The Thinking Person’s Retirement Choice

Quick: How do you set your annual retirement savings goal?

Very wealthy households usually seek professional assistance. Once you get to the point where planning for estate tax is an issue – when you and your spouse expect to leave more than $11 million in gross estate – it’s indispensable, since you must juggle multiple types of tax.

But if you’re like most people, you base your savings on a combination of IRS contribution limits (for IRAs), 401(k) employer matches (if you’re employed) and rules of thumb, such as 10% of pretax income.

A recent study found that most American retirement savers do exactly that. They let the system decide for them how much to save based on the tax rules and their employers’ whims.

That’s understandable. But the interesting fact is that they do so regardless of the type of savings vehicle they use… with remarkable results… results that provide a fascinating free lesson in retirement planning.

To Roth or Not to Roth: That Is the Question

IRAs and 401(k) plans come in two flavors: traditional and Roth. Contributions to the former are tax-exempt – i.e., you don’t pay tax on the income you set aside for them. Your accumulated contributions plus investment growth are taxed when you withdraw them in retirement.

Since the IRS gave you a tax break when you saved into a traditional vehicle, it insists on its pound of flesh when you retire in the form of annual required minimum distributions (RMDs). Those can create massive headaches and tax complications for retirees.

Contributions to a Roth vehicle, on the other hand, are subject to tax… but the proceeds are tax-free when you retire – and there are no RMDs.

At the level of logic and math, the decision to go the traditional or Roth route should depend on a combination of your cash flow needs during your working life and your expectation of future tax rates.

All else being equal, if you need more money now and/or expect taxes to remain the same or fall in the future, you’d go the traditional route. If you can spare the extra tax now and/or expect tax rates to rise in the future, you’d choose Roth. That’s because if you expect future taxes to be higher, it makes sense to pay them now when they’re low.

Dumb Luck

In 2017, a married couple filing jointly can contribute a maximum of $11,000 to their IRAs, whether Roth or traditional. Contributing to a traditional IRA lowers their current tax bill; they’ll pay later. Contributing to a Roth leaves it unchanged, but future withdrawals are tax-free.

In theory, that sets up a complex net present value calculation of current versus future income, tax rate expectations and other factors.

But most Americans don’t think about that. They contribute the same amount whether it’s to a traditional or Roth vehicle. As Harvard Business School researchers found, that’s because they simply save according to the IRS maximum, whether it’s a traditional or Roth IRA.

If they have a Roth IRA, this accidental choice creates a huge unintended retirement windfall.

Let’s say the couple saved $5,000 a year in an IRA for 40 years, earning a 5% annual return. Their balance at retirement will be more than $600,000.

If the IRA is a Roth, the full balance is available for their retirement spending. If it’s traditional, taxes are due on the balance.

Let’s say their tax rate is 20% in retirement. That’s what they’ll pay on withdrawals from their traditional IRA – which they must take whether they need them or not, due to the RMD rules.

If they opt for a Roth, on the other hand, their taxes will already have been paid, and they’ll enjoy $120,000 extra spending power in retirement – about $700 a month more.

A No-Brainer

I’ve said it before, and I’ll say it again: U.S. income tax rates will be higher in the future. That makes a Roth IRA a more sensible choice.

Our current income tax rates are the lowest in over a century. Our national debt is enormous and growing. Those in charge of the federal government show no signs of reining it in – quite the opposite. The population is ageing, but retirement benefits are politically sacrosanct. Our national infrastructure requires urgent and expensive repairs. And so on.

Want to Build Your Net Worth? A Two Concept Approach

Last week I was reading a social media post where the author wanted to learn how to increase their net worth. This 20 something wanted recommendations of what do now and in the future to ensure a comfortable retirement. The general consensus was purchasing assets which would rise over time. I noticed one of the things overlooked in the replies was which assets to buy now that would only appreciate.

First, we do not know which asset classes, businesses, metals, or exotic investments are going to grow. There is a long accepted warning the financial industry provides which goes like this, “past performance does not predict future returns”. If we do not know which assets will grow and past performance does not predict future returns then how does one build wealth? It is really simple and predicated on two things. The first is a budget and second is compounding interest.

Before we go any further let’s perform an exercise. Take out a sheet of paper and draw a line down the middle. On the left, write down your assets. These are possessions you own including banking accounts, investments, and properties. On the right, list your liabilities. These are things you owe money for such as a car, line of credit, student loan, or mortgage. If the total on the left is greater than the right you have a positive net worth. If the total on the right is greater than the left you have a negative net worth.


Budgeting is the most integral part of a household’s financial success. Budgeting is not just for poor people or those living paycheck-to-paycheck. I have heard this misconception many times and refute it with passion! Melissa and I were married in 2005 and did not budget. We had no clue where the little money coming in was going. Five years later we created an annual budget on an excel spreadsheet. Every January we sat down for an hour reviewing our income, projected bills, and goals for the year. We became more efficient but our annual savings was not congruent with projections.

The best way to stir curiosity is with facts. Facts motivate and provide substance about why to make a change. With that being said, this is not a comparison. The following information is a simple case study of one Upper Midwestern middle class household.

In full transparency I calculate savings rate as gross income after federal and state taxes have been deducted. It is difficult to control what Uncle Sam and your state take from each paycheck. To demonstrate why using a budget is so important I would like to provide some facts. Using an annual budget, we saved 32% of our income. The last year we did this was 2015 and over the preceding three years our prognostications were not reality. We were not doing a monthly zero based budget. One year ago, we started, and our savings rate increased by 15%. We are able to allocate 47% of our income towards giving, retirement planning, vehicle sinking fund, principle only mortgage payments, and college savings. If you are surprised about the difference so was I. Simply put, we became more efficient with our finances.


Compound interest is crucial to building net worth. In fact, Albert Einstein coined it the 8th wonder of the world. Compounding can work for or against you in the form of interest on debt or growth of an investment. My favorite metaphor is an anvil and rabbit.

Imagine debt as an anvil. It is bulky, heavy, and impedes free movement. Contrast the anvil with the remarkable reproductive capacity of the floppy eared mammal known as Mrs. Rabbit. A rabbit can produce 1-14 bunnies per litter and their gestation cycle is 28-31 days. Rabbits can be impregnated within minutes of giving birth and have a litter every month. Thankfully someone has calculated that one female bunny starting at 6 months and plugging away for seven years could have a family tree of 90 billion! Now it is not probable that any reader here will ever amass billions of dollars but just in case we accept donations.

The following two scenarios are provided to illustrate the effect of compound interest. Constants for this exercise are compounded annual growth rate (CAGR) of 8%, savings rate of $1,000 per month, and retirement age of 65.

As mentioned previously, compounding can work against you in the form of debt. Let’s assume all readers are fiscally responsible and using compounding to their advantage. What I hope is taken away from these two scenarios is the time value of money. Another useful topic is the rule of 72 which we have discussed in the past.

Scenario 1

Bob, Bill, and Brad all contributed $1,000 per month until retirement but they started at different ages. Bob’s nest egg vastly out gained Bill and Brad’s because of time. Are you surprised by the $2.4 million dollar difference between Bob and Bill’s nest egg? Brad would have needed to invest $5,000 per month for 23 years to come near Bob’s nest egg. By doing this he would have come a little short and his total contributions would have been $1,000,000 more!

Scenario 2

Bob’s early start is once again evident. He is able to generate a nest egg of ~ $4,000,000 and cease investing 15 years prior to retirement. It is interesting to look at Bob’s situation in each scenario. There is only a $350,000 difference in the accounts and a total contribution difference of $180,000. It is difficult to start investing early but these examples solidify the importance of getting an early start. If Bob decided he wanted to retire early, he could take his nest egg and live a life of minimalism.


Finally, I hope you found today’s post valuable. Behavior is the single largest predictor of success with money. Of course, knowledge is important but delayed gratification and identification of need versus want always produces superior results. It is never too late to implement these recommendations. I do not care if you are 10 or 30 years from retirement, it is never too late to budget monthly and put your money to work.

If you are married with separate finances this is for you. If you want to strengthen your relationship, work on money matters together. Yes, this means combining your finances. I get it, one of you is a saver and the other a spender but that is not the point. Communication is imperative in a relationship and working together will create dialogue about fear, anxiety, life goals, and aspirations.

Forget Social Security: Start a Kiddie Roth

If you’re at or near retirement, you’ll almost certainly get the Social Security benefits you’re due under federal law.

That’s because even though the Social Security system is long-term insolvent, you are very special to an important group of people.


Older Americans are the country’s most powerful single voting bloc. Their turnout is higher than any other age group. They pay attention to policies that concern them, and vote accordingly. They show up to town halls, and they speak freely.

Having a wizened granny shouting at you for plotting to take away her retirement money is terrible optics.

That’s why every proposal to “reform” Social Security exempts people born before a cutoff date calculated to keep older voters happy. They’ll get their Social Security.

But what about their grandkids?

The $7,000 Baby

According to a proposal I saw recently, if the U.S. government deposited $7,000 into an individualized retirement account whenever a baby is born, with no further contributions, every newborn would be able to retire reasonably comfortably.

If that $7,000 earns the average projected return of the nation’s public pension plans until our babe in arms is 70, the account will hold almost $1 million. That’s enough for a retirement benefit of $73,000 a year in today’s dollars for 23 years.

There are several problems with this proposal.

Bad things could happen in 70 years. In fact, according to Murphy’s Law, they will happen. Some of those things might disrupt this well-laid plan.

That’s one thing to worry about.

More important, however, is the fact that today’s politicians won’t do this because babies don’t vote. And their parents have low turnout rates in congressional elections. There’s just no political incentive to do anything this clever.

But the underlying principle is sound… and it’s available to you to implement right now.

Social Security, Family-Style

Anybody with an income can open a Roth individual retirement arrangement (IRA). A 14-year-old working her first summer job cutting the neighbors’ grass can do it – no problem. Even if the kid earns just $1,000 over the course of the summer and puts it into her Roth, it will compound powerfully as the years go by.

Of course, no kids do this… at least I haven’t come across any.

Like politicians… like any of us… kids have a powerful bias for the present. They want to use that $1,000 for something cool right now, not to pay for orthopedic shoes and oat bran when they’re 70.

But as a parent – or especially, as a grandparent – you know it’s a great idea. You can feel in your bones how great it is because you’re living right now with the consequences of decisions you made decades ago.

So here’s a nifty idea.

If you are able to do so, help your progeny open a Roth IRA in their name. As they earn income over their teen years and 20s, contribute to it on their behalf.

Federal law determines the amounts of those contributions. First, if your grandchild (for example) earns $3,500 over the summer, you can only contribute up to $3,500 to their IRA. Nobody can put more into an IRA than they earn in a year. Second, you can only contribute up to the IRS maximum, which is $5,500 for 2017.

If you did this for, say, 10 years – from age 15 to 25 – you could ensure that the kid retires a millionaire (assuming, of course, that he or she doesn’t blow the IRA before then, but that’s a different parenting issue).

Let the IRS Fund Your Grandkids’ Retirement

The nifty thing about this little plan is that it can leverage tax laws in a unique way.

Under the tax code, the contributions you make to someone’s Roth IRA are gifts, but they are exempt from gift tax. And as long as they don’t exceed $14,000 in a calendar year ($28,000 for couples), such contributions don’t eat into your lifetime gift/estate tax limit (currently $5.49 million).

And because they are gifts, your “kiddie” Roth contributions aren’t considered part of the recipient’s annual taxable income. So when you contribute to a Roth IRA for a youngster, they benefit twice: first, by receiving a tax-free gift that will grow over the years, and second, by not having to pay the income taxes that would normally be due on Roth IRA contributions.

If you want to be really clever, make your kiddie Roth contributions from your Social Security income… that way, the benighted system will benefit your grandkids even after it’s long gone bankrupt.