There are many methods available to right-size a bloated 401k or IRA account and beef up your Post-Tax asset.
Tax buckets may be categorized as Taxable, Tax-Deferred, Pre-Tax, or Post-Tax accounts. Account examples and tax treatments are summarized in the table below. Detailed account characteristics are captured in “Tax Treatment of Investment and Retirement Accounts.”
Tax-free retirement can be achieved by optimally allocating your savings during your working years between the various tax buckets (refer to the article “A Framework for a Tax-Free Retirement”). However, even if they are so allocated, the assets can still be reallocated using the methods described below.
Roth Conversion: This allows assets to be moved from a Traditional IRA to Roth IRA. The process is simple; however, the converted amount is added to the current year’s taxable income. Hence, to avoid a large tax bill, convert smaller amounts over multiple years. For example, convert an amount that, when added to your taxable income, will only take you up to your current tax bracket limit.
After-Tax 401k Rollover: Unlike a regular 401k, the After-Tax 401k contribution limit is quite high at $57K for 2020 (this limit is inclusive of employee contribution and employer match made toward a regular 401k). Not many companies offer an After-Tax 401k, but it is an effective way to beef up Post-Tax assets. Avoid the pro rata rule by diverting After-Tax contributions and earnings to Roth and Traditional IRAs respectively. The contributions are post-tax; hence they can be immediately rolled over to a Roth IRA if the company offers an in-service rollover option.
SEPP or 72(t) Distribution: Substantially Equal Period Payments allows penalty free withdrawal from a Traditional IRA account prior to someone turning 59.5, provided the withdrawal is taken for at least 5 years or until the person turns 59.5, whichever is longer. Ordinary income tax is still owed on the entire withdrawal. The withdrawal amount is calculated using one of three methods, of which the Amortization method typically yields the highest value. The annual withdrawal amount is ≈3-5% of Pre-Tax account value, depending on age.
IUL Investment: An Indexed Universal Life policy allows you to participate in the market growth (subject to some caps) but with principal protection. The premiums paid into the policy come from a Taxable account but once inside the IUL, the asset grows and can be used tax-free just like a Roth IRA. Refer to “How IUL Works” and “Mechanics of IUL” for a more in-depth discussion of this topic.
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