s just making more work for himself by creating another account he’s got to remember to take required minimum distributions [RMDs] from when he turns 70½ .

Can Carl roll the after-tax money in his 401(k) account directly into a Roth IRA? No. This would only be possible if it were in a Roth 401(k) account.

What Carl should consider is converting all or part of his rollover to a Roth IRA. As regular readers of this column know, I’m a huge fan of Roths. In Carl’s case, a Roth IRA would provide a number of benefits:

-All of the future appreciation on the assets in the Roth are forever removed from income tax

-Roth withdrawals have no impact on the taxation of Social Security benefits

-They will not make you more likely to be subject to the upcoming 3.8% Medicare “surtax”

-There are never any RMDs from a Roth IRA; the assets can grow tax-free as long as you like

-A Roth is a fabulous gift to leave a beneficiary. Although it is subject to estate tax, the beneficiary pays no income tax when she or he takes RMDs. If these are “stretched” out over the beneficiary’s life expectancy instead of withdrawn as a lump sum, they can multiply the value of your bequest many-fold.

Ms. Buckner is a Retirement and Financial Planning Specialist at Franklin Templeton Investments. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

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