Why My $1MM May be Greater than Your $1MM

Retire on 1 million dollars

Why my 1MM is bigger than your 1MM

Saving one million dollars (1MM) is a big deal.  One million dollars is a lot of money.  For many, seeing that seven-figure number is an instant sign of success.

For those who have reached the million-dollar mark before retirement, you should give yourself a pat on the back.  You are among the lucky few.  In fact, Fidelity recently reported that of their 13 million 401(k) plans, only 72,000 have surpassed the million-dollar mark (for those doing the math that is less than 1%).

However, what if I told you that not all million-dollar retirement buckets are created equal?

What if I told you that “this” $1,000,000 retirement bucket may be worth more than “that” $1,000,000 bucket?

Would you believe me?  Would you want to know more?  Well, you certainly should.

The fact is, depending on what type of account you have, your one million dollars may be more or less valuable than you think.  More specifically, is your money being saved in an IRA, a ROTH IRA, or a non-IRA investment account?

A Look into Your Retirement Income

Upon an individual retiring, one of the biggest questions I am asked as a financial advisor is how much money he or she can spend during retirement.

While overly simplified (and potentially outdated) rules of thumb would suggest between 3-5% of your investment balance, most financial advisors realize that the real answer is a bit more complicated.

Let’s look at an example with the following hypothetical assumptions to illustrate my assertion:

  • A married couple, both of whom are 65 years of age
  • A joint income from Social Security of $48,000
  • A one million-dollar investment portfolio, from which they plan to withdrawal 4% per year, or $40,000

In addition, we will simulate the after-tax income received by retirees, assuming that their one million dollars is in:

  1. A Traditional IRA,
  2. A ROTH IRA, and
  3. A non-IRA investment brokerage account (for this account, we will assume a basis of zero and all income will be treated as a long-term capital gain).

By simulating a tax return, we can calculate the total amount of hypothetical after-tax dollars received by this 65-year-old couple.

Traditional IRA ROTH IRA Non-IRA Brokerage
Total Income $88,000 $88,000 $88,000
Total Federal Tax $5,066 $0 $0
After-Tax Income $82,934 $88,000 $88,000

 

In this scenario, you can see that a retiree who makes withdrawals from a ROTH IRA or a non-IRA brokerage account will receive an after-tax amount that is  higher (a little more than $5,000 for this 65-year old couple) than the person who withdrawals from a Traditional IRA.

It’s interesting to note in this example, at this income level, that there is no difference in after-tax income between the ROTH IRA and the non-IRA brokerage account.

How Will a Higher Income Affect the Analysis?

Many retirees have a higher income need in retirement than the $88,000 exemplified above.  Therefore, I felt it prudent to analyze how a higher total income would impact the after-tax income received by the retiree.

Specifically, I assumed additional income in the form of a $30,000 pension.  In this hypothetical example, the total retirement income is $118,000.

Traditional IRA ROTH IRA Non-IRA Brokerage
Total Income $118,000 $118,000 $118,000
Total Federal Tax $13,519 $2,291 $8,156
After-Tax Income $104,480 $115,709 $109,844

 

You can see from the chart above that Traditional IRA investments continue to produce the lowest total income for a retiree.  In addition, you will notice a difference between the ROTH IRA and the Non-IRA brokerage account.  As total income increases, having retirement assets in a ROTH IRA becomes more and more valuable.

(For the technical geek in us all, one of the main drivers in the low tax requirement of the ROTH IRA is the taxation of Social Security.  Social security has very specific rules regarding how much, if any, is taxable to the recipient.  In this ROTH IRA example, only $14,500 of a total $48,000 of Social Security received is taxable.  For both the traditional IRA and the Non-IRA brokerage account, $40,800 of Social Security is taxable.)

When Does My Traditional IRA Equal My ROTH IRA?

As you can see from the above examples, distributions from ROTH IRAs in retirement produce a higher after-tax income than those from a traditional IRA.

To think about it another way, a one-million-dollar ROTH IRA portfolio is worth more than a one-million-dollar traditional IRA portfolio.

In order to “equalize” the after-tax income to the retiree, a higher distribution would be needed from the traditional IRA.  We can calculate that distribution to be $55,000.

You will see from the hypothetical chart below that the total income to the retiree would be $133,000.

Traditional IRA ROTH IRA
Total Income $133,000 $118,000
Total Federal Tax $17,263 $2,291
After-Tax Income $115,764 $115,709

 

While we can mathematically create an equal after-tax income in retirement by withdrawing more money from the million-dollar investment, it’s important to remember that now the retiree could be exceeding what some consider a “normal” withdrawal rate of 4%.

For example, by withdrawing $55,000 of $1,000,000 from the traditional IRA, the retiree has a withdrawal rate of 5.5%.  That percentage, depending on a number of factors, could be higher than what some financial advisors recommend.

In order for this retiree to maintain a 4% withdrawal rate, they would need to have saved more money before retirement.  The amount needed would’ve been $1,375,000!

In this scenario, we can suggest that a million-dollar ROTH IRA could actually be “equal” to a $1,375,000 traditional IRA!

THAT IS 37.5% MORE THAT WOULD NEED TO BE SAVED BEFORE RETIREMENT!

What Can I Do About My Retirement Plan?

Many clients love the immediate tax deduction provided by traditional IRAs and 401(k) plans.  For that reason and others, many retirees lean towards keeping a majority of their money in traditional IRAs.

However, for all retirees, it’s important to consider the long-term impact of your decisions on your retirement plan.  Does it make sense to have all your money in an IRA that is taxed as ordinary income?  Or should you be diversifying the types of accounts you have, just like you diversify your investments*?

Regardless, it’s critical to any retirement plan that you avoid using a simple metric to determine how much you may need to save prior to retiring.  By not incorporating income-tax planning, other income sources, your age, and numerous other factors, you may be missing the mark!

*Diversification does not guarantee a profit or protect against a loss.

The above hypothetical examples are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

Contributions to a Roth IRA are not tax deductible and there is no mandatory distribution age. All earnings and principal are tax free if rules and regulations are followed. Contributions to a Traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status and other factors. Taxes must be paid upon withdrawal of any deducted contributions plus earnings and on the earnings from your non-deducted contributions. Penalties for early withdrawal may apply if funds are withdrawn prior to age 59 ½. None of the information in this document should be considered tax advice. Please consult with your legal or tax advisor for more information concerning your individual situation.

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