Author Tom Anderson discusses the value of debt in wealth building through the four phases of life. Joe and Big Al go over 6 common myths that can mess up your retirement, and how much you need to save in order to have $1 million when you retire. Also, how will making a large IRA withdrawal affect your taxes, Medicare and Social Security? What are the pro-rata rule and aggregation?
- How much do you need to save to have $1 million at retirement? (0:55)
- Tom Anderson: The Value of Debt In Building Wealth (11:48)
- Tom Anderson: The Value of Debt Through the Phases of Life (22:58)
- Big Al’s List: 6 Common Myths that can mess up your Retirement (31:19)
- Big Al’s List: 6 Common Myths that can mess up your Retirement (continued) (40:56)
- Email Questions:
- I’m 74 years old and retired. I am collecting RMDs and I’m in the 15% tax bracket. If I withdraw a large sum say $100,000 from my IRA will it be taxed at 15%, or will it raise my income and cause me to be taxed at a higher rate the year following? Also, will it affect my Medicare premiums and Social Security payments? (50:03)
- Does the pro rata rule include 401(k) balances? (58:59)
“People take on the wrong type of debt, they take on too much of it, and they take it on at the wrong stage of life. And so what I’m trying to do is, throughout life, is have different levels of debt, the right debt, at the right times.” – Tom Anderson, Author, “The Value of Debt In Building Wealth”
That’s Tom Anderson, author of “The Value of Debt in Building Wealth.” Today on Your Money, Your Wealth, Tom talks about using debt to build wealth, just how much debt you should have through the four phases of life, and how that relates to the Da Vinci Code. Also, Joe and Big Al do the math to figure out how much money you need to save each month in order to have a million dollars when you retire, and they cover six common myths that can mess up your retirement. They’ll also answer your email questions: like how will a large withdrawal from your IRA affect your taxes, medicare and Social Security, and does the pro-rata rule include 401(k) balances? For that matter, what is the pro-rata rule and what the heck is aggregation? Now, here are Joe Anderson CFP and Big Al Clopine, CPA with some answers.
:55 – How much do you need to save to have $1 million at retirement?
JA: Hey Alan, there’s a number of people have in mind when it comes to reaching financial freedom. What number do you think that is?
AC: Well, are you talking about the magic number? I think most people would say a million dollars.
JA: A million bucks. Alright, I would agree with that. So how do you get to a million? I’ve got some numbers for you. So, I think a lot of times it’s like, well how much money do I need to save to have a million? Of course, the longer you have…
AC: If you have had one year, you need to save about a million. (laughs)
JA: (laughs) You need to save about $999,000. But let’s say if you have 30 years, or maybe it’s five years, or somewhere in between. So we’ll start out, and then it depends of course on the average expected rate of return.
AC: Of course. But what are you using?
JA: These are all hypotheticals. Let me just have a caveat here of hypothetical, these results may not happen to you.
AC: Right and this is just a possible rate of return.
JA: This is just a couple of kids having a conversation about, “I wonder what it would take to build a million dollars?” So let’s say you have 30 years. So you’re 35 years old. 65, that’s a…?
AC: Yeah. Start saving 35, retire at 65.
JA: So if you’re 35 or younger, you have 30 years, if you could get a 12% average rate of return.
AC: 12%, that’s a lot.
JA: $283 a month. That’s not too bad. 35? $283 a month. IF you could get a 12% rate of return. The likelihood of getting an expected rate of return of 12% over 30 years? Aaah!
AC: That’s tough.
JA: There could – it’s definitely possible.
AC: It’s possible, and there are certain asset classes that do tend to do well over the long term. But the problem is they’re volatile and you never know what period of time…
JA: So you gotta to be 100% fully invested in the equity markets. Maybe an asset class that has higher expected returns than maybe large companies stocks, like an emerging market.
AC: Yeah, like smaller companies, value companies, emerging markets. You’re probably all into those.
JA: Right, very volatile asset classes.
AC: And you might have five years of down time and just abandon it, it doesn’t work.
JA: Yeah right. So $283 a month. But then, you know what’s going to happen to ya. You’re going to hit that 29th year, but you’re still all in those asset classes, and then it’s going to drop 50%. (laughs) That last year, you just had one more year!
AC: If only I’d saved $285 a month!
JA: It doesn’t matter because now you’re almost a million dollars, now it’s worth $500,000. All right, so what would you say is a better rate of return that we can use for someone with 30 years? 6% would you say?
AC: Yeah I’d say even 7. 6 or 7.
JA: All right, I’ll give you both. 6%, $991. 1000 bucks a month. If you save that for 30 years at 6%, million bucks. Hypothetically. 7% is $815.
AC: $815. OK, so somewhere between 800 and 1000 bucks a month, at age 35, given a 6 or 7% rate return, is what you need to save each and every month, and you have to stay fully invested at all times.
JA: Correct. So that’s 30 years. So anywhere from $283 to 1000. (laughs) OK. Let’s say you have 15 years.
AC: So you might think it’ll be double, but it’s a lot more than double.
JA: It’s $2000 a month. $1,982 for 15 years. If you save $1,982 per month for 15 years, 12%. Now you’re at a million. If you got 6%, you need to save $3,421 a month.
AC: $3,421 – that could be tough.
JA: Fifteen years, so what are you? 50? Key earning years?
AC: True, and the kids, hopefully, they’re out there in college, or maybe out of college, you’ve got more disposable income.
JA: So you’re saving about 40 grand a year.
AC: Yeah, that would be a lot.
JA: Yeah, for the average Joe. So that’s why this million dollars I guess is a key number.
AC: It’s a tough club to get to.
JA: 10 years. So if you got 10 years to go and you want to get a million bucks.
AC: That’ll be ugly.
JA: You’re 55, want to retire at 65, you haven’t got a dime saved and you want that magic million. Do you want to be a millionaire? At 12% you need to save $4,304. 6%, $6,072 per month.
AC: So now we’re getting up there. You’re taking my whole salary, Joe.
JA: That’s a little rich. How about 5 years. Wanna go 5 years? Al, you’ve got about 5 more years, right?This is what you’ve got to do, buddy. Well, you’re a good stock picker, aren’t you? You can get 12%, no problem. Save $12,123 a month. 12% in 5 years, that’s a million.
AC: So, but if the market has a correction in the next five years, that’d be tough.
JA: How about 6%?
AC: Let’s try that.
AC: $14,000. Ok, so I need a raise, Joe.
JA: Alright. Well, you’re talking to the wrong guy. 3%. You know, five-year time frame, you probably need to be a little bit more conservative. So if you get 3% over that five-year time period, you need to save $15,430 a month. That’s after tax.
AC: OK. You’re saying somewhere between 12 and $15,000 a month, I gotta save to get to a million if I start at age 60 and have nothing. Good thing I have more than nothing.
JA: Yeah. You look at the big wallet on Big Al. (laughs) So, you know, looking at that. I got another little fun fact for you. Now that I’ve depressed everyone in the first five minutes of our show, here. Let’s say if you have a 30-year life expectancy, and you want to retire, and you want to spend $100,000 a year. Everything has to come from your overall portfolio, that portfolio will grow at 6% per year. It will be zero at the end of 30 years. You need $2,040,108. That’s what you need to accumulate if you want to spend $100,000.
AC: Now that’s more than a 4% distribution rate.
JA: But there could be fixed income sources. So let’s say you have a pension. Social Security. Maybe some real estate income. Maybe a side gig. And let’s say that that brings in $50,000. So you want to spend $100,000, you’ve got $50,000 coming in, now you need a portfolio that’s going to sustain $50,000. So, that’s a $1,020,000. So yeah, it’s about a 5% burn rate, because it’s going to go down to zero, it’s growing at 6. So this chart here – there’s a little side note here, “potential pension and Social Security benefits are not represented in the illustration at all.”
AC: Got it. And it probably doesn’t include taxes.
JA: Exactly. That’s the big deal.
AC: I know right because taxes aren’t free, it turns out.
JA: But let’s say if you want to spend $30,000, Al, and you’ve got five years left to live. All you need is $141,000. So a couple of things you could do. You could shorten your life expectancy a little bit if you don’t have enough cash flow.
AC: How do you do that? You just don’t eat well? Don’t exercise?
JA: Smoke a lot of cigarettes, drink a lot of booze. Get that Harley out. Don’t wear a helmet. (laughs) And I read something, it was by the Research Institute and they were like, you know, this whole retirement crisis is not real. Like people are just fine living off of their Social Security. I guess the majority of the population probably is.
AC: Well, they have to be, right? (laughs)
JA: They have no choice. So anyway. Just thought I’d get you depressed. Now you need to save $15,000 a month and you need several million dollars to support the lifestyle you’re accustomed to.
AC: I guess the moral of the story is the earlier you start, the better.
JA: Yeah. Well, there’s a lot of things that you can toggle. You can delay your Social Security. What was that stat that you and I were talking about?
AC: Yeah, so it’s something like… Now we know that if you start saving at age 25 versus 35 or 45, but they did a stat. If you start saving at 45 versus 25 – so you start saving 20 years later – it’s about the same impact of planning to retire at age 62 and working until age 70. So in other words, those eight years on the back end…
JA: Is worth 20 years of accumulation on the front end.
AC: And the reason that happens is, a bunch of reasons – you’re generally making more income, higher wage earner at that point. Secondly, you’ve got savings already. So it’s just compounding. And third is, your Social Security becomes a lot higher because you take it at 70, versus 62. It’s what, about a 72% increase versus 62. And then the bad thing is your life expectancy is shorter, so you have fewer years to fund it. So that’s how this can work.
JA: Yeah, I still think that 70 should be the new retirement age.
AC: Yeah, I’ve heard you say that before.
JA: We’re living a heck of a lot longer. People are in great shape.
AC: The problem though is a lot of people, they have to leave their jobs, not by their own choice.
JA: Right. What, 50% are forced into an early retirement. So it’s always good to start planning. Check our website out if you’d like, PureFinancial.com we got to take a break. Show’s called Your Money, Your Wealth.
Nobody knows what’s ahead for investors, but Larry Swedroe’s book “Playing The Winner’s Game: Think, Act, And Invest Like Warren Buffett” offers bedrock investing principles that can help you profit in today’s shaky markets. Right now it’s available for FREE to Your Money Your Wealth listeners, just click “Special Offer” at YourMoneyYourWealth.com to get yours. Learn how to think like Warren Buffett and build a well-designed portfolio based on solid evidence and your highest interests. “Playing The Winner’s Game: Think, Act And Invest Like Warren Buffett” by Larry Swedroe – with a foreword by Joe Anderson, CFP and Big Al Clopine, CPA. Click Special Offer at YourMoneyYourWealth.com to get your free copy.
11:48 – Tom Anderson: The Value of Debt In Building Wealth
JA: Hey, welcome back to the show, the show’s called Your Money, Your Wealth. Joe Anderson here, Certified Financial Planner. I’m with of course Big Al Clopine, he’s a CPA. Thanks for tuning in. We’ve got Tom Anderson back on, Al.
AC: We do. And it seems like we talked to Tom recently, but he wrote a new book.
JA: Yes he did. And there’s no relation. I wish. Andersons are smart people, you know that Big Al.
AC: I was thinking that you were going to say, I did some research, and Tom is a distant cousin. But that’s not true. (laughs)
JA: Yeah I guess not, no. (laughs) Well probably somewhere on the family tree.
AC: Well I suppose we’re all related somehow. (laughs)
JA: Well let’s bring him on. Tom Anderson, welcome to the show.
TA: Joe, Al, thanks so much for having me. Really appreciate it.
JA: Well, you know, the books that you have written, and you speak all over the country on, in some cases when it comes to traditional financial planning, could be a little controversial, if I do say so when it comes to the value of debt in retirement. Or value of debt in growing your business. When I think a lot of the other pundits might say, you want to be debt free. Let’s talk about how you can utilize debt, and what’s different with this new book, versus the other books that you’ve written.
TA: Yeah, so I think you’re right, it is a controversial topic. And so I try to minimize that controversy by basically saying, “look, there are different types of debt. We can’t group it all into the same category.” And what we need to do is, we need to use all of the tools and resources that we have available to us, to have the highest probability of success with the least amount of risk. And that’s what this book series is about. And so, the first book we kind of outlaid the general ideas. The next one was about retirement. And this book is really about building wealth. How much debt we should have. We’re trying to make sure that we’ve got the right ability to enjoy life today, be prepared for emergencies, and be on track for the retirement that we all want to have.
JA: You know, what I love about it is that you look at both sides of the balance sheet. You’ve got the equity side and the debt side. And then, when you think of building wealth, a lot of times you’re like, “well, if I look at a net worth statement, I look at my assets, then I look at my liabilities, and I subtract my liabilities from my assets, and that equals my net worth.” So if I have larger debt or if I continue to hold that debt, how is that actually going to build me wealth?
TA: Well if you just hold the debt, and you don’t grow the assets, then it mathematically can’t grow your wealth. (laughs)
AC: So there’s a qualifier. (laughs)
JA: I suppose. I’m not that bright Tom. (laughs)
TA: Well, but this is important, and this is where it is controversial because my books aren’t about buying things that you can’t afford. They’re not about ways to do kind of stupid things that we shouldn’t be doing. It’s about living responsibly. And part of being responsible is that, if you can choose to have some strategic debt in place, I assume you’re going to save the difference. Most people are vastly under-saved, not only for retirement but for the curveballs that life can send all of us. And I want people to have more liquidity and more flexibility. And if you have that, then some debt can actually be good for you.
JA: So let’s talk about that. What are some of the strategies that people should think about?
TA: Well, first of all, they should group debt into different categories. I have basically three categories of debt. What I call oppressive, working, and enriching debt. Oppressive debt is going to be things like credit card debt. You’ve got a credit card at 19%, then you need to step in and pay that down. That will oppress you. Payday loans will oppress you. Any debt at a rate greater than 10%, get rid of as fast as you possibly can.
JA: Yeah most definitely. But I think when people think of debt, that’s what they’re thinking of. It’s like no, pay that thing off. You’ve got credit card debt, or go to Best Buy and then you get conned into buying that nice TV, and you want 20% off? Yeah. Open up a Best Buy card, and then next thing you know, it’s kind of this tumbling effect if you will.
TA: Yeah. You know we all want that new flat screen TV with more features and so forth, and we can put it on the merchant’s card, and that is not what this is about. Can’t do that. Where conventional wisdom and I are on the exact same page is get rid of all of that type of debt as fast as you possibly can. It’s not about that type of debt. But there are other types of debt where some people have student debt, and maybe that debt is at a rate of 5 or 6%, in some cases lower. You want to be cautious in paying that down, because you need to value the liquidity of having the money in the bank, to be able to weather the storms that life sends us all. And enriching debt is going to be debt that you choose to have, yet could pay off. That one becomes a little more complicated, but we think about mortgages. If you could build up money in the bank instead of paying down on the house, that gives you more liquidity, flexibility, and more money working for you long term, which increases the chances that you’ll be on track for retirement.
JA: Would you suggest then that everyone would have a 30 year fixed mortgage?
TA: Well, mortgages are tricky. There isn’t a one size fits all. And the 30-year mortgage can certainly be attractive if you intend to live in a house for 30 years. A lot of times that’s not the case, that people don’t plan to be there that long. So generally, to start the conversation, if you’re planning on being in a property less than five years, the rent versus buy math will oftentimes be in favor of renting. I think more people should be renting, and there’s an illusion of the benefits of homeownership for short term periods of time. The longer the period of time, the right mortgage depends on how long you’ll be in the property.
JA: And so how would you calculate that? 10 years or 20 years or?
TA: Well, I’ll tell you a quick story. So it’s a favorite one of mine, but I was walking down the streets in Chicago when I ran into a friend, and he was a physician, and he kind of came up in and gave me a chest bump and he said, “Tom, I just got the best 30-year fixed mortgage!” And he’s telling me his rates, and let’s say it was 5%. And he’s so proud that he’d shopped and got the best loan. And I said your wife told me that you guys are going to move to the suburbs in five years. I’m going to actually put it at three years. What they should have done was a five-year interest only mortgage. Because they thought they were locking interest rates for 30 years. But if they could have been on a mortgage at 3.5 or 4% they would have saved 1% times the amount of their mortgage. Now in this instance, it was a large mortgage, but if it was a $500,000 or a million dollar mortgage, you’re saving $5,000 or $10,000 a year. On a $200,000 mortgage, you could save $2000 a year by having the right mortgage in place for the length of time that you intend to be in the property. So many people forget that important component when they’re refinancing their homes.
JA: You know, Al and I’ve done several different types of analysis. In your book, you mathematically prove that having certain debt is going to enrich your overall wealth. And we’ve done the same. And I’m a big believer of having a certain type of debt because we see individuals that want to be debt free at retirement, and that is a phenomenal goal. However, there is a lack of liquidity as you said. So they might be paying double to their mortgage to get all of this capital down, but they have very little money in retirement accounts. Or, not enough cash reserves, or there’s no diversification in how they’re saving, in regards to maybe they should be putting the money into a Roth IRA, or maybe just a brokerage account, to get them a little bit better liquidity when they do start drawing these things down. But how do you educate someone, even if you show them the numbers? Because it’s such an emotional thing to get that mortgage paid off. How do you explain that to someone that is that emotionally tied to being debt free?
TA: Yes. So what’s better than being debt free is being able to be debt free. And so, what I mean by that is, if you save up the money in the bank, and are benefiting from the power of that compound interest throughout time, then you have the ability. You can always choose to pay down on your mortgage at any point in time. That’s the power of these ideas. Save the money, instead of putting it down on the house. You can always choose to pay down, any time you don’t like the strategy. That’s the beauty of it.
AC: I think that is a big key though, is you’ve got to save the difference. And if people can’t save it, maybe they should do the forced savings on the mortgage. But if you can save it, and you have the discipline, the numbers really do work out. You can prove that it’s better to have debt, rather than paying it off too quickly.
TA: The math is clear. And when you think about it, look, we had attitudes with respect to exercise, we’ve had attitudes with respect to our diet, smoking. You know, people used to think smoking was not bad for you. And then we learned, hey, smoking is actually bad for you.
JA: It is?
TA: (laughs) It is!
AC: Yeah. Joe hasn’t got that study yet.
TA: The same thing I think is true about that, is that the math is compelling that a little bit of debt, the right way, will increase the chances that you do not run out of money in retirement. And life is full of risk. I want people to have the least risky risk possible. And so I understand that that is risky. But if you can have some debt, and maybe it’s true that the only way you can save is if a bank forcibly takes money from you and makes you pay down your debt. But you can also set up a plan to dollar cost average, or to monthly save into your savings account. And I think you should try that, and see the power of that strategy over time. If you don’t like it, you can always go back.
AC: Yeah. It’s probably not unlike a company. A company, very often, will borrow money so that they can go out and hire more people, and create more sales. They create more value, and ultimately more profits, and it’s the same kind of principles down on the individual level.
TA: Joe and Al, you’ve heard the saying, “It takes money to make money.” The more money that you have working for you, mathematically, the better the chances are you’re going to be on track. It’s that simple. Why people are so reluctant to let money be in the bank working for them, I don’t understand that.
Your Money, Your Wealth isn’t just a podcast, it’s also a TV show! Check out Your Money, Your Wealth on YouTube to see Joe and Big Al talking about planning for retirement over your entire lifespan, investing biases you may not realize you have, Social Security claiming strategies, and… Pure Financial Feud! Watch clips of the Your Money, Your Wealth TV Show – just search YouTube for Pure Financial Advisors and Your Money, Your Wealth.
22:58 – Tom Anderson: The value of debt through the phases of life
JA: Talking to Tom Anderson about debt and how to utilize that. You know, if you look at government. So we’ll ask the question, “Well what do you think is larger, the stock market or the bond market?” And what do you think most people tell us, Tom?
TA: Well, of course, I think the stock market.
JA: Yeah the stock market is a lot larger than the bond market. And I try to give this analogy – it’s pretty stupid, but it’s like if you think of the bond market, think of the globe. And then if you think of the stock market, think of Santee. It’s like this really small city here outside of San Diego. (laughs) It’s not that drastic, but governments, they borrow money. That’s the Treasury. Trillions, versus companies, or governments, don’t issue stock. They issue bonds. And a bond is debt. So it’s just, being a little bit more aware of both sides of the balance sheet really do enrich your life, which I think you do a phenomenal job of explaining in these books.
TA: Well I appreciate it. And you are exactly right. Governments embrace that as a way to finance their operations. The infrastructure, all of the needs that governments have. Companies embrace debt, Nobel Prizes have been awarded on this topic, to what’s the optimal corporate capital structure. Look at companies like Apple, they have billions of dollars of cash, they have billions of dollars of debt. That’s because they value the liquidity, the flexibility, and the tax benefits of that debt. Yet people are shunning the ideas that governments and companies and Nobel Prizes have been awarded on. I think we can learn from what they’re doing, and we can embrace it, that there’s a better way that creates a higher probability of success.
AC: So Tom why don’t you take us through. So with your new book In Building Wealth, how does that relate to a 40-year-old, let’s say, that’s saving, versus a 60-year old that’s about to retire.
TA: So, I do put a little bit of attention on age, but more than age, what I try to look at is, we’re all at different stages of life. And I look at those stages as your net worth, relative to your income. So if your net worth is less than 50% of your annual income. So let’s say for easy math, you make $100,000 and your net worth is less than $50,000, then you’re in what I call the launch phase of life. And during this phase, you want to try to avoid all forms of debt. You just really want to focus on building up that liquidity and savings. You could be 25, or you could be 40, but if you’re in the launch phase, eliminate all forms of debt, and build up money to break the check to check cycle.
JA: Would that then include a mortgage?
TA: Actually, this is, again, kind of against conventional wisdom, but even a mortgage. During that phase, I don’t want you to take on debt. Even what we can both argue is good debt. I don’t even want you to have a mortgage in that phase. Because so many people jump into homeownership too early, and I had a personally bad experience with it. I moved into a house, and then the furnace went out, and I had a $6,000 bill. And I paid it, and I basically still had heat and just less money in my account, and then I was back to check to check. And then I had to do the roof. (laughs) So homeownership has benefits, but there’s a lot of expenses associated with it. You don’t have liquidity, you can’t handle those curveballs.
JA: What’s the next phase?
TA: The next phase is when you’re coming into that independence phase. This is when your net worth is between 50% and two times your annual income. Super easy math. If you have $100,000 in income if your net worth is between $50,000 and $200,000. Now we’re starting to get into independence. Here, absolutely, homeownership is going to come on the table. Many other things and I started to talk about how we can build up money for those big life changes. Maybe they’re kids, maybe they’re new homes. Trying to you know get married. Many things happen during this phase of life, oftentimes it’s in our 30s, and in many cases, it can be our 40s, and in some cases even our 50s. Here we want to embrace the right amount of debt. We want to have good debt in our life, and we don’t want to pay that debt down. I’m actually comfortable having a higher debt level during those phases, and all additional money I want to build up your liquid investment assets, not to pay down that good debt.
JA: Let’s go to the other phase and then I’ll recap.
TA: Sure. So freedom is when your net worth is between two and five times your annual income, and then equilibrium is when you’re between five and 20 times. If your net worth is more than 20 times your annual income, you can take all my ideas with debt and throw them out the window. So if you make $100,000 and have a net worth of more than 2 million bucks, you don’t need debt. Anyone that tells you that you do, they can’t mathematically prove it. But until you’re in those zones, I want you to reduce your debt ratio by building up your assets, rather than paying down debt. And that’s all that the book is about. Once you break through that 20 times ratio, which we should put you on a path to how you’ll get there, you can whatever you want to do.
JA: So when you’re in different phases, you want a different debt ratio. And I think that’s where people might get a little bit confused when they just hear the words “building wealth with debt” because if you’re at a certain phase, it’s like no, you should not have any debt at all. And I think the people that get in trouble with debt, they have debt in the wrong phase, potentially.
TA: That’s exactly right. People take on the wrong type of debt, they take on too much of it, and they take it on at the wrong stage of life. And so what I’m trying to do is, throughout life, launch, independence, freedom, and equilibrium is have different levels of debt, the right debt, at the right times. And so, actually, the way the ratios were come up with is through what’s called the Fibonacci sequence. Are you familiar with what’s called the Divine Ratio, or the Golden Ratio?
AC: Nope. We’re shaking our heads. Educate us.
JA: I told you, I’m not that smart. (laughs)
TA: Have you seen the movie The Da Vinci Code?
AC: Yes I did see that.
JA: Yeah, Tom Hanks. Love him.
TA: Yeah, Tom Hanks. So what happens is, da Vinci was obsessed with this. Have you ever seen the picture of the man with his kind of arms spread out and his legs? It’s the Vitruvian Man. And what it’s talking about is, it’s the perfect proportions in our bodies. If you think about it, the proportions in a rose are the same as a hurricane or the Milky Way. Mozart and Beethoven have been obsessed with the ratios. And there was a mathematician called Fibonacci, and in the beginning of The Da Vinci Code, there’s a reference to that sequence. It’s called The Divine Ratio or God’s Ratio because there’s a series of ratios of balance. And what I actually do in the book is I apply those ratios of balance to your financial life, saying that we can be a rose or a hurricane or the Milky Way, and we can have different levels of balance throughout our life.
JA: That’s great stuff, Tom. I really appreciate your time. I know you’re super busy. Guys, you gotta get this book, it’s The Value of Debt In Building Wealth. Best seller. Thomas J. Anderson. Tom, thanks a lot again. Any last parting words for our audience?
TA: It’s like red wine, chocolate, the right amount, the right way. Good for you. Too much of that, bad for you. So it’s all about focusing on the phases of life, and balance would be my big themes for people to embrace these ideas going forward.
JA: So as we go into the weekend you’re telling me to drink in moderation.
TA: Exactly right. (laughs)
AC: That’s what I heard. (laughs) He said it right to you!
JA: Oh boy. Tom knows me well, alrighty. (laughs)
It’s been three decades since the last major tax reform, but this could be about to change in a major way. That said, the President and the Republican Party are still divided on a number of key policy questions. Visit the White Papers section of the Learning Center at YourMoneyYourWealth.com to download the white paper “Tax Reform: Trump Vs. House GOP” for a deeper look into the proposals. How might income tax, estate tax, and business tax change? Are your tax strategies at risk? Download the Tax Reform white paper to find out more. Visit the White Papers section of the Learning Center at YourMoneyYourWealth.com
31:19 – Big Al’s List: 6 Common Myths that can mess up your Retirement
AC: I don’t want to mess up my retirement. So what are the things that I have to watch out for? And myth number one, Joe, is that you have a magic number.
JA: We just talked about magic numbers.
AC: I know. It’s an easy assumption. All you need to have a comfortable retirement is save enough money so you can withdraw 4% each year of your nest egg. But that’s so-called 4% rule doesn’t work for everyone because it depends on your lifestyle, your health, your investment portfolio, the sequence of returns in the market. There’s a lot of things that it can depend upon. For example, if you are the type of person, you retire and “I don’t want to take any risk, everything is going into my bank CD or government T-Bills,” then your rate of return is not going to be enough to sustain a 4% distribution rate.
JA: Well, it could, if you’re just going to burn it to zero and hopefully you die the day before.
AC: Yeah, the flip side of that is if you’re in poor health. And so that’s the other factor.
JA: Or your age when you started.
AC: Yeah, what’s your life expectancy. And the tricky thing about that, as you know is, you don’t really know when you’re going to pass away. Generally – unless you go to a fortune teller or something like that – but generally, you don’t know. So you may live to 80, but you may live to 90. So maybe you ought to plan till 90 because you just don’t know.
JA: I think it also depends on what you’re going to spend, how much you’re going to spend. You know I might just binge-watch Netflix.
AC: That’s your retirement? (laughs) $9.99 a month!
JA: Right, and I’m done. Yeah. You ever see The Leftovers?
AC: Leftovers. No. You watch all this stuff I don’t watch.
JA: I get these recommendations. It’s about like… I don’t know, I think it had something to do with the Bible. And I’m going to sound really ignorant. But millions of people disappear.
AC: Oh, you’re talking about The Rapture.
JA: Yes there is. Thank you. I didn’t want to say something – raptor, or….
AC: Yeah, I’ll help you out there. The Book of Revelation.
JA: Thank you. See, right there. That’s why I got Big Al.
AC: I’ll help you out on matters of religion.
JA: Yeah. So it’s a pretty interesting program.
AC: Actually that would be kind of interesting.
JA: There you go. Leftovers, check it out.
AC: So the second one here, Joe, is that Medicare will cover all of your health care in retirement. We know that’s not true. Fidelity tells us that a 65-year-old couple is going to need to spend around $250,000.
JA: Well if Fidelity tells us, of course…
AC: Then you know it’s true. But Joe, I’ve got a second source: Employee Benefit Research Institute. So here’s what they say. The 65-year old that wants a 90% chance of having enough savings to cover health care expenses in retirement? The average male would need $124,000, the average female $140,000. So if you add those two together, it’s about $164,000. So we’re getting some collaboration from different sources. And the way that they come up with that is, just realize this, that Medicare doesn’t cover everything. And in a lot of cases, you’re going to be out of pocket for a bunch of stuff. That’s sometimes why people get supplemental insurance. But that’s expensive too. So you’ve got to factor that in.
JA: But you know what bugs me about that stat, is that I think sometimes people will use that stat to scare you to think that you need an additional $250,000 in the bank.
AC: Yeah, and so you think I’ve got $200,000, it’s going to fund my retirement, so I got nothing.
JA: I got nothing left. Everything’s going to go to health care. And when you get close to retirement, it’s like, you’re dotting your I’s, crossing your T’s, you’re taking a look at every penny that you have, and making sure that this lasts you for the next 20-30 years, and then you get these stats coming out, saying, well an average couple is going to spend $250,000, and right off the bat I’m thinking, “wow, I need an additional $250,000, on top of that, just to cover health care?” Well no, do the math, it’s a few hundred bucks a month.
AC: Yeah and this is the article, Joe, it was CNBC that published it. And even the way that it’s written here, it says a 65-year-old wants once a 90% chance of having enough savings. Then they go on, “the average man would need to save $124,000 and the average woman would have to sock away $140,000, which I agree with you, it’s misleading, because really, a better way to say this is, “this is what you’re going to spend over your lifetime. And you have, hopefully, sources of income like Social Security, like pensions, like your savings.” That’s where this comes from. It’s not like you need this store of funds.
JA: Yeah you have your little health care safe. (laughs)
AC: A little bucket. (laughs) I got my bucket for fun…. (laughs)
JA: I got my envelope. That would have been a fat envelope! I got my healthcare envelope, there’s $264,000 in ones…
AC: You know what’s interesting though, is not included in these figures, is long term care. So long term care, if you need that, this is over and above this $250,000-ish.
JA: Yeah. That’s a real scary statistic there too because a lot of us are going to need some sort of care.
AC: It’s probably half, right? Or more?
JA: Yeah well it depends on the stats. It could just be for a couple of weeks. Or it could be for several years. So you look at the average stay in a long term care facility, what is it, about three years, three and a half years, depending on if you’re male or female. But that’s an average. So some of us, like Christopher Reeve, he needed long term care for many, many years.
AC: Yeah, and a lot of people go in for a month or less.
JA: Right. Or they die or get a hip replacement or something.
AC: So you need some convalescence, so you’re not necessarily there forever. So that happens. So here’s another myth Joe, which is you cannot count on Social Security benefits. How many people that we talk to that say, “You know what, Joe, Al, let’s not even include Social Security in the plan because I don’t think it’s going to be there. And the truth is this, even if the Social Security Administration runs out of money, as they’ve projected in 2034, 79% of your benefits will still be paid out. Why? Because people are still contributing to the Social Security Administration because they’re working. So in other words, I’m not saying this is great, but I’m saying that worse case, under current projections, you will receive almost 80% of your promised benefit. Now, the truth is, that’s only if Congress, Senate, President make no changes, which is not likely, to be honest, because so many people are depending upon Social Security. And by the way, they’ve made changes in the past that have fixed it. It’s just that no one wants to fix it because it adds more tax dollars and it’s very unpopular. So what will likely happen is, as we get closer to 2034, someone will have to fix it. And there you go.
JA: And I know some people are thinking too, well we don’t know. I mean of course we don’t know what’s going to happen in 2034.
AC: All you can do is kind of take your best guess. But here’s what I will say though, is, if you have a lot of assets, it is possible that means testing will come at some point, which means that, if you’ve got enough income or assets, maybe you’re not allowed to take Social Security. That’s not true now. But that is possible.
JA: Yeah I think that’s definitely one way, they’ll probably delay Social Security benefits for people in their 20s, 30s, 40s.
AC: Yeah, since we’re living longer, then we kinda need to – the youngest stage will, instead of 62, will be 63 or 64.
JA: Or they might keep the earliest age at 62, but the full retirement age, it won’t be 67. It might be 70, 69. Something like that. Or they’re going to change the cost of living adjustments on it. It could be means tested or a combination of all of it. They could increase our payroll taxes.
AC: Yeah, that’s probably the most likely, Joe, is it’ll be kind of a little bit of everything.
JA: But here’s what I’m confused about, is that the millennials is the largest generation by numbers. So we hear constantly that the baby boomer, this age wave, is coming through now. And they’re going to disrupt the stock market because they’re going to be taking money out of their accounts. It’s like oh my God, it’s all these fear mongers, it drives me nuts. But if the largest generation is the millennials, let’s say in the next 20 years, now they’re all in the workforce.
AC: Yeah, and they’re investing, and they’re saving, and they’re contributing to Social Security Administration. So I would agree, I think that a lot of the original predictions maybe, if you will, years ago, were based upon the baby boomers being the largest generation. And lo and behold now the millennials are.
When it comes to planning for retirement, what you have now, versus what you actually need are two entirely different things. How do you get from point A to point B? Do you have a plan to achieve your retirement goals? Visit YourMoneyYourWealth.com to sign up for your free financial assessment. There are so many things to think about – income; risk; asset allocation; inflation; taxes; Social Security; health care; Medicare; long-term care; the list goes on and on. Talk to a professional. Sign up for a free two-meeting assessment with a Certified Financial Planner™ at YourMoneyYourWealth.com
40:56 — Big Al’s List: 6 Common Myths that can mess up your Retirement (continued)
AC: Joe, I’m working on a list here called the six common myths that can mess up your retirement. And here’s one that says that you will be able to work as long as you want to. And people, more and more, they’re planning on working longer to save for retirement. About 30% of U.S. workers over age 60 say they don’t plan to retire until at least age 70, and 20% say they don’t believe they will ever retire. That’s a survey on Careerbuilder. Now here’s another one. EBRI Retirement Confidence Survey. So they say more than half the people expect to work past age 65. But their current stats, Joe, people working past age 65, it’s only 15%. So a lot of people are not able to work. And if you think about it, how could that happen. Well, there’s a lot of reasons. Your own health, your spouse’s health, your parents, maybe you’ve got to take care of them, or maybe your job, it’s passed you by, maybe somebody younger, quicker takes your position. Especially if you have a technical type position, and you’re not keeping up, and a lot of times, if you’re in your 50s and 60s, your salaries are higher, and companies look to try to decrease that salary, so just be aware that you don’t always have control over that.
JA: Hey here’s another Confidence Survey. The 2016 Retirement Confidence Survey. And worker confidence survey. Planned age retirement before 60, so they surveyed. 8% said they plan on retiring before 60. 8%. Actual retirement age before 60, 35%.
AC: No kidding. That’s a big difference.
JA: So you take a look at people, of what they’re planning on doing, and what the actuality is, it’s significantly different. Significantly. 60 to 64, when they said: “what age do you plan on retirement.” Between that age, 16% said, “Yeah, I think that’s the age I’d like to retire.” Actual: 34. So you’re looking at 70% of actual retirement ages is before 64. 35 and 34, pretty close. And so, if you look at people that plan on retirement, 70-plus? 26%. Actuality? 8%.
AC: Yeah. And that’s consistent with that Voya survey that came out a few years ago that said about 50% leave the workforce, quit sooner than they were expecting. So all right Joe here’s another one, you will spend less and pay fewer taxes in retirement. Well, that’s an interesting statement. That certainly is true for some people.
JA: I would say most, most. Not our listeners, but most.
AC: Yeah. So if we focus on our listeners that have saved and done the right thing, and they’ve got assets, you probably want to spend more. How many people have we talked to that say, Joe, Al, we’ve wanted to do these trips, we’ve been meaning to fix the home, thinking about getting an RV.
JA: Right. But a lot of those people still don’t pull the trigger doing it, because they are fearful of running out of money.
AC: That’s true too.
JA: Even though they can easily afford it. They were diligent savers. They have millions in the bank, and they want to do some different things, but they won’t do it. There’s more anxiety. It’s like, I don’t want to be a burden, we saved all this money. We’re just going to continue to live within our means, and they might not know what living within their means in retirement. Because of your paycheck, let’s say you made $70,000. But if I’ve saved millions or got millions, then that means what? I probably maxed out my 401(k) plans, I’ve saved into my Roth IRA plans, and then after tax, they’re probably living off of $30,000, $40000 a year. So that’s what they’re accustomed to. But now, they’re in retirement, they have potential pensions, they have Social Security, and millions and they’re still only wanting to spend that 40. So no, you’ve got to find out what you can spend to enjoy it, spend your money. We encourage you all the time to spend your money. But know how much that you can spend, and make sure that you have a plan in place to devise that strategy.
AC: And it works both ways. Because we have lots of people that are spending way more than they should. And then the flip side, and it just happens all the time, the folks that have saved, they get into that mindset of living below their means, which is great. Now they retire. They’ve got plenty, they can do virtually anything they want to do, and they can’t pull the trigger.
JA: Having a saver try to spend is a challenge.
AC: It is. And having a spender trying to save, that’s a tough one too. (laughs) You ought to be somewhere in the middle I suppose.
JA: What you say you are? Spender or saver?
AC: Me? I would say, well, in my 20s I was definitely a saver. Then when I got married that sort of switched a little bit because Anne is…. she’s interesting. She has this big side of her which is “live for today.” Enjoy today, which I love, I agree. But she also has a saver side to her, so she’s somewhere in the middle, I would say, and I’m more of a saver. Now, over time, I’d say we’re both kind of more in the middle. But yeah, no, by my nature I’ve been a saver, but I’ve learned, because of her, to enjoy the moment as well.
JA: Right. That’s where challenges come in with marriage. Where I’m a spender and she’s a saver or vice versa. That can be interesting.
AC: Yeah, it can be really tough. And of course, if you have to savers, great. God bless you. If you have to spenders, watch out. (laughs)
JA: Hopefully someone has a very large income. (laughs)
AC: Right. (laughs) And my last myth here Joe is that you’ll live in the same place throughout retirement. Nearly 90% of older Americans want to age in place, and 80% say that they believe their current residence will be where they always live. But nowadays, and especially in Southern California, a lot of people have the majority of their wealth and/or their equity in their homes. And that’s not always possible. And plus, you think about the home that may be made sense for your kids, two story home, big, big yard, you get older and that’s tougher to take care of, tougher to go up and down the stairs, although I would maintain this, and now I’ve just turned 60. We have a home with stairs, which, I think it’s great. I think that’s great for your exercise as long as you can do it.
JA: See, I run the convention stairs downtown San Diego. Al runs up and down his house. (laughs)
AC: (laughs) I do! I have a routine where I run 80 flights in a row, it takes me about 20 minutes.
JA: How big is your house?! 80 flights! Are you going up and down a hundred times?! What are you doing?! (laughs)
AC: Yeah, up and down, up and down, up and down.
JA: Do you get dizzy?
AC: No. It’s 15 steps. So I’m doing 80 times 15. (laughs) I tell you, you get a pretty good workout. I don’t have to run the convention center, I’ve got the Clopine house
JA: Yes. Oh man, I’ve got to come check that out.
AC: Try it, see if you can do 80 times.
JA: Oh yeah. Do you throw a couple pushups in there? Some lunges?
AC: I don’t, but after I’m done I’ve got to walk in circles. We’ve got a living room that goes to the kitchen, family room, in the hallway. You just walk in circles. And so it’s a self-contained gymnasium home retreat. (laughs) It’s like, perfect. I don’t ever have to leave.
JA: Oh God. (laughs) I haven’t seen this, well maybe because I haven’t been to a mall in, I don’t know how long. But, growing up in Minnesota, it got really cold as….
AC: So you stay inside.
JA: And as a teenager and things like that, you’d go to the mall. And these little old ladies, nice gentlemen. They got their walking shoes on, headphones, cruising around the mall. It’s inside. Oh, Clopine, you’d be all over that. You get little hand weights. Move your arms, get little body workout? (laughs)
AC: No, I just get a couple cans of peas. I don’t need any of that fancy stuff. (laughs)
JA: Oh god. (laughs)
It’s time to dip into the email bag, with financial questions courtesy of Advisor Insights from Investopedia, and you, the Your Money Your Wealth listeners. Joe and Big Al are always willing to answer your money questions! Email firstname.lastname@example.org – or you can send your questions directly to email@example.com, or firstname.lastname@example.org
50:03 – JA: Alan. I’m 74 years old and retired. I am collecting RMDs and I’m in the 15% tax bracket. If I withdraw a large sum say $100,000 from my IRA will it be taxed at 15%, or will it raise my income and cause me to be taxed at a higher rate the year following? Also, will it affect my Medicare premiums and Social Security payments?
AC: Wow, there’s a lot of questions there. That is a good question. Let’s start first with the taxes. And we have a marginal tax system, which means the first few dollars that you earn is taxed at 10%. Then there’s a 15% bracket, 25% bracket 28. It gets as high as 39.6. So this individual is in the 15% bracket, and we’ll just assume he’s single. The 15% bracket goes up to about $37,000 of taxable income. So let’s just assume with his required distributions – and I don’t know whether Social Security is taxable or not, but that extra $100,000 will be taxed maybe a little bit in the 15% bracket, but mostly in the 25% bracket, and probably some in the 28% bracket. Some potentially, even worse, maybe subject to alternative minimum tax, depending upon how close this individual is to there. So I guess the answer is no. When you draw more money out, it’s a graduated tax schedule, so you’re going to put yourself into higher taxes. Now, understand this though, if you put yourself into the next bracket by a dollar, you only pay the extra tax on that dollar. Not the whole thing.
JA: Yeah that’s a great point. $75,000 is, let’s say, the 15% tax bracket for a married couple. So if it’s $75,000 and he wanted to convert, let’s say, $100,000. And if he had no other income, he’s got deductions, exclusions, and exemptions. So we would need to see his tax return to determine how much of that $100,000 is going to be taxed at what rate. So looking at your 1040, you would want to look at line 43, which is the second page, about halfway down of your tax return. There’s going to be a number there, line 43, that’s going to tell you what tax bracket that you’re in. Then you can look at the tax tables – you could go to IRS.gov and look at the tax tables – you’d say I have room in the 15% tax bracket, let’s say, of $25,000. So maybe he would take a distribution of $25,000 versus the hundred. Or you look at how much money does he have in his retirement account? How much is his RMD? How old is his wife, and how much is in her retirement account? Then she’s going to have an RMD if she’s younger, and then what are those two RMDs together, required minimum distributions out of retirement accounts are going to be combined, and what tax bracket is that going to put them in? So there are different things. But to go back to what you said Al, if it’s $1 over, let’s say if he took more money out, and it jumped like $500 more into that other tax bracket, well just a $500 would have been taxed at that higher tax rate, not the whole amount. Where I think people get confused is like, well I fill in that 25 or 20% tax bracket. So does that mean everything is then taxed at that rate?
AC: Yeah I would honestly say, maybe as many as a third of the people that I talk to, they think that’s how taxes work. $1 in, now I’m in a higher tax bracket for everything. It’s just that extra dollar. Now a couple more points on this one is, when you have more income, because when you take money out of an IRA, it’s considered income, then potentially more of your Social Security income is taxable, because there’s this concept where the amount of tax that you pay in Social Security is dependent upon your provisional income, and your provisional income is virtually all your income, plus half of Social Security, in a rough sense. So here’s what can happen. For those of you that are in the 15% bracket, you take more out of your IRA, and now all of a sudden more of your Social Security is taxable. And I just saw an example recently, of someone that took about $7,000 more out of their IRA, it caused their taxable income to go up by $10,000. So in other words, they are paying 15%, but they’re paying 15% on $10,000, not $7,000. So the effective rate on that $7,000 that they pulled out might be 22%, or even as high as 27%, depending upon where you are on the scale. So be aware of that.
JA: Yeah, it’s a weird scale with Social Security, because all of a sudden each dollar that you add is ordinary income, let’s say as a retirement distribution, it will add another dollar if you’re in the zone for taxable income of your Social Security.
AC: Yeah. And that’s a hard thing to explain, but I’ve seen in some cases where someone has pulled out an extra $1,000 from their IRA, and they ended up paying about $270 of extra federal tax, because all of a sudden, that extra dollar, which they pay tax on, caused more of their Social Security income to be taxable.
JA: Right. It could then go up to 85 cents of the dollar is going to now be subject to tax. Because you get 15% of your Social Security income tax-free. Another thing too to be aware of, the higher the income that you have, it’s going to be subject to taxation, but it’s not necessarily going to reduce your payment unless you have taken your Social Security early, and you have earned income. So this example, he’s taking money out of a distribution from a retirement account. So no, it would have zero effect on the actual dollar payment that you’re receiving from a growth standpoint, but your net might be completely different after taxes because maybe more of that’s going to be subject to income tax.
AC: Right. And so, at the current time, when you take Social Security early at age 62, all the way to full retirement age, which this year is 66 years and two months, well then there’s limitations on how much earned income – in other words, how much salary you can have – once you get over that age, 66 years and two months, it doesn’t matter how much you make, whether it’s salary or not, it doesn’t impact your benefits. It does, however, impact how much you pay for Medicare premiums. Because the more that you make, you can go up into higher levels and as a single taxpayer, you’re gonna love this Joe. I guess I wasn’t paying attention because I printed out the 2014 tables. So it’s about three years behind. (laughs)
JA: Where did you even find that?
AC: I don’t know. I was on the Internet because I lost my other sheet.
JA: Well, you know I have a stack of about a thousand of those.
AC: Yeah, I just know where they were, and I got to ask you. Anyway (laughs) in 2014, a single taxpayer once they made over $85,000, they started paying more in Medicare. It’s about $90,000, something like that, currently. (laughs)
JA: So where Medicare premiums are means tested, the more income that you have, the higher the premium you’re going to pay.
AC: That is correct.
JA: Where Social Security is not there yet. So the more income that you have, they’re not going to reduce that. But the Medicare premiums will increase with the higher income that you have. But they just take a look at the last two years. So if you do have a big jump, some of it is, you could fight the increase in payment as well, depending on the circumstance of how that income was created. Just FYI.
AC: Yeah I guess one other side point Joe is, for those of you that are in the 15% tax bracket, and again, this is defined as a single taxpayer with taxable income of about $37,000. Married taxpayers have about $75,000, give or take. If you’re in this bracket, then if you have capital gains, if you sell a stock or bond, mutual fund, outside of retirement, so not part of your retirement accounts, and it’s at a gain, well your capital gains rate is zero. So let’s say you’re married, your taxable income is $60,000. You could sell $15,000 of gains and pay no federal tax on that because the capital gains rate is zero when you’re in there 15% regular rate. I get this question as well. If that’s true, can I sell my rental property with a million dollars of gain to pay no tax? And the answer is no. It’s the same idea, it’s a graduated schedule. The first $15,000 would be tax-free in that example. But everything else would be taxed at 15% capital gains rate, or 20% rate, once you get over about $45,0000.
JA: I have a question that was given to us about the pro-rata rule.
AC: Oh boy. OK. That’s hard to explain. (laughs) We’ll give it our best shot.
58:59 – JA: So the question is, does the pro rata rule include 401(k) balances?
AC: OK. Well, the quick answer is no. (laughs) How about that?
JA: Well, depends on what’s in the 401(k) balance. How about if I have after tax? What if I have Roth?
AC: Well, the 401(k) balance doesn’t affect pro-rata rule unless you roll it.
JA: Well there’s multiple pro-rata rules. What one are you referring to?
AC: Well give me the question.
JA: That’s the question. Are you thinking like backdoor Roth type of pro-rata aggregation rule?
AC: Well let’s start with IRAs.
JA: You’re thinking of aggregation.
JA: I’m saying pro-rata.
AC: Same thing.
JA: No it’s not.
AC: OK. Enlighten me.
JA: Alright. Aggregation is aggregating all of your accounts. So if I have, let’s say, multiple IRAs, and if I have after-tax balances in one IRA, and I have pretax balances in all my other IRAs. So if I look at taking money from the after tax account in my IRA, I can’t just say give me the after-tax money. And let’s say I have $10,000 in that after tax account. $5,000 after tax, another $5,000 of growth. $10,000 is the total balance. The pro-rata rule is that, if I took a distribution, let’s just say that was my only IRA account, if I took a dollar out of there, 50% of it is going to be tax-free. 50% of it is going to be taxable. That’s pro-rata. The aggregation rule is saying wait a minute, how many more IRAs do you have? And let’s say I have five other IRAs, with a total of $80,000 or let’s call it $90,000. So now I have a total of $100,000 in IRA balances. So that’s aggregation.
AC: OK. Well then I’ll amend what I said, they’re related. (laughs)
JA: Sure. Well, it depends on what you’re using. I think we use that in conjunction, only when you’re looking at trying to do a backdoor Roth IRA conversion.
AC: Here’s the point I want to make I guess, which I think you kind of made, which is when you take money out of an IRA, if there’s basis, the IRS doesn’t let you look at an IRA individually. They aggregate all of them together as if you had one IRA. And then any after-tax balance in there, let’s say it’s 5% of your total IRAs, it doesn’t matter which IRA you draw it out of. 5% is tax-free and 95% is taxable.
JA: Right. So if you have the 401(k) and a bunch of IRAs, and you’re looking at the pro-rata rule, then they would not include that 401(k), because that 401(k) would have a separate pro-rata rule within the 401(k) plan.
AC: Correct. So if the question is, does the account balance in my 401(k) affect the pro-rata rule in my IRAs, the answer is no. Because they’re separate. That was the answer I gave at the very beginning. (laughs)
JA: Got it. Well, the question I received was about a 401(k) plan. And it has after-tax Roth dollars, and pretax dollars, within the 401(k) plan. You’re taking distributions from that, how are those distributions calculated. So does the pro-rata rule apply? And the answer is yes.
AC: Yes it sure does. Unless you roll the after-tax money to a Roth, you are allowed to do that directly, and the pretax money to an IRA. Now you’ve effectively separated them.
JA: For instance hypothetically, a client comes in. Million dollar 401(k). $100,000 is after tax contributions. $200,000 is Roth IRA contributions. So then you look at, how the 401(k) works is that the after tax and the pretax, not Roth, will be in the same bucket. But your Roth is in a totally separate bucket.
AC: Yeah. They call that a sub-account or something like that.
JA: Even though you get one statement. Even though you take a look at it and you’re saying OK, well here’s my 401(k) plan. Yes, but you have two totally separate accounts that are managed differently because every contribution that you put into an after-tax dollar… Let’s say if I can put more than the $24,000. I’m over 50. I put in more into the after tax. Well, that after tax portion, any growth of that is going to be what? Taxed at ordinary income rates. So that’s just the same as a pretax account, but your after-tax contributions will not be double taxed. iIf I have a Roth account, and I put dollars in, and let’s say I have a $100,000 contribution, but those contributions are going to grow over my time period of investing. So they have to keep it in a separate accounting system, so they can keep everything separate to see what those Roth dollars grew to because all of those are going to come out tax-free to you. So this is where it gets a little bit confusing when you have a 401(k) plan with Roth contributions, after-tax contributions, and pretax contributions. What do I do? Do I keep it in the plan? Do I roll it out? If I take distributions, how do I calculate all this stuff? Good news is, is that I think if you have that hodgepodge in your 401(k) plan, that is really good news. Because you can separate all that stuff very, very easily once you separate from service. You could say, my Roth 401(k), I’m going to roll that into a Roth IRA. A lot of pros there, because there is a required distribution in a Roth 401(k). There is no required distribution for a Roth IRA. Those after-tax contributions? Guess what. Boom. Roll those right into your Roth IRA. And then now, the growth of that after tax stays in the 401(k). Plus your other pretax. You take those dollars out. It’s going to be taxed on ordinary income, but you roll that into an IRA, that’s tax-free until you pull the money out. Now you can separate all this stuff, and consolidate the certain tax brackets. And then you have a lot more control of how much taxation that you want to hit on your tax return, versus using the pro-rata rules that the IRS has given us.
Alright! Well, that was a mouthful. Hey hopefully enjoy the show. That’s it for us today. For Big Al Clopine, I’m Joe Anderson. We’ll see you again next week. Show’s called Your Money, Your Wealth.
So, to recap today’s show: The earlier and more you save, the better your chances of having a million dollars when you retire. You should consider the possibility that you won’t be able to work as long as you want to. You should also carefully weigh all the factors involved when deciding whether to make a large withdrawal from your retirement account. Pro-rata and aggregation are different but related. And right about now, hiring a professional to help you with all this stuff sounds like a very good idea.
Special thanks to Tom Anderson, author of “The Value of Debt in Building Wealth” for explaining the types of debt, the four phases of life: launch, independence, freedom, equilibrium, and how much debt you should have during those phases. It’s all about balance and the golden ratio.
Subscribe to the podcast at YourMoneyYourWealth.com, through your favorite podcatcher or on iTunes, where you can also check out our ratings and reviews. And remember, this show is about you! If there’s something you’d like to hear on Your Money Your Wealth, just email email@example.com. Listen next week for more Your Money Your Wealth, presented by Pure Financial Advisors. For your free financial assessment, visit PureFinancial.com
Pure Financial Advisors is a registered investment advisor. This show does not intend to provide personalized investment advice through this broadcast and does not represent that the securities or services discussed are suitable for any investor. Investors are advised not to rely on any information contained in the broadcast in the process of making a full and informed investment decision.
Your Money Your Wealth Opening song, Motown Gold by Karl James Pestka, is licensed under a Creative Commons Attribution 3.0 Unported License.