401(k) Millionaires: Here’s How to Avoid Going Broke in Retirement

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. Becoming a 401(k) millionaire requires decades of hard work and sacrifice. Previously, a seven-figure nest egg shone as the gold standard among retirement planners, but the shine has dulled as a portfolio of that size no longer guarantees the same security. What steps should you take to protect your savings and avoid going broke in retirement? Sheryl Rowling has a list of tips. The certified public accountant is the editorial director of financial advice for Morningstar. Welcome back to the podcast, Sheryl.

Sheryl Rowling: Thank you. I’m excited to be here.

Hampton: I’m glad you’re here. You’ve recently written about the do’s and don’ts for a seven-figure retirement portfolio. Why do you think a million-dollar nest egg requires financial finesse and strategy?

Rowling: Well, first of all, I want to say that if you’ve managed to save a million, or two, or three million for retirement, you’ve done a great job. Having said that, it doesn’t mean you can just sit back and spend money and not pay attention to it. That is enough money to retire on comfortably, but you have to pay attention to withdrawal strategies and taxes.

Hampton: Let’s get into what retirees should do. Talk about why the period from the time they retire until they’re forced to take required minimum distributions is important.

Rowling: Yeah, this is a really great opportunity that a lot of people don’t pay attention to. These days, when people retire, they retire at 60 or even 65; you don’t have to take required minimum distributions until 73. If you’re not taking retirement distributions, and you’re not getting wages, and especially if you’re not getting Social Security yet either, you probably have very low taxable income. When you have very low taxable income, that gives you a unique opportunity to convert some of your IRAs to Roth. The big advantage of that is you can do some of these conversions each year and pay little to no tax. Once your IRA is converted to Roth, you have two really big advantages. First of all, you never pay tax on the principal or earnings again. Second, it doesn’t count toward a required minimum distribution. It reduces your required minimum distributions.

By being aggressive during these tax-valley years of having lower income, you can convert a lot of your big income coming up at age 73 to Roth and get a permanent benefit that will last throughout your lifetime.

Hampton: Now the tax and spending bill lifted the state and local tax, or SALT deduction, to $40,000 for taxpayers bringing in less than half a million dollars. How can they leverage this tax write-off?

Rowling: Well, $40,000 is a huge increase from what used to be, which was $10,000, especially if you’re in a high-tax state like California and New York. Being limited to $10,000 meant a lot of people could not itemize deductions. With a $40,000 write-off maximum on your state and local taxes, it gives you the opportunity to itemize. It’s very important to pay attention to that $500,000 number. If you’re at $499, $999, you can take the $40,000. If you’re at $500,001, you can’t take the $40,000. You have to be careful about where your income lands.

Hampton: Just two pennies more made a difference.

Rowling: Exactly. Exactly.

Hampton: Now, a cash bucket can shield retirees from having to withdraw from their portfolios during a market downturn. Where can they stash their cash to cover their everyday needs?

Rowling: Well, I personally like to stash it in a savings account or money market that’s earning a decent interest rate. You don’t want to invest your emergency cash or your ongoing cash needs bucket because you’re going to be withdrawing from it regularly. The key to having a bucket like that is that you can be pulling cash from that as you need it to cover your lifestyle expenses without having to sell when there’s a market dip. You’re not taking a risk on your portfolio having to sell when the market’s down just to fund your monthly expenses.

Hampton: Well, let’s pivot to the don’ts for a million-dollar retirement portfolio. How can early overspending ruin a lifetime of careful saving?

Rowling: Well, it’s a difficult transition for many people when they’ve spent their whole life saving and building up their portfolio. When you’re adding money regularly to your portfolio, you can kind of make up for little mishaps along the way. When you’re retired, you’re not putting money in. If you spend too much in the early years, your portfolio doesn’t have enough room to grow to handle you for the later years. You have to be careful not to grossly overspend in the beginning.

Hampton: Now, big portfolio withdrawals or aggressive Roth conversions could trigger higher Medicare premiums. Can you explain?

Rowling: Yes. There’s something called IRMAA, which looks at how much you should pay for your Medicare premiums, and it’s based on your income from two years ago. If you do aggressive Roth conversions that boost your income up by a large amount, you could end up paying higher Medicare premiums down the road. When you’re looking at converting to Roth or recognizing significant income, you should really work with your CPA to make sure that you’re balancing tax savings from one side with possible increased Medicare premiums down the road.

Hampton: I just want to mention that you are a CPA, so you stay up to date on all this.

Rowling: I do. I do.

Hampton: Another misstep could leave heirs with a hefty tax bill if pretax retirement accounts hold a significant amount of wealth. How do retirees fix this, Sheryl?

Rowling: OK. Well, what happens is if you have a large IRA and you pass away and you leave that to your child, your child has to take out the money over 10 years.

They can’t keep it beyond 10 years, and they have to pay ordinary tax on it. If your child inherits a million-and-a-half-dollar IRA, they have to take out an average of $150,000 every year, assuming it doesn’t grow during that time. And $150,000 of ordinary income can push them into a higher tax bracket. You have to think about how you are going to leave money to your heirs. If you leave IRA money to charities, they don’t get a tax haircut. If you leave stock and securities or your house to your heirs, that gets a basis step-up, so if they sell it right away, they pay no tax whatsoever. Being careful about what you leave to your heirs and also working on those Roth conversions can help prevent your heirs from having to pay tax later on.

Hampton: Explain why it’s beneficial to shift a portfolio’s asset allocation in one’s golden years.

Rowling: Well, typically when you’re younger, you have a more aggressive asset allocation, and that’s because, again, you’re earning money, you’re adding to the portfolio, you can handle volatility, and so you’re going to have a more aggressive allocation with a greater percentage to stocks and equities. As you get older and you’re pulling money out, that volatility can really hurt you. If the market drops, you don’t have as much to build back with. Reducing volatility is important by including a higher proportion of bonds in your portfolio. You want to be careful not to be overly aggressive, but you also don’t want to be overly conservative because you want to keep up with inflation. This is where getting the advice of a professional is a good idea, but generally the older you get, the more bonds should be in your portfolio.

Hampton: As we wrap up our conversation, what are the takeaways to preserving a seven-figure nest egg?

Rowling: I think the biggest takeaway is that you shouldn’t assume that it doesn’t need attention. When you’re looking at how much taxes can take away, it could be 40% or more. Doing things in a tax-smart way can save you a lot of money. You want to make sure you’re working with a CPA that can help you with yearly Roth conversions, and you want to make sure that you’re working with an investment advisor that can implement tax strategies when managing your portfolio and helping figure out your withdrawal strategies. Add to that being aware of how much you can comfortably take each year. If you carefully manage your portfolio, it will last you through retirement and provide for your lifestyle. If you assume everything’s going to be OK and pull money out blindly, you could be in trouble.

Hampton: A lot of great tips. Thank you, Sheryl, for helping current and future 401(k) millionaires.

Rowling: Thank you so much, Ivanna.

Hampton: That wraps up this week’s episode. Thanks for making this show part of your day. A couple of reminders: Give Investing Insights five stars on Apple Podcasts to help others find the work we’re producing for you, and subscribe to Morningstar’s YouTube channel to watch new videos from our team. Thanks to senior video producer Jake Vankersen and associate multimedia editor Jess Bebel. I’m Ivanna Hampton, editorial multimedia manager at Morningstar. Take care.