Three Tax-Diversification Strategies for Maximizing Wealth in Retirement

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1 Three Tax-Diversification Strategies for Maximizing Wealth in Retirement Christine Fahlund, CFP, senior financial planner Tina Wilcox, QKA, relationship manager Copyright 2010 T. Rowe Price. All rights reserved.

2 What We Will Cover Tax law changes in 2010 and new opportunities Concepts of Tax Diversification and Maximizing Investment Wealth Three strategies for your employees today to potentially generate more wealth in retirement Ways to help participants achieve their financial goals through education and plan design 1

3 Maximizing Wealth in Retirement Cumulative After-Tax Withdrawals (spending) After-Tax + Balance = (cushion) Total Investment Wealth in Retirement 2

4 What Tax Law Changes Regarding Roth IRAs Occurred in 2010? In 2010 and thereafter, all investors, regardless of income, can convert or roll over assets to Roth IRAs (limits for making contributions still apply). Until 2010, there were income limitations for both contributions and conversions/rollovers to Roth IRAs. In 2010 only, if the participant chooses to roll over a distribution to a Roth IRA they are permitted to either: include taxable income on their 2010 tax return due to a conversion or rollover in 2010 to a Roth IRA OR declare half of the taxable income on their 2011 tax return and half on their 2012 tax return. 3

5 New Opportunities Account Type Employer-Sponsored Plan (Eligible Withdrawals) Roll over to a Traditional IRA or to a Roth IRA If eligible, based on income limitations Roll over to a Traditional IRA or to a Roth IRA All eligible, regardless of income Traditional (or Rollover) IRA Convert assets to a Roth IRA If eligible, based on income limitations Convert assets to a Roth IRA All eligible, regardless of income Roth IRA Contribute to a Roth IRA If eligible, based on income limitations If ineligible to contribute to a Roth IRA, now able to use a 2-step process: 1. Make contribution to a Traditional IRA 2. Convert those assets to a Roth IRA All eligible, regardless of income 4

6 Most Plan Participants Today Are in a Double Straitjacket Assets are mostly in tax-deferred retirement accounts Current employer retirement plan Prior employer retirement plan Traditional IRA (Rollover) Distribution amounts: are required at the later of retirement or age 70½ are taxed at retiree s ordinary income tax rate at that time Tax diversification strategies prepare participants for a tax-wise drawdown of assets in retirement 5

7 Tax Diversification Tax diversification: Include assets in tax-deferred, tax-free, and taxable accounts for better protection against changes in future income tax laws and marginal brackets The concept is not new: Don t put all your eggs in one basket Tax diversification concept was introduced when Roth IRAs were added in

8 Account Types Tax-deferred Tax-free Taxable Employer Sponsored Retirement Plans - 401(k) and 403(b) plans Roth contribution accounts in 401(k) and 403(b) plans (if offered) Money market (Emergency funds) Traditional IRAs Roth IRAs Brokerage (including company stock) Rollover IRAs Rollover Roth IRAs Mutual fund accounts Savings 7

9 Potential Benefits of Tax Diversification Tax-deferred Tax-free Taxable Tax-deferred growth X X Tax-deductible contributions X Tax-free distributions X 1 Excluded from RMDs X 2 X No early withdrawal penalties X On-going tax-free distributions for heirs X 8 1 Earnings are only tax free if certain conditions are met - 5 years AND age 59½, death or disability. 2 Exception: Roth 401(k) assets are subject to RMDs, so must roll the Roth assets in the 401(k) to a Roth IRA to avoid having to take RMDs.

10 Typical Role in Retirement of Each Account Type Tax-deferred Tax-free Taxable Regular Withdrawals Defer withdrawals Emergency fund Support daily lifestyle Hold assets in reserve ( cushion ) Hold company stock Legacy assets for children & grandchildren 9

11 Before-Tax Accounts vs. Roth Accounts Maximum Roth Contributions to a 401(k) Starting at Age 45 $675,000 More After-Tax Wealth by Age 95 $2,500,000 $2,000,000 Net Assets After-Tax Taxes $1,500,000 $1,000,000 $500, $0 Traditional 401(k) Contributions with Initial Tax Deduc tion Roth 401(k) Contributions and Taxes Traditional 401(k) Withdrawals Roth Rollover IRA Withdrawals Traditional 401(k) Legacy Assets Roth Rollover IRA Legacy Assets Contributions, Withdrawals, and Ending Balances Assumptions: Plan participant contributes $16,500 to plan account each year from age 45 through age 49. At age 50 through age 65 contributes $22,000 each year. If participant contributing to a Traditional 401(k) receives a tax deduction (total $121,660) which participant spends; if contributing to a Roth 401(k) has had to pay taxes each year (total $168,972) prior to contributing. Assumed to be in a 28% federal income tax bracket. Investment return assumed to be 8% in accumulation, 6% in distribution (starting at age 66). Withdrawal strategy for assets in the Roth 401(k) is to roll the assets into a Rollover Roth IRA (to avoid having to take required minimum distributions) is to withdraw 4% of the amount accumulated by the end of age 65 and increase that amount 3% annually for inflation. Withdrawal strategy for assets in the Traditional 401(k) is to initially withdraw 4% with 3% annual increases as described for the Rollover Roth IRA; then, beginning at age 70½ the participant withdraws the larger of the planned amount or the minimum distribution amount required by the IRS. Total withdrawals and ending balances through age 95 are compared after-tax (in blue) and the $675,000 advantage takes into account the tax deduction for participant's contributions to Traditional and the taxes paid by the participant contributing to the Roth. This chart is for illustrative purposes only and not meant to represent the performance of any specific investment.

12 Before-Tax Accounts vs. Roth Accounts Making Maximum Roth Contributions to 401(k) Starting at Age 45 29% More After-Tax Assets by Age 95 Cumulative After-tax Withdrawals or After-Tax Ending Balance $2,000,000 $1,800,000 $1,600,000 $1,400,000 $1,200,000 $1,000,000 $800,000 $600,000 $400,000 $200,000 $0 Roth Rollover IRA Cumulative Withdrawals Roth Rollover IRA Balance Traditional 401(k) or Rollover IRA Cumulative After-Tax Withdrawals Traditional 401(k) or Rollover IRA After- Tax Balance Age of Plan Participant 11 Assumptions: Plan participant begins taking distributions at age 66 and is assumed to be in a 28% federal income tax bracket. Investment return assumed to be 8% in accumulation, 6% in distribution. Withdrawal strategy for assets in the Roth 401(k) is to roll the assets into a Rollover Roth IRA at age 66 (to avoid having to take required minimum distributions at age 70 1/2). Then begin by withdrawing 4% of the amount accumulated by the end of age 65 and increase that amount 3% annually for inflation. Withdrawal strategy for assets in the Traditional 401(k) or Rollover IRA is to initially withdraw 4% with 3% annual increases as described for the Rollover Roth IRA; then, beginning at age 70 1/2 the participant withdraws the larger of the planned amount or the minimum distribution amount required by the IRS. Cumulative after-tax withdrawals and after-tax ending balances through age 95 are compared. The combined increase in after-tax assets by contributing to the Roth 401(k) and rolling over in retirement to a Rollover Roth IRA is 29% after adjusting for tax deduction on contributions to Traditional and taxes paid before contributing to Roth. This chart is for illustrative purposes only and not meant to represent the performance of any specific investment.

13 Strategy One Tax Diversification Through Contributions

14 Higher Contribution Limits Result in More Rapid Tax-Diversification Tax-deferred Tax-free Taxable $16,500 $22,000 (if over 50)* 401(k) or 403(b) $16,500 $22,000 (if over 50)* Roth 401(k) or Roth 403(b) Unlimited contributions Taxable Accounts $5,000 $6,000 (if over 50)* Traditional IRA $5,000 $6,000 (if over 50)* Roth IRA (if eligible) 13 *If the participant wishes to contribute to more than one type of account in the same year, the combined contribution amounts must not exceed the contribution limits for each individual type of account.

15 Contribute Regularly to Selected Account Types ACTUAL THEORETICAL CHOICES POTENTIAL OF ACCOUNT CHOICES TYPE OF COULD ACCOUNT BE FEWER TYPE Tax-deferred Tax-free Taxable 401(k) or 403(b) Roth 401(k) or Roth 403(b) Taxable Accounts Most employees eligible All investors eligible Traditional IRA May be ineligible based on current IRS regulations Traditional IRA Nondeductible contributions Roth IRA (if eligible) May be ineligible based on current IRS regulations If ineligible, execution would require a two-step process All investors eligible 14

16 Strategy#1 Summary - Contributions Take Action: Consider allocating at least some of your contributions to the Roth 401(k) subaccount (if offered by your plan) Consider contributing to a Roth IRA each year (if eligible) If ineligible, contribute to a Traditional IRA and convert that to a Roth IRA Reasons: More flexibility and control over your money than if all of it is in tax-deferred accounts. Your portfolio may provide a cushion for the latter half of your retirement (e.g., for medical expenses or long-term care). You will not pay ordinary income taxes on the withdrawals 15

17 Strategy Two Tax Diversification by Rolling Over Assets in Prior Plans

18 Prior Employer Plan Rollover Opportunities If you have many years until retirement: Consider rolling over most or all of your tax-deferred assets in the next few years. Time is on your side. If you are close to or just started retirement: Consider rolling over a portion of your tax-deferred assets. One-Step Strategy Roll over entire account with prior employer to a Roth IRA. One and done. One tax bill. Multi-Step Strategy Roll over a portion of prior employer account to a Roth IRA. Repeat periodically, if desired. Pay taxes due on each partial rollover each year in which a rollover is made. 17

19 Strategy #2 Summary Rollovers to Roth IRAs Take Action: Consider rolling over assets from an employer account to a Roth IRA 1 Consider converting some of the assets in your Rollover IRA to a Roth IRA 1 Reasons: This approach is likely to be faster in achieving tax-diversification (i.e., rather than making small annual contributions to a Roth IRA) More flexibility and control over your money A financial cushion for the latter half of your retirement Income tax-free withdrawals from the Roth IRA, if the distribution is qualified (withdrawals from plans or Traditional IRAs will be taxable) No RMDs at the later of retirement or age 70 ½ 18 1 Taxes due at time of rollover or conversion.

20 Strategy Three Regularly Set Aside Assets in a Taxable Account

21 Strategy #3 Summary Taxable Accounts Take Action: Start building an emergency fund in a taxable account (Set aside some of your earnings each month until account equals approximately 6 months of current income.) Reasons: No early withdrawal penalties No ordinary income taxes on the withdrawal amount, as you would if you were withdrawing from a tax-deferred account. 20

22 Next Steps For Plan Sponsors

23 Education Can Drive Results If your plan offers Roth 401(k) contributions, promote it: Statement messaging Electronic communications, including s, and interactive calculators Educational articles Employee meetings Work with your T. Rowe Price representative to develop a communications strategy that educates participants about the advantages of tax diversification 22

24 23 Plan Design Opportunities

25 Summary Three tax-diversification strategies: 1. Contribute to Roth 401(k)s and Roth IRAs directly or two-step process 2. Convert and roll over employer plan assets to Roth IRAs 3. Set aside assets in taxable accounts for emergencies, liquidity, and sometimes more favorable tax rates. 24

26 94554 Through education and plan design you can help participants maximize their after-tax wealth in retirement

27 T. Rowe Price Retirement Plan Services, Inc., its affiliates, and its associates do not provide legal or tax advice. Any tax-related discussion contained in this presentation, including any handouts, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this presentation.