Pensions. Remember those things?
No? Well then gather round, young Millennials. It’s Story Time!
You see, back in the days of yore (i.e. the 60’s), companies had these magical things called “pensions” that they offered to their employees as part of this other magical thing called “benefits.” I know, I know, it sounds crazy but it was a different time. I also think cars worked by sticking your feet through the bottom and running on the pavement back then.
ANYHOO, here’s how these things worked. The employer would automatically take a small contribution off their employee’s paycheck (pre-tax, of course). Then a professional money manager would make all the investing decisions for them. Finally, when the employee retired at 65, this “pension” would pay a part of their salary to them for the rest of their lives. This all happened automatically, of course, with no effort needed by the employee! Retirement planning was, for the most part, just taken care of for them.
I know, I know. Stop laughing. It was a different time!
In case it isn’t glaringly obvious, pensions have gone the way of the dodo, along with “stable employment” and “work-life balance.” Nowadays, defined-benefit pensions mostly exist in government jobs. The private sector, having realized how bloody expensive it is to run a pension, has mostly switched from a defined-benefit system, where your income in retirement is guaranteed by the company, to a defined-contribution system, where they MIGHT provide some 401(k) contribution matching, but the onus of properly investing and managing your retirement income falls onto you, the employee.
So if pensions by and large no longer exist, why am I talking about them at all?
Well, for some strange reason, we’ve recently gotten a string of emails from readers who a) are Baby Boomers with pensions, b) are retired or nearing retirement, and c) wondering how our 401(k)/RRSP withdrawal strategy would work for them.
I never turn away a good question, so despite the fact that we’re mostly concerned about millennials and the issues we face, I thought it would be interesting to MATH SHIT UP on a Boomer facing regular retirement.
How to Withdraw From Your 401(k)/RRSP
So first things first, what 401(k) withdrawal strategy are these Boomers talking about?
Obviously, we wrote about this before, but let’s do a brief recap here.
When you’re working, it pays to contribute money from your paycheck into your 401(k) or RRSP. These are both pre-tax retirement savings accounts, and allow you to defer your taxes by reducing your taxable income by the amount that you contributed.
Note that I said defer, not eliminate. When you later withdraw money from your 401(k) or RRSP, that amount withdrawn gets added back to your taxable account, and could potentially cause you to pay taxes on that withdrawn amount.
So in early retirement, our 401(k)/RRSP withdrawal strategy is to withdraw from these tax-deferred accounts in such a way that you pay no taxes at all. For RRSPs (which are Canadian), this means withdrawing from your RRSP accounts each year the value of your personal exemption, which is a tax credit that every Canadian gets automatically that offsets your tax liability to 0. Americans with 401(k)’s (or similar accounts) have to jump through additional hoops because they’re restricted from accessing their accounts penalty-free before the age of 59 1/2, so to get around this they have to construct what’s known as a 5-year Roth IRA Conversion Ladder. Click that link to learn exactly how to do this.
But for Americans, the strategy is basically the same: Withdraw/convert as much as your standard deduction, which for some reason as of 2019 is the same amount as the Canadian personal exemption: $12,000 per person. So a married couple filing jointly could withdraw $24,000 from your 401(k)/RRSP accounts, and pay zero dollars in tax!
How Does a Pension Affect This?
OK so how does a Boomer retiring with a pension affect this strategy. Well, first of all, a Boomer who’s close to retiring is likely over the age of 59 1/2, so they can just do a straight withdrawal from their 401(k) accounts without all that Conversion Ladder stuff since the age-based penalties don’t apply to them anymore.
And second of all, the withdrawal strategy I’ve outlined above assumed no other income. After all, you’re retired! You’re supposed to stop earning income from your job! That’s kind of the entire point of retiring.
Except if you have a pension, that breaks this assumption.
I know, I know. Tiny violin.
When you have a pension, you have an automatic, baseline amount of income every year, and that’s great. But it also pushes you into a tax bracket where you can’t get money out of your 401(k)/RRSP anymore for free.
As of 2019, here are the American federal tax brackets for joint married-filing-jointly couples.
|10%||$0 to $19,400|
|12%||$19,401 to $78,950|
|22%||$78,951 to $168,400|
|24%||$168,401 to $321,450|
|32%||$321,451 to $408,200|
|35%||$408,201 to $612,350|
|36%"||$612,351 or more|
So let’s say that someone has a pension worth $30,000 a year. That means that they’re in the “unfortunate” situation of eating up their Standard Deduction of $24,000 of tax-free income, which leaves them $6000 of income at the 10% federal tax bracket.
The preceding paragraphs has been corrected from an earlier version due to the eagle-eyed observations from reader MikeyB. Thanks!
That means that if this Boomer withdraws even a single dollar, they will have to pay taxes on it. And because this happens consistently each and every year, the option of withdrawing/converting money at the 0% tax bracket, as we advocate, is off the table.
So what do we do? Is our retiree screwed?
The Top Up Method
Of course not. Being forced to pay taxes because you make too much money in retirement is never a bad thing. But it does mean you can’t just blindly take out $24k every year and be done with it. You have to do a little more analysis.
Fortunately, the strategy isn’t that hard. I like to call it The Top Up Method.
Here’s how it works.
- Add up you and your spouse’s annual pension payout
- Figure out which tax bracket this puts you in.
- Take the upper limit for that bracket, subtract it off your pension amount, and that’s how much you should withdraw from your 401(k)/RRSP every year.
So for example, if our Boomer retiree couple had a pension worth $30k each year ($6000 after the $24k Standard Deduction(, by looking at 2019’s tax brackets, this would put them in the 10% tax bracket. The 10% tax bracket has a range of $0 to $19,400. So that means our retiree should withdraw $19,400 – $6,000 = $13,400 each year from their 401(k).
Why is this? Because if your pension by default pays you $30,000 each and every year, then the absolute minimum tax rate you can ever pay on a 401(k) withdrawal is 10%. So as long as you’re stuck paying 10%, you may as well get as much out as you can at that tax rate.
So in other words, whatever tax bracket you happen to find yourself in, Top Up (see what I did there?) the bracket you’re currently in. That way, you will withdraw as much as you possibly can at the minimum tax rate you possibly can. Just don’t cross the boundary into the next bracket.
What About State/Provincial Taxes?
My analysis here is using federal tax brackets, but so far I haven’t mentioned state taxes. Why is that?
To keep the lesson simple.
Wall Street loves to convince people that money management is complicated. They do this so you’ll hire them to manage your money. But the truth is, money management is not complicated. But there isn’t a one-size-fits-all solution. I like to teach the techniques, and trust the reader to apply them to their unique situation.
The Top Up Method is a great example of that.
State/Provincial income taxes add a layer of complexity onto the relative simplicity of the Top Up Method. Some states, like California, have a layer of progressive tax brackets that add on top of the federal tax brackets. Others, like Texas, don’t have a state income tax at all.
However, the technique remains the same.
- Add up you and your spouse’s annual pension payout
- Figure out which (combined) tax bracket this puts you in.
- Take the upper limit for that (combined) bracket, subtract it off your pension amount, and that’s how much you should withdraw from your 401(k)/RRSP every year.
And We’re Done
So there you have it. If you’re lucky enough to have a pension, figure out the minimum tax rate you can pay, then maximize the HELL out of that tax bracket you happen to be in.
That’s how a pension affects your 401(k)/RRSP withdrawal.
Questions? Comments? Let’s hear it in the comments below!
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