Surprise! Fritz here.
I know I said I was retiring from full-time blogging, but we’ve just started a two-month home expansion project (a 700 sq ft addition), and our house is a construction zone. My treehouse writing studio is an oasis from the chaos, so I’ve had some time to write. Here’s what our front hallway looks like at the moment (you can see why I’m hiding writing in my studio):
PS: You can watch the project’s progress on my Instagram or Facebook account, if interested.
Anyway….on to the post.
My Biggest Surprise in Retirement
If you’re a long-time reader, you know how much I planned for retirement.
That planning paid off.
My transition into retirement went smoothly (check out my Retirement Reality Series, where I journaled through the transition), and I’ve enjoyed the last 7 years more than any period in my life.
And yet, there’s one financial element that caught me by surprise.
Today, I’m sharing it with you.
I suspect you’ll be surprised, too…
I planned well for retirement, but this one financial element caught me by surprise.
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My Biggest Surprise in Retirement
I’m fortunate to have saved aggressively in my company’s 401(k) since I started my career at Age 22.
It’s what allowed me to retire at Age 55.
And yet, like many folks my age, those savings were predominantly in “Before-Tax” accounts in my company’s 401(k) plan. Sure, I got the tax break while working, and I felt like a genius. Besides, we didn’t have the option of investing in a Roth, so the decision was easy.
I knew those taxes would come due when I “got old,” but I’d worry about that later.
Later has arrived.
As I shared in my Retirement Drawdown Strategy, when I retired, we had 56% of our retirement savings in Before-Tax accounts, as shown below:
The Golden Age of Roth Conversions
Now that I’m retired, I’ve been laser-focused on doing annual Roth conversions to reduce that Before-Tax balance. As I wrote in The Golden Age of Roth Conversions, it makes sense to do Roth conversions in your early retirement years (be careful if you’re getting ACA subsidies, and ugly Aunt IRMAA can be a problem if you’re 63 or older). I won’t rehash the arguments for why; you can read about it in the linked article.
My goal is to manage the taxes on my terms, rather than being “forced” into whatever the Required Minimum Distributions rule requires in my 70s. I’d also like to get as much of that money converted into a Roth for the benefit of my wife, in the event I die early (she’d pay higher taxes as a single tax filer vs. our current “Married Filing Jointly” status). For now, I’m playing the tax bracket “stuffing” game (topping off my selected tax bracket with Roth conversions) and trying to be smart about minimizing the taxes I pay throughout my retirement.
The Bad News: The Roth conversions are not making as much of a difference as I had hoped.
And that, in summary, is my biggest surprise.
My Biggest Surprise in Retirement: It’s Hard To Reduce Your Pre-Tax Account Balance!
We’ve all heard about the power of compounding and how valuable it is in personal finance. If you want a refresher, check out my post, “The Most Powerful Force in the Universe.”
What I didn’t think about, and only realized after I retired and started doing Roth conversions, is the fact that compounding makes it difficult to reduce your pre-tax account balance.
Despite doing aggressive Roth conversions, our pre-tax balance isn’t coming down like I expected!
In fairness, part of that “problem” is driven by above-average returns since my retirement in 2018. First world problem, I know. But it’s still been a big surprise.
Let’s do a hypothetical example to demonstrate the point.
To make the math easy, let’s say you have $1M in your pre-tax account, and your first full year of retirement is 2019. If you had that entire $1M in stocks, here’s what would have happened without doing any Roth conversions (S&P 500 returns from ycharts, including dividends):
In this example, a $1M portfolio would have grown to $2.6M in 6 short years. That’s the power of compounding. Amazing!
Let’s modify the above example, and say you’re doing an annual Roth conversion of $50k.
How much impact would Roth conversions make? Not much…
Despite doing annual Roth conversions of $50k, the pre-tax value has still doubled, to $2.15 M!
A More Realistic Scenario – $500k
Ok, I hear you. No one has $1M in their pre-tax account. I got your attention, though, right?
Fair enough, let’s assume the starting balance is $500k (which compares nicely with the average 401(k) balance of $573k for folks in their 60’s):
The problem remains.
With a $500k starting balance and $50k annual Roth conversions, the account has still grown by $357k (to $857k), or 71%.
Bottom Line: It’s difficult to reduce your pre-tax account balance due to the power of compound interest.
In fact, the only way to reduce your pre-tax account is to do annual Roth conversions in excess of the annual return generated by the pre-tax portion of your portfolio. Sticking with the $500k example, an average annual Roth conversion of $89k would have been required to maintain the pre-tax balance at $500k, as shown below:
(Note: you could argue about my $0 Roth conversion in a down year, but it’s just an example. Quit whining and do your own math – wink.)
What About A 60/40 Portfolio @ $500k?
No one has a 100% stock portfolio in their pre-tax accounts, right? Let’s see what things look like if our retiree had a 60/40 stock/bond allocation in his pre-tax accounts. We’ll use the S&P 500 for stocks, and Vanguard’s Total Bond Market Index Fund (VBMFX) for bonds, we can find their annual returns here.
Without any Roth conversions, the account would have grown from $500k to $990k, as shown below:
Add in our $50k/year of Roth conversions, and the ending balance is $609k, an increase of 22%:
Bottom Line: Even with a 40% bond allocation, it’s difficult to reduce your pre-tax balance via Roth conversions.
We’ve done aggressive Roth conversions every year, yet I continue to be frustrated by how little we’ve moved the needle. In full transparency, we’ve reduced it, but only by 15% of its starting value. That’s far less than I would have expected, given the size of the conversions we’ve done.
I’m grateful, as I realize this “problem” is a result of a strong market through my first 7 years of retirement, but I still worry about those darned RMD’s. Perhaps a decade of 3% returns will help, but that’s not the type of help I had in mind. (BTW, that article, written in Jan 2025, seems a bit prophetic now…)
A Note About Asset Allocation “Location”
This is a reasonable place to mention which assets should be held in which type of tax-structured account.
One of the more advanced techniques (“tweaking”, some would say) for optimizing your portfolio is Asset Location Optimization, which focuses on putting certain assets in certain tax buckets to optimize after-tax returns. For example, since bond income is taxed at your nominal tax rate, it’s best to hold them in your Before-Tax accounts (which are taxed at your nominal rate when doing a Roth conversion/RMD/withdrawal). Compare that to stocks, which are best in your Roth, where the higher growth is tax-free.
Below is a chart summarizing the concept (I discuss this in more detail here):
When my investments were in a 401(k), the plan rules didn’t allow me to shift assets between account types, so I held the same asset allocation in both my pre-tax and Roth 401(k). One of the main reasons I said “Goodbye to my 401(k)” was to give flexibility to move asset classes within different tax-structured accounts per the above chart, which I’ve been doing since closing the 401(k) in mid-2022.
A note on nomenclature: “After-Tax” and “Taxable” are the same names for funds held in a taxable account (e.g., brokerage), and “Before-Tax” and “Pre-Tax” are the same names for funds deducted from your annual income when contributed (e.g., 401k or Traditional IRA).
Our Asset Allocation By Account Type:
As the table below demonstrates, while our overall portfolio is 66% stocks, our Roth allocation is 96% stocks (you want the highest growth in your tax-free account). Compare that to bonds, where our overall portfolio holds 16%, but our pre-tax bond allocation is 34% (you want bonds in pre-tax, where they’ll be taxed at your marginal rate). It’s not a perfect implementation of the table above, but we’re moving in that direction.
I should note that most of the 25% “Alternative” allocation in our pre-tax is in a REIT, which is similar to bonds from a tax perspective. I hope the lower allocation to stocks in our pre-tax account (44%) will help reduce the power of compounding and allow us to draw down the pre-tax balance more effectively via future Roth conversions.
A note about the taxable allocations: the 25% “Alternative” in our taxable account represents our second home in Alabama, which we include in our “spendable” assets since we could sell the property, if necessary, to fund retirement needs. Also, our taxable account’s 16% bond allocation is held primarily in tax-free municipal bonds.
The Difficulty of Covering The Tax Burden
A note about how to cover the tax burden associated with Roth conversions is in order.
To make the best use of Roth conversions, it’s best to cover the tax burden with taxable funds (rather than using some of the pre-tax money to cover the taxes). This maximizes the amount of money you’re moving into the Roth, rather than “diverting” some of those funds for taxes.
Sounds great in principle, but the second part of my “biggest surprise in retirement” is how much after-tax cash gets consumed paying those taxes on the Roth conversions. I always knew the tax would come due, but I didn’t realize how painful it would be. I’m committed to paying taxes with after-tax money to maximize the value of the Roth conversion, but it takes a lot of cash.
As you’re planning for your retirement, do not overlook the tax burden.
Every quarter, I wince as I send Uncle Sam my Estimated Quarterly Tax payment. I’ve enjoyed the benefits of tax deferral for 4 decades, but we can’t avoid the taxman forever. I’ve sized Bucket 1 in my Bucket Strategy accordingly, and we’re doing fine. But the impact of those taxes is easy to miss in your pre-retirement planning.
I take some solace in the fact that we’re (hopefully) being smart in managing our Roth conversions, and the result should be a lower tax burden throughout our retirement.
Pay them now, or pay them later.
The one fact is…you will pay those taxes.
No surprise there.
Conclusion
There you have it. My biggest surprise in retirement is how difficult it’s been to reduce our pre-tax account balance despite aggressive annual Roth conversions. I realize that’s primarily due to the power of compounding in a strong market, but it’s still been a surprise. Also, I knew the increased tax burden would consume a lot of cash, but “knowing it” and “living it” are two different things.
Dealing with drawing down your pre-tax accounts is a surprise you should be prepared for as you plan for retirement.
It’s not as easy as you think.
Don’t be surprised.
That’s it for now…time to head back inside and face the home expansion chaos.
Your Turn: If you haven’t yet retired, have you included tax impacts in your spending forecasts? If you’ve already retired, are you facing the same surprise that I am? Finally, would you be interested in an article about our home expansion project? Let’s chat in the comments…
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