Wow! Big news this week. It looks like we are about to see the largest retirement legislation in over a decade. One part of it will have a massive impact on almost every Oil & Gas retirees and Chemical retirees. Anyone in any industry that saves $2Million or more in a pre-tax account will be affected. This bill is one of the best examples of why financial planning absolutely must include estate planning and tax planning along with investments/retirement planning.

“The U.S. Senate is considering a bill that would tax Botox. When Botox users heard this, they were horrified. Well, I think they were horrified. It’s difficult to tell.” -Craig Ferguson

“Make sure you pay your taxes; otherwise, you can get in a lot of trouble.” -Richard Nixon

First, what is it?

What is the SECURE Act? SECURE stands for Setting Every Community Up for Retirement Enhancement. The bill covers a few different things:

-Multiple Employer Retirement Plans-Historically, massive corporations have had access to excellent 401(k) plans (meaning no extra fees for participants and plenty of low-cost funds available in the plan). Smaller companies have not had the same experience. It’s much more common to find fee-ridden 401(k) plans with expensive funds at small employers. This will help remedy that (hopefully).

-Potential for more annuity options in retirement plans. We’ll talk through annuities later. On the one hand, I’m skeptical of annuities being introduced to retirement plans with lower fiduciary standards.

-Ability to make IRA contributions past age 70.5

-RMD (required minimum distribution) age is moved back to 72.

-The “stretch” IRA provision is removed. This is a really big deal. The stretch provision allowed a beneficiary of an IRA to stretch out distributions over their lifetime (i.e. take a little bit out over 50 years). Now, most beneficiaries will have to liquidate the entire IRA they inherit within ten years.

Why it affects Oil & Gas retirees

The SECURE Act is going to generate a lot of revenue for the US government. This means those affected by it will see a tax hike. Who exactly are the ones paying for it? Anyone approaching retirement with more than $2Million in pre-tax assets.

Most Americans do not reach 2Million+ in their 401k because of the current benefit structure of their employer (well, that and because they’re not saving aggressively like this). What do I mean? The average 401(k) match is only 2.7%. Compare that to the typical Energy company. Houston has several major employers that put in 10-20% if the employee puts in 6-7% (sometimes much less). It goes well beyond just a 401(k). Whether it’s pensions, PWAs, stock plans with an NUA element, or just the sheer size of the 401(k) match (deferred comp can also play a tangential role here), Houston companies are putting in way more than 2.7%.

Result? If you work at a major energy company for ~30-40 years, you’ll likely amass a few million in pre-tax assets. Have two spouses working? Pre-tax assets can reach nearly 10Million.

Every industry has pros and cons for the path to success. If you’re in tech, most of your wealth is tied up in your startup. This brings with it a completely different set of estate, investment, and tax issues. If you work for a major Energy company, most of your wealth is usually tied up in pre-tax assets. The SECURE Act puts you right in its crosshairs. In order to avoid a significant tax increase in the coming decades, you need tediously plan prior to age 72. We’ll break that down below.

We’ve covered the why. So now, exactly how will it affect you?

So, if you’re nearing retirement age and are likely to have more than 1Million in pre-tax assets, here’s what will happen to you because of this new bill.

Throughout your life, the IRS will take a little bit each year once you reach RMD age. RMD=Required Minimum Distribution. When you turn 72, you’ll be forced to take out part of your 401(k) or IRA each year and pay taxes on it.

The much bigger issue is what happens to your beneficiaries. That is where Uncle Sam will rake it in. How? Well, let’s run a scenario.

Let’s pretend Clyde and Mary are retiring from Exxon this year. Their financial summary looks like this:

-62 years old

-2M in a pension

-2M in a 401(k), $800,000 of which is in XOM stock with an NUA opportunity

-$700,000 in after-tax investments and savings

-Primary home is paid off

-Kids (2) have graduated college and have started working

-They plan on spending about $100,000 each year

Most retirees in their position end up rolling over their 401(k) and pension into an IRA. Let’s assume Clyde and Mary, along with their advisor, properly navigate their NUA opportunity with $500,000 of their XOM stock. That leaves them with $3.5Million in an IRA. It’s important to point out that before this new tax bill truly affects them, they will have an impending tax bomb set to go off at RMD age. Why? Well, if their IRA grows at 7%/year, they could have $7Million by the time they’re 72. At this point, they’ll take out a small percentage (~4%) each year (RMD).

Now, let’s give an extremely brief overview of portfolio income history. You may have heard of the “4% rule.” Summary-if you take out 4% of your portfolio in year one of retirement and give yourself a slight raise each year for inflation, your portfolio should last and produce income for 30 years. This assumes a well-diversified 60% stocks/40% bonds portfolio. Over the last century, that portfolio has ended the 30 year retirement period with the same balance about 2/3rds of the time. Almost half the time, your portfolio would have doubled in value-all while giving you income each year for three decades! However, it’s still important to not take too much more than ~4.5%/year because if you start by taking out 6-7%, there’s a chance you will run out of money in a couple of decades. This is why you and your advisor need to have a detailed plan around your income. But at the end of the day, if history is any indicator, a ton of current retirees will pass along large IRA’s to the next generation. Let’s be conservative and say their portfolio stays at $7Mil decades later when they pass away.

Quick estate planning note: If Clyde and Mary have a pass-through trust, there could be some tax problems. I’ll write more on this later, but let’s assume the children split the inheritance equally.

So, each child will get $3.5Million in an inherited IRA.

They will both be forced to take out that $3.5Million within the next ten years. This is potentially during their children’s peak earning years. Imagine they both have household incomes of $200,000. Now, they’re going to have to take on an additional $350,000 in income. Before the SECURE Act, they could have taken a fraction of that as income. Now, they will be forced to take substantially more as income. Plus, income tax rates could potentially be a lot higher than they are today. End result? Clyde and Mary’s kids use up all of the lower tax brackets with their income from their current employment. So the inherited IRA in our example could be taxed anywhere from 24-40%+ (depending on where tax rates go in the future). Imagine if both of Clyde and Mary’s kids end up paying about 33% in income tax on their inherited IRAs? That would be more than $1Million in taxes alone for each of them-over $2Million combined.

Again, if you’re retiring with more than $1-2Million in your 401(k) and pension, this will likely be a scenario you face.

Now, I’ve served and planned with hundreds of families heading into retirement. Everyone has a different perspective on what they want their kids to inherit. Do you want to know the one thing every single family I’ve worked with agrees on?

They want their kids, or not-for-profit institutions of their choosing, to receive their money more than the federal government.

What can you do about it?

Now let’s see what our example couple should do to remedy their situation. One of the most critical actions Clyde and Mary can take is converting a large chunk of their pre-tax assets into a Roth IRA. I’ve written on the subject before, and it is at the core of financial planning for Energy retirees. However, now it is really amplified. While the exact amounts to convert each year are best done on a case-by-case basis, for many, it may make sense to fill up your tax brackets just below the 32% rate. What does this mean? Clyde and Mary should live off of their after-tax assets and use after-tax savings to pay the tax bill from the Roth conversions. Take a look at the tax brackets below for a married couple filing a joint return. We won’t dive too deep into whether or not they’re taking the standard deduction or itemizing-see my article on how O&G professionals can structure their charitable giving.

Taxes for Oil & Gas retirees

 

With deductions, they can stretch their income close to $200,000 per year and only pay about 14-15% or $28,765. They can fill up all of that income with Roth conversions. How? First, they should defer Social Security as long as possible. In short, there are a couple of advantages: 1. It’s nice to lock up the highest SS benefit possible, and 2. It frees up their taxable income to make a much more impactful tax decision (why take Social Security at 65 when that is a prime age for a Roth conversion?). Now where do they fund their $100,000/year expenses? That comes from their after-tax savings. So, they can convert ~$200,000 per year into a Roth. Let’s pretend they do this for seven years. They will spend through all of their after-tax savings, and some of their XOM stock, but it’s worth it. Another way to think about it-visually. Consider their options with just that $1.4Million in their IRA ($200,000 x 7-for seven years of Roth conversions).

 

Option 1 on the left is Clyde and Mary ignoring my advice on Roth conversions. Option 2 on the right is seven years of Roth conversions. Would you rather pay around $200,000 in taxes now or almost $2Million a couple of decades from now? I went 20 years into the future-now imagine if we go 30-40 years and the assets are definitely with their children now. And as we already discussed, what if tax rates go up? Regardless, the marginal tax rate faced by just this portion of their assets could easily be around 33%. Would you rather pay ~15% now or potentially a much higher rate decades from now?

If your situation allows it, we can also go even more extreme and fill up the next bracket and do over $300,000 per year in Roth conversions. As you can tell, this also sheds light on how valuable after-tax savings can be as you approach retirement. It gives you flexibility. It gives you options.

Conclusion

It’s important to change the way you think about taxes. For most, taxes are something you associate with your tax return each year. This is fine, but your tax return is retrospective. You’re reconciling with the IRS things that already happened. Instead, you need to focus on tax planning for the coming years (really for the coming decades).

Navigating what’s in your best interests requires a very experienced advisor working in tandem with a good CPA and estate planning attorney. Make sure it’s a CFP® professional in a fee-only structure.

As you can tell, the SECURE Act could end up costing some Energy retirees and their families millions in taxes. Proper planning around the SECURE Act, however, can save you a fortune.

Tax planning, just like investments and every facet of financial planning, is highly customizable to meet your unique situation. If you have any questions or would like to have a quick chat about how we can help, click here! Our first consultation is complimentary.


Brownlee Wealth Management is a fee-only financial planning firm in The Woodlands, TX.

Our background and expertise is helping Oil & Gas and Chemical professionals and retirees with their financial plan. Most of our clients have complex compensation structures, stock options, defined benefit (pension) and defined contribution (401k) employer-sponsored retirement plans. We help these families organize their estate plan and navigate the tax code to dramatically lower taxes over the coming decades. We then plan for college funding and income in retirement. Finally, we establish an evidence-based portfolio tailored to the best interests of the client.

BWM serves clients as a fiduciary and never earns a commission of any kind.