Study Hall

Do you have a favorite teacher from your time at school? How about one that particularly challenged you to be a better student? It could be a primary, secondary or college instructor who you remember particularly fondly. I had one in 5th and 6th grade (I went to a weird school where we had the same teachers for two grades in a row). Let’s call her Strictus Academicus. She was strict but fair and taught me how to channel my smarts and energy in a positive direction. I thrived under her tutelage, and the academic discipline she forged within me carried on for the rest of my life.

Yep. Just like I remember it.

Much like Strictus Academicus, I am going to break out the ruler and be stern but fair with you. Don’t worry, no one’s knuckles are getting rapped, and no one will be staying after class. However, I am assigning some prerequisite reading and podcast listening. The prerequisites are for those of you not familiar with the difference between Traditional and Roth retirement savings vehicles. Many apologies for doing this, but I cannot allow you to continue reading the bulk of this post until you read or listen to the following articles.

I can hear the groans already. Yet, I need to talk higher level stuff, and if you don’t have the basics down, then I am afraid I will lose you. I may loose you anyways because this stuff is not the most exciting. The knowledge could save you money, time, and hassle though. And I would rather loose your attention out of boredom than confusion. As for your assignment, since other people have explained the basics much better than me, it will be easier if you to simply learn from them. For those of you Roth and Traditional Retirement Account (TRA) novices, see the bullet points below prior to class convening. And don’t worry I was just like you two years ago.

Queue school bell ringing …

Homework

• My Money Design – Roth IRA vs. Traditional IRA 2017 – Which One Is the Better One to Have? – This article is a good but basic review of the two vehicles and their pros and cons. The author believes that each serves their purpose.
• Mom and Dad Money – Traditional vs. Roth IRA – A more advanced look at the pluses and minuses of the different forms of retirement investment vehicles with some examples. Explains the power of the back door Roth which allows an individual to avoid some tax liability through conversion of the Traditional IRA to a Roth. Again, the author sees situations where one vehicle is more appropriate than the other.
• Mad Fientist – Traditional IRA vs. Roth IRA – The Best Choice for Early Retirement – This article makes the definitive argument that the Traditional IRA (any type of Traditional account actually) is the way to go if you intend to retire early and make use of the backdoor Roth option. It shows you the potential $100K difference the decision could have which is persuasive. It does not take into consideration pensions or social security.
• Better Off with Jill Schlesinger Podcast – Episode 11 – Tax Prep with Ed Slott – Jill interviews Ed Slott, the nation’s leading expert on the IRA. Ed comes down definitively on the side of the Roth during the first 10 minutes of this podcast but is thinking mostly in terms of a normal retiree who works until their mid-60s.

The Two Sides of the Debate

I’ve noticed an interesting phenomenon, which should be apparent to you as well after reading and listening to the above-assigned homework. In the standard retirement realm (i.e. work until you are 67), the Roth options ( ie. Roth IRA, Roth 401K, Roth TSP) get a lot of love as retirement investment vehicles. That is due to the assumption that in a standard retirement scenario (for a good saver I might add), a retiree’s TRA Required Minimum Distributions (RMDs), Social Security checks, and lack of tax deductions (i.e. mortgage or kids) would place a retiree in the same, or even a higher, income tax bracket than they are during their working years. Thus, post-tax contributions during your working years to a Roth account are at least tax savings-neutral if an individual ends up in the same tax bracket. They are also more straightforward since they do not have RMDs. Roth contributions are tax savings positive should one end up in a higher tax bracket. Roth accounts, as the argument goes, are also far more flexible since an individual can access their principal (but not their interest) penalty free anytime — unless it came from a TRA to Roth conversion — in which case you must wait 5 years. Finally, Roths are much better tools for estate planning purposes.

Yes, you with your hand raised? Did you have a question?

In contrast, within the FI realm where the general assumption is that an individual will retire much earlier than the standard 67 years, there is an almost laser-like focus on maxing on the TRAs (i.e. 401K, Traditional IRA) over the Roth. As you’ve learned from several of the above articles, maxing the TRA option is done in anticipation of early retirement where an individual’s income will be much less than their working years, making the tax liability for withdrawing the money from a TRA (either through regular withdrawal or through a Roth conversion) low to nil.

The key arguments in favor of this “max the tax deferred TRA” option by the FI community are:

• Save the tax now when in a higher income tax bracket during your work years by contributing to a TRA.
• Max the TRAs out, and you may possibly end up in a lower income tax bracket since contributions do not show as earned income on tax filings.
• Invest the “saved” money that you avoided paying to the Taxman and watch it grow (in excess of an extra $100K in Mad Fientist’s article)
• Retire early once you reach FI; roll over all your TRAs to a Traditional IRA.
• In early retirement, if you need access to the funds in your Traditional IRA prior to 59 and 1/2 years, you can avoid the 10% early withdrawal penalty by converting the funds to a Roth IRA. The money must lay untouched in the Roth for 5 years afterwards, so best to save 5 years worth of living expenses in good old savings or taxable savings accounts.

Or

• If you are over 59 and 1/2 you can simply withdraw the money from the Traditional IRA.
• Either way, the conversion or withdrawal of funds from your Traditional IRA is a taxable event which appears as ordinary income. But if you live frugally, your need to generate large amounts of income are low. Therefore, your income tax bracket will be lower than your working years, allowing some or all of the withdrawn/converted funds to match up against your deductions and exemptions.
• FI minded people are quick to point out that if you stay at or under the 15% Adjusted Gross Income (AGI) tax levels, you can make up any needed difference between your converted/withdrawn Traditional IRA funds, and your annual income needs, through sales of investments out of your regular investment account which are classified as Long Term Capital Gains (LTCGs). LTCGs are taxed at 0% when your AGI tax bracket is 15% or less.
• Thus an individual can profit by $100Ks between tax avoidance and wise investing of the money saved from tax avoidance measures.
  

  I’m sorry did you say $100K difference?

Some FI advocates even argue in favor of contributing to taxable accounts (i.e. plain old investment accounts at places like TD Ameritrade, Vanguard, etc.) prior to Roth, but after the TRAs are maxed out, due to the taxable account’s flexibility.

Debate Club

Math was never my strong point.

It is hard to argue with the math of the max-the-tax deferred TRAs argument when you see it laid out in front of you on FI websites like the Mad Fientist. As a result, right about now you may be thinking “what is holding me back from maxing out every Traditional account I have access to?”. Nothing … if you do not intend to have any other income in your retirement years. For those of us in the Golden Albatross scenario though, the low-to-no income argument causes either immediate or longer-term problems, depending on the nature of our pension program.

Take my case for instance. In a normal year, my family and I fall in the middle of the 15% tax bracket after all the tax deductions and tax credits. I am planning to retire from the military in the next three to five years, somewhere between 21 and 23 years of service. At that point, I will (probably) pay off our mortgage since it makes our likelihood of running out of money in retirement extremely small. Other than some possible side gigs, I am not planning to work anything like a “real” job. However, I will earn approximately $55 – $60K a year (in today’s dollars) from my military pension. That starts immediately, no waiting period, and adjusts annually with inflation. My calculations show that I will need to withdraw approximately $20K more a year (again in today’s dollars) to meet our planned living expenses. I intend for that $20K a year to come from our taxable investment account as LTCGs, which will be taxed at 0% but will still count against our AGI.

Add in the few deductions and exemptions we will still qualify for, and guess which tax bracket my family will fall in? You’ve got it. 15%. In fact, as long as I reach my retirement point, my family and I will never fall below the 15% tax bracket. It is mathematically impossible unless the tax brackets change significantly upwards to include more people in the lowest two tax brackets (which is the opposite way they need to go to repair our budget deficit in the US). In fact, the likelihood is that my family and I may even bump up in tax brackets later in retirement when social security and RMDs from TRAs kick in (assuming we do not convert the funds from the TRAs).

Now you might remember the Mom and Dad Money article (referenced above) discussed the need to compare marginal tax rates when contributing vs. effective rates when you withdraw in order to decide whether to go with TRA vs. Roth contributions. However, in his article he also notes that if you are set to receive a pension, then the argument tilts in favor of the Roth:

Finally, I’m ignoring the possibility that you have a pension or that you will receive Social Security income… The existence of either of those would change the calculations below in favor of a Roth, though not necessarily fully in favor of it. – Mom and Dad Money

• If you are only set to receive a small pension that would not cover all the value of your annual tax deductions and exemptions.
• If your contributions on the front end during your working years bump you down a tax bracket — effectively supercharging your retirement savings.
• If you are a resident of a high-income tax state.

Which brings me to an extremely important point. Primarily, we future pensioners need to understand what our pension benefits entail, when those benefits begin to pay out, and how much those benefits will be. This is something I write about in other articles, so I will not go in depth here. Just know it will require some research on your part. The other thing we must determine is the difference between our pension payments (once they start) and our estimated living expenses in retirement — what I call your “Gap number”. Knowing your Gap number will determine how much you will need to withdraw from your investments (be they TRAs, ROTH or normal taxable accounts) in order to live comfortably. If you do not know how to conduct the required planning to determine your Gap number, see my two articles on the GRO2W planning process.

According to my calculations we should be …

Some of us like police, fire, and military retirees will have an immediate “floor” of taxable retirement income the day we stop working (i.e. a number we will not go below) which is taxable. Others will have to wait until the designated age that their pensions payments begin (still taxable once it starts). Whatever age your pension kicks in though, the “floor” of earned income it creates, in conjunction with a lack of tax deductions (assuming that mortgage is paid off and the kids are already out of the house) may put you in a position in where Roth makes more sense. Of course, that all depends on how much other money you will need to withdraw to meet the Gap number.

Which brings me to a second extremely important point. This stuff is complicated. We’ve already addressed numerous hypothetical scenarios that probably have your head spinning. Trust me mine was spinning just trying to verbalize my thoughts for this post. Given the complicated nature of these decisions and the fact that you may be 20+ years away from retirement, I would strongly advise sitting down with an accountant or tax professional during the offseason (for taxes). Have them help determine your options and optimal way ahead from a tax perspective. It will be worth your time and money if you can find one who specializes in decisions like this.

Go long, for about 20 years, and break for the end zone.

Alternatively, it might help to sit down with a fee-only Certified Financial Planner (CFP), committed to the Fiduciary standard, with a low potential for conflict of interest, and pay them a one-time only fee to chart your different options. They could even create a plan which you could execute. It would be expensive, but again highly probable that it will save you money in the long run.

A Final Argument for the Military Personnel in the Audience

One final point. It is worth noting that if you are in the military, there is one sure-fire life hack that the Roth TSP affords. Should a military member happen to deploy to a combat zone and qualify for the combat zone tax exclusions (CZTE) then money you contribute to a Roth account is tax-free going in and coming out. There is a difference between how much Officers and Enlisted can exclude from taxes (for Enlisted it is unlimited), and you can only contribute up to the $18K annual limit for the Roth (plus catch up if you are over 50). So if you know that you are deploying during any given tax year to a combat zone it pays to defer your TSP contributions until you get there. I would check with your pay clerk or personnel services prior to putting plans into action. Unfortunately, I did not embark upon my financial educational journey prior to any of my previous deployments to the Middle East, so I never made use of this life hack. However you can damn well bet if I deploy again, I am going to max out that benefit.

Affirmative. I say again, max out my Roth TSP.

Which brings up another point. A lot of our allowances are already tax-free. Basic Allowance Housing (BAH), Basic Allowance Subsistence, and Cost of Living Allowance outside the Continental US are just a few examples. Although it is simply an accounting trick, but if you are able to save anything extra from these pays, it is in your best interest from a tax perspective to stick them in a Roth plan of some sort for the same reason mentioned above. For instance, if you receive $2000 in BAH, but only spend $1500 on rent don’t simply pocket the rest into a general checking or savings account. Invest it into your Roth plan. There are very few instances in life will you ever be able to invest money that is both tax-free on the way in and out of an account. This is one of those perks of being in the military.

Summation

My reason for writing this article was to point out one of the main differences I’ve noticed between the “mainstream” FI community and those of us in a Golden Albatross scenario. Specifically, I wanted to inform future pensioners who intend to leverage their pension to achieve FI that our planning considerations are a little bit different. This was not meant to be a rebuttal of FI or one of its core principals: aggressive but legal tax avoidance. I embrace both ideas fully and wish I had discovered each earlier. However, the max-the-tax deferred TRA method most FI acolytes espouse is not a one size fits all prescription. It works for the majority of FI followers, but not necessarily for those of us who will earn a pension. Determining which option is better comes down to a far more individual set of circumstances than any cookie cutter approach could address. Thus, I reiterate my recommendation to talk to an accountant or a tax expert in order to get your plan correct.

With that said, please lend your scrutinizing eye to my ideas regarding the Roth, and let me know if you see a flaw in either my knowledge or logic. I do not claim to be a tax expert or a professional advisor, just a guy who has researched this issue a good bit — as well as one who made a lot of tax mistakes and learned the hard way (by paying the IRS a lot more money than necessary). My arguments seem logical and fact based to me, but they may not be correct.

Class dismissed! …. you can queue the Van Halen music now.