The Retirement Cliff

At Ahara Advisors, we seek to manage your wealth and financial health. We try to optimize your after-tax return on your investments, your retirement assets, and, ultimately, your potential wealth transfer to your heirs or philanthropic endeavors.  These elements are sometimes in conflict with one another. 

For example, it may be most tax efficient, in the near term, to invest in a traditional retirement plan (IRA/401k), as your contributions are deductible from your current income thereby lowering current-year taxes. However, when you retire and are required to receive distributions from these retirement vehicles, you will be subjected to ordinary income tax rates on both the principal and earnings.  Understanding the nuances of these different tax rates, and the path that will likely lead to best outcome for your family, is part of the service we offer to families.

There are 2 distinct concepts here; required distributions and tax rates (ordinary vs. capital gains), which we need to unpack to determine how we should address your retirement preparation.

Required Minimum Distributions (RMD)

When you save for your retirement, you may contribute to a “traditional” vehicle (non-Roth 401k / IRA) that has a tax-advantage benefit.  This benefit is meant to entice you to build a nest egg to use when you reach retirement age.  By contributing to the traditional vehicle, the funds you contribute are not included in your income when calculating your income tax, thereby reducing your AGI[1], therefore reducing your tax liability and maximizing your current available cash. This can be especially compelling if you reside in a state with high income taxes (e.g., CA, HI, NY) and hope to retire in a state with no income taxes[2].  Not unlike Social Security and Medicare, which are government programs, to which you’ve probably contributed your whole working life, a retirement savings plan is important in order to provide sufficient financial resources during your older years when you may not be working/employed.

The government has set specific requirements for you to start withdrawing these traditional funds at age 72, given their deferred income tax status, so that you may satisfy the liability in due course.  These are referred to as RMDs (required minimum distributions), which carry a 25% penalty if ignored.  This has been referred to as a retirement cliff, although other situations have also shared this term, because as you approach the specific age you’ll need to withdraw a percentage of the total traditional value and you will be taxed at the ordinary income tax rates on those funds.  Note that if you are not careful, you may end up paying a higher rate than you would otherwise have paid when contributing to the plan, through taxes and/or penalties. 

Below you may find an illustration, which assumes that you will have accumulated a traditional retirement account value of $5mm by age 72.  The RMD % line reflects the required distribution of 3.6% at age 72 and increases in percentage terms as you age, based on the IRS’ life expectancy tables.  This distribution plus a social security payment will initially place the retiree in the 23% tax rate, which will increase (assuming a 7% annual return on investment for the balance of the account) to a potential 31% tax rate 20 years later, noting that these are only federal income taxes.  Those who live in CA or NY will have significantly more tax liabilities. 

Source: Ahara Advisors

Why is this a concern?  Simply stated, it may have been more prudent to contribute to a Roth plan when your effective income tax rate was significantly lower. Alternatively, if you either continue to realize high earnings during your career or if you accrue a very large traditional retirement account, your tax rate on these distributions may be higher than when you funded the accounts.  For example, if you have been fortunate and are earning $500K+ annually at the time you are 72, and you’ve accumulated $5MM in traditional retirement account savings, you will be forced to withdraw ~$200K that year from your retirement accounts, which when combined with your earnings, will place you in a very high tax bracket and you will therefore have to forfeit a significant portion to income taxes.  This cycle will continue as you age, and the RMD will grow in percentage terms based on the IRS’ life expectancy tables.  If you had pivoted away from traditional retirement accounts into a Roth vehicle, at some earlier point in your career, when your tax rate was lower, given that most growth in value occurs later in life when your principal has grown, you may have shielded yourself from some of these tax costs. 

At Ahara Advisors, we guide our clients through these tradeoffs, and provide guidance on when pivoting away from traditional to Roth vehicles may be beneficial, as we take a global perspective on your investments and lifestyle as well as your desire to be impactful in society.

[1] Adjusted Gross Income - the total income you report that's subject to income tax.

[2] AK, FL, NV, SD, TN, TX, WA and WY currently have no state income tax.