Personal finance: The Myth of IRA retirement accounts

In the 1970s, about 70% of retirees had pensions.

Today about 14% of retirees have a pension.

Congress enacted legislation to create IRA and later 401(k) and Roth accounts. In IRA accounts, workers could contribute a small amount for retirement. The funds would grow within the account, tax free, until withdrawn in retirement. Then, the withdrawals would be treated as ordinary income and taxed as ordinary income.

The theory at the time was that “in retirement” our incomes would be less and thus our future taxes would be less. But inflation pushed everyone’s income (and expenses) up into higher tax brackets. The effect is that IRAs may not have been the tax advantaged retirement investment for many.

401(k)/Roth plans were contributions made after taxes – and would be tax free when withdrawn in retirement. Wage earners could deposit much higher amounts of money than allowed for IRA accounts. Roth accounts came later – and unfortunately many of us did not know about the tax consequences after dutifully doing what “experts” told us to do. We should have converted old IRAs to Roth plans long ago. Our mistake. IRAs were not convertible to Roth accounts until around 2010/2011. (In my case my mother’s health was going downhill and she passed away in 2012 and I was unaware of this new option, and shortly afterward we moved – which was the most difficult move we’d ever done. This was the short window we should have used to convert the IRA to Roth because of the future Medicare premium impact this conversion would have …)

IRA to Roth Conversions Can Increase Medicare Part B Premiums – and your tax bracket

There is a double whammy about “tax free” IRA accounts – Medicare premiums are based on your income. If you saved for retirement using an IRA, you will have to do some large withdrawals every year – by around age 73, you are mandated to withdraw funds. These withdrawals increase your income – which potentially raise your monthly Medicare Part B premiums far higher. A “feature” that no one told younger workers who were encouraged to set aside funds in IRA accounts.

It’s not just paying the taxes on past IRA growth – you have to pay higher Medicare premiums which can be considerable – and the effect can last for years.

Once you hit a higher income threshold, Medicare “locks” you into the higher premiums for two years, even if withdraw all of the IRA account in one year.

Retirees should instead start the conversion process much earlier

1. Begun converting their IRA accounts to Roth accounts starting at age 59 and 1/2 when money can be withdrawn from IRA accounts without penalty.
2. Withdraw as much as possible by age 63 – Medicare looks back 2 years to determine your Medicare premium at age 65.
3. If you have large assets to sell, such as planning to sell your home, this too impacts your Medicare premium for 2 years. If possible, sell by age 63.

If you reach age 65 without having done this, your next option is to try and sell everything at once and convert your IRA to a Roth plan – all at once – and take the financial hit on Medicare premiums for two years, after which they will revert back to earth.

EXCEPT – this may (and likely will) move you into a much higher Federal tax bracket. While good for your Medicare premiums (only a 2-year impact), you may pay much higher Federal taxes when you do this.

The original IRA – while it deferred taxes on capital gains/interest while held – the effects on taxes and Medicare premiums once retired may eliminate the promised tax savings. Further, for some, who may now live in a high tax state – and will owe not only Federal taxes but also high state taxes. (In our situation, a back of the envelope calculation suggests we could see, between Federal and State taxes, plus higher Medicare part B premiums – a tax rate approaching 30-40% – literally, handing over up to 40% of over IRA “retirement” savings to the government. We are considering moving to a lower tax state – there are many such options to choose from.)

Indeed, today’s recommendation is to NOT use IRA accounts:

Financial planners generally recommend Roth savings for workers who are likely in a lower tax bracket now than when they retire, like young people who are early in their careers

401(k) contributions: Most companies now allow Roth savings

Bottom Line

If you have an IRA, convert it to a Roth a least 3 years before you turn 65. Medicare Part B premiums are based on your prior 2 years income when you turn 65. By converting early, you are back to your “regular income” 2 years before turning 65 and getting on Medicare.

From AI Assistance:

Concerns About Traditional IRA Accounts

The Traditional IRA was designed to provide workers with a tax-advantaged way to save for retirement. However, the mechanics of taxes and income in retirement have led to significant concerns, which some individuals view as manipulative or problematic.

Tax Implications and Brackets

1. Changing Tax Rates: Traditional IRAs allow for tax-deferred growth, but withdrawals are taxed as ordinary income. For retirees, this could mean that they find themselves in higher tax brackets due to:

• Inflation: The cost of living rises, which can cause nominal income to increase even if purchasing power remains the same.
• Withdrawal Strategy: Cashing out a significant amount at once can push retirees into higher tax brackets.

1. Perceived “Tax-Free” Status: The expectation that retirees will pay lower taxes is often based on previous income levels. Reality may not align, leading to potential disappointments in the anticipated tax burden.

Medicare Implications

1. Income-Related Monthly Adjustment Amount (IRMAA): Withdrawals from IRAs increase reported income, impacting Medicare premiums:

• Medicare uses one’s modified adjusted gross income (MAGI) from two years prior to determine premiums.
• Sudden large withdrawals can cause retirees to face significantly increased premiums for their Medicare Part B and Part D plans.

1. Financial Strain: The combination of increased taxes and higher Medicare premiums can diminish the purchasing power of retirement savings. Many retirees may find their actual resources for living expenses are less than expected.

Summary of Pros and Cons

Conclusion

While Traditional IRAs can still serve as effective retirement savings tools, they come with challenges that require careful planning. Rising tax brackets, inflation, and increased healthcare costs can significantly affect the perceived benefits of these accounts.

It’s advisable for individuals to consult financial advisors to develop strategies that minimize tax impact during retirement and optimize their withdrawal methods.