Retirement Transition Lesson #2

If you remember the old Fram oil filter, you’ll remember their famous tag line “pay me now or pay me later”. The advertisement implied that paying a little (or a little bit more) now for a Fram oil filter compared to a cheaper brand of oil filter would save you lots of money on major engine repairs later.

That “when to pay” theme is relevant for this retirement blog, particularly as it relates to income tax impacts from 401K and IRA decisions. Advice about Roth vs Traditional investments has shifted over time, reflecting changes in tax policies and the changing demographics of the workforce. I made decisions based on advice I heard and read years ago. I would make some of those decisions differently based on what I know now.

Please note that I am not a financial advisor or a tax advisor. Treat my viewpoints as lessons learned from the school of hard knocks. Consider your own situation as you make your own financial decisions.

Roth accounts were introduced in 1997, and the first Roth IRAs were opened in 1998. I was 16 years into my career at the time, and my investments were primarily into 401K accounts. Common financial advice at the time advocated using 401K investments to reduce your current income tax and deferring taxes until retirement when it was assumed you would be in a lower income tax bracket. That seemed prudent at the time. Saving for retirement was a responsible goal and by investing those savings into a traditional IRA/401K, I could lower my tax burden at the same time. That allowed me to make larger investments and maintain higher take home pay.

Roth 401K investments were introduced in 2006 and were touted primarily for younger people just entering the workforce, since their investments would be able to grow tax free for a long time. At least that was the advice I received at the time, and I adopted that approach as my primary investment strategy.

Traditional IRA General Rules	Roth IRA General Rules
Contributions are before-tax	Contributions are after-tax
Distributions treated as ordinary income	Distributions are tax free
Earnings are tax deferred	Earnings grow tax free
Subject to required minimum distributions	No required minimum distributions
Withdraw without penalties at age 59 1/2	Withdraw earnings tax free after five years

Common financial advice for retirees now recommends minimizing overall taxes by managing taxable income and factoring tax rates into the decisions. This means balancing traditional IRA/401K required minimum distributions (RMDs) with Roth distributions in a way that optimizes lifetime tax payments. It considers your personal situation regarding tax brackets, RMDs, retirement income sources, and other factors. The optimized approach ultimately puts more money in your own pocket over time, unless you prefer to contribute more money in taxes over your lifetime.

In 2010, backdoor Roth IRA conversions were introduced. This strategy allows traditional IRAs to be converted to Roth IRAs. It required paying the taxes due at the time of the conversion, but it allowed investments to be withdrawn tax free after five years and to grow tax free as well. This strategy helps reduce traditional IRA RMDs that begin at age 73 (or later depending on birth year). RMDs typically grow over time as your age increases. Many hard-working retirees began realizing that the traditional IRA investment and related deferred income was a ticking time bomb that was leading to higher tax burdens over time.

Flash forward to 2023 when I retired at age 63. During my last few years of working, I invested small amounts of money in a Roth 401K account. After retiring, I rolled that small amount of money into a Roth IRA. Then I began looking for ways to legally lower my future tax obligations and maximize the money I had available to live on and to pass along to heirs or other worthy organizations.

Looking back, I wish I had chosen to “pay more tax now” during my earlier career and invested more heavily in Roth accounts to “pay less tax later”. In my own personal situation, I plan to defer collecting social security until age 70 and RMDs will begin at age 75. That leaves me with a window of opportunity to complete Roth backdoor conversions in the next 5 years and a limited opportunity for 5 additional years after I begin collecting social security. I completed my first Roth backdoor conversion in 2024.

Fortunately, stock market returns have been very good for the past couple of years. That may or may not continue in future years, but what I quickly discovered is that my goal to lower my traditional IRA investment balance and grow my Roth investment balance was only partially successful. I was able to grow the Roth balance by making Roth backdoor conversions. But the traditional IRA withdrawals that supported the Roth backdoor conversion were quickly replaced by favorable stock market returns. In short, I was running a race to lower RMDs and found out I was on a treadmill. I was working hard but not making any progress. I have been evaluating ways to adjust my approach to be more successful. I’ve included some websites and articles below that were helpful as I considered my options.

There could certainly be worse problems to face in retirement, and I feel blessed to be dealing with this issue rather than wondering how I am going to pay my bills. But I am hopeful that some of you that are earlier in your careers will have the opportunity to reconsider your investment strategy and make some adjustments before you find yourself in the same situation as me.

Relevant Reference Material:

My Biggest Surprise in Retirement - The Retirement Manifesto – a blog I follow

Required Minimum Distribution (RMD) Calculator – provided by AARP

Open Social Security: Free, Open-Source Social Security Calculator – optimize when to collect SS

Fram Oil Filter Commercial- 1972