A 7-Point Checklist to Reboot Your 401K (Part 2)

In Part One of “A 7-Point Checklist to Reboot You 401K”, we looked at three topics to help you make the most out of the money invested in your 401K or other retirement account. In Part Two of this series, we talk through four more tips that may help you achieve a secure retirement.

4. Understand your options for passing your 401K and other retirement accounts to the people you love.

Have you named beneficiaries properly on your retirement accounts? Do you understand the potential complications of how your retirement accounts pass to your loved ones? The two main issues to consider are 1, making sure you get the money to who you want it to go to with the controls you desire, and 2, making sure the beneficiaries don’t get eaten alive with income taxes.
First, let’s discuss the hierarchy of how 401Ks and other retirement accounts typically pass to your loved ones. Simply put, the will that you’ve carefully crafted to define your final wishes has absolutely no control over these accounts if you have living beneficiaries designated. The beneficiary designation supersedes the will.  While this rule of law creates opportunities, it also creates some threats to your hard-earned money.

On the positive side, retirement accounts bypass probate when you have beneficiaries named, meaning your loved ones simply need to produce a death certificate and proof of identity, and the assets pass directly to them. Negatively, though, naming a beneficiary on your retirement account doesn’t involve the legal language and forethought that wills have. One of the biggest reasons wills have so many pages of legal language is to make sure that if people don’t die in the anticipated order, your loved ones are still taken care of. When we see people in our office for the first time, the overwhelming majority of them have the potential to disinherit an entire branch of the family tree.  And the will won’t fix the problem.

The point of legal planning is to make sure that doesn’t happen, and wills and trusts cover that pretty well with the other assets you own. But with beneficiary designations for retirement accounts, how do you fit all of the necessary language into a small box on a beneficiary form?  There simply isn’t enough room.

The second big issue is dealing with the income taxes on your IRA or 401K.  According to the IRS, the vast majority of all IRAs are cashed in when the second spouse dies, triggering a tax bill for your loved ones as much as 43.4%, plus any state taxes that may be owed.

IRA and 401K distribution planning is, in our view, the most overlooked area in estate planning today.  For help with preparing your beneficiary designations, download a free copy of our Beneficiary Designation Checklist.

5. Have a bulletproof withdrawal strategy so you don’t fall into the retirement tax trap.

For most people, the number one expense in their lifetime is taxes. IRAs and 401Ks are great places to accumulate money because you are not paying taxes on that money as it grows. With a traditional 401K or IRA, you also get a tax deduction on the contributions (subject to income limitations).  But once you begin taking money out of your retirement accounts, you must pay your partner, Uncle Sam. And, unfortunately, every dollar is taxed coming out.

When planning for retirement, you should consider what your tax bracket is now (while you are contributing money), and what your tax bracket is likely to be when you take money out, typically in retirement. Many retirees can be very intentional about the taxes they pay.  Different investments have different tax ramifications as they generate 1099s, and investments outside of your 401K or IRA are typically more tax-friendly when withdrawing the money as income.

Another potential opportunity comes in the form of Roth IRAs and Roth 401Ks. They differ from traditional IRAs and 401Ks because you pay taxes on the investment upfront with no tax deduction, and then when the money comes out, it is income tax free. Contributing money to a Roth pays off when your tax bracket in retirement is higher than when you’re putting the money in. For those nearing retirement, that’s not very common. Most workers will retire in a lower tax bracket – which doesn’t make Roth accounts the best option for many older workers. For younger workers, tax diversification may be effective because it is so difficult to predict what our tax structure will look like in 20 or 30 years. If you utilize both a traditional 401K and a Roth (if eligible), you get some of the benefits from each.

The bottom line, though, is the need to develop a detailed financial plan that measures how you should be making your contributions now, and how you are going to take money out later. Or, if you are already retired, a plan that specifies how you are taking money out and balances what you are paying tax on now, versus what you may pay taxes on in the future – especially at age 70 ½ , when you must begin required minimum distributions.

6. Watch out for Required Minimum Distributions (RMDs).

At age 70 ½, the government requires that you start taking money out of your retirement account (except for Roth options). It is important that you be aware of those rules, and how you can take advantage of opportunities before you turn 70 ½.

First, let’s discuss the rules. As an example, let’s look at Tom, born in April 1947.  Tom’s first RMD will be in 2017, because he will turn age 70 ½ in October of 2017. However, Tom does not have to wait until October to take the RMD.  He can take it anytime during the calendar year. All the IRS cares is that the RMD is taken in 2017 and reported on the tax return. Tom does have the option of putting off the first distribution until the spring of the following year (by April 1^st 2018), but if he does that, he will then have to take two minimum distributions in 2018: one for 2017, and one for 2018.

If you’re retired and are not yet age 70 ½, you may benefit from Roth conversion planning.  For example, if you have large IRAs and 401Ks, you know you will have to face the tax man soon.  However, if you can keep your tax bracket low with effective planning, you may be able to do Roth conversions in low tax brackets today in order to lower the tax bill on RMDs in the future.

However, if you have a traditional investment plan, that 4 percent rule may not work – especially if you retire in your mid-60s or earlier. One reason is because people are living longer lives. The average joint life expectancy for a couple in their early 60s is close to 30 years. Your money needs to last, and inflation, investment risks and healthcare costs are all powerful opponents.

A second reason is that we live in a world where both stocks and bonds are expensive.  Stocks are near all-time highs, and interest rates are near all-time lows.  This reality makes it unreasonable to expect robust returns over the coming decade, and a traditional investment plan of stocks and traditional bonds may not be very effective, making the 4% rule dicey.  However, with a properly crafted income and investment plan, we believe many of these risks can be mitigated.

If you’d like to learn more about these and other important retirement planning topics, please consider attending one of our upcoming adult classes through the University of Tennessee and Pellissippi State.