The $250,000 Mistake Most Retirees Never Know They Made

Tyler Gardner (0:00)

The retirees who do this well don't have better portfolios than retirees who don't. They have a better practice. The same way that some people have a journaling practice or a meditation practice, they have a tax practice. And man, does it compound over 30 years into hundreds of thousands of dollars of difference. This is the part the financial industry has done a terrible job of selling. The annual tax practice is the highest ROI work a retiree can do.

Hello friends, this is Tyler Gardner, welcoming you to another episode of Your Money Guide on the Side, where it is my job to simplify what seems complex, add nuance to what seems simple, and learn from and alongside some of the brightest minds in money, finance, and investing. So let's get started and get you one step closer to where you need to be.

Quick note before we dive in. August pre-order incentive for my book Real Wealth is now live, and this one is my favorite so far. Pre-order this month, tell me you did at tylergardner.com/book, and I will send you a draft chapter of a new book that I'm already working on. And no, not even my editor at Norton has seen this writing yet. This sneak peek is yours to keep, delivered to your inbox in early September. Pre-order today, and you're locked in for every monthly incentive through December 1st. tylergardner.com/book. Now let's get into it. Several years ago, I sat down with a very nice retired couple. Let's call them Jim and Linda, because every example couple in personal finance is named Jim and Linda. Now, they came to me convinced they had done everything right. They had saved aggressively, they had maxed every tax-deferred bucket the IRS had ever invented, and by the time they walked into the meeting, they had about 3.5 million in a traditional IRA, 180,000 in a Roth, and a paid-off house. Jim was 71, Linda was 69 They both looked at me with a kind of calm financial satisfaction that comes from doing 35 years of correct things in a row.

And one of the first questions I asked them is, have you done any Roth conversions? They had not. We did a quick calculation on a notepad. I told them, as gently as I could, that they had just spent the last six years, the years between Jim's retirement at 65 and the RMD start at 73, sitting on top of the single greatest tax arbitrage available to retirees in the modern US tax code, and they hadn't quite taken advantage of it. Conservative estimate of the missed opportunity, just in undone Roth conversions during those six years, somewhere between $180,000 and $250,000 in lifetime federal taxes that were now going to be paid for absolutely no good reason, except that nobody had ever taught them how to do Roth conversions. Linda looked at Jim, Jim looked at me, the room got a little quiet.

Welcome to part three of the Decumulation series, and it is, by my count, the most expensive episode you will listen to all year. Not because it costs you anything, as always, this is all free, but because the cost of not understanding what's in it, compounded over the rest of your life, is actually staggering. Today, we're going to address three topics that very few people I know explain properly and simply. Roth conversions, RMDs, and the Irma Cliff. So, sit back, you might want to bring a pen, maybe a glass of wine, and I'll do my best to simplify what needs to be simplified.

Part one, why your traditional IRA is a beautiful thing for both you and the IRS.

I want to start by reframing how you think about your traditional IRA, because the standard framing is kind of wrong, and the wrong framing leads to the wrong decisions for 30 straight years.

The standard framing, and I've been very guilty of this, goes like this. Ooh, my traditional IRA is worth $1.2 million.

Therefore, I have $1.2 million.

I am a person with $1.2 million in retirement savings. And this is, I'm sorry to report, not quite true.

What you actually have, if your traditional IRA holds $1.2 million, is, depending on your future tax brackets, somewhere between $720,000 and $960,000 in spendable money.

The rest belongs to the federal government. They just haven't asked for it yet. You're holding it for them. You are, in fact, a slightly fancy escrow account on behalf of the US Treasury and the Treasury will eventually send someone over to collect. You might have heard others refer to this as the wrapped tax bomb, and I think it's the single most useful mental model for understanding traditional IRAs. Every dollar in there is going to be taxed at your ordinary income rate the moment it comes out. Not your cap gains rate, not some special retirement rate. Your full, regular, no discount, no coupon, ordinary income rate. Whatever the tax brackets look like in the year you withdraw, that's the rate. And unfortunately, we don't have control over what those rates might look like in the future. This matters because most retirees look at their traditional IRA balance and they feel rich. And they are. Just not quite as rich as the screen suggests. The screen is showing you the gross. The IRS is collecting the difference between the gross and the net, and the longer you wait, the bigger that difference tends to get. Because the money keeps growing, which means the tax bomb keeps growing along with it.