There is seldom a time during any year-end tax discussion that I am not answering the questions of “To Roth or not to Roth.” And this is understandable. The amount of confusion around this decision is remarkable. There are all kinds of myths revolving around the real value of using a Roth. (If you need a refresher, the Roth IRA is the retirement account from which contributions are after-tax and distributions are tax-free)
The decision of whether to go Roth boils down to three factors: 1) current versus future tax rates; 2) the impact of required minimum distributions; and 2) the true value of funding an account that is really all yours, versus one where Uncle Sam still has an interest in the form of future taxes.
In this decision, the most impactful factor by far is in comparing current and future tax rates. In comparing these rates, we should focus on marginal tax brackets, or the rates on the last dollars earned.
The most important question: what is the anticipated tax rate at the time of distribution? And how does it compare to the current rate on income? Will that rate be higher or lower? If the tax rate is lower when one retires (or even better, lower for the next generation), the clear winner is the pre-retirement account.
Conversely, great wealth destruction occurs when we get this wrong and save by paying higher rates today to accumulate in Roth accounts, and then defer taking that income at a time when our tax rates are lower.
Should tax rates remain the same, there is no advantage to saving in either type account. That’s because the net effect is the same after tax. A taxpayer who earns $10,000 and pays the tax at a 22% rate to save $7800 in their Roth will have $15,600 10 years later at a 7.2% earnings rate. That same taxpayer could save $10,000 in their pre-tax account, have $20,000 in 10 years, take their distribution at a 22% rate, and net effect is the same, they have $15,600.
Under today’s rules, there is one distinct advantage of a Roth IRA: they’re not subject to required minimum distributions (RMDs) while those RMDs are required in pre-tax savings accounts at age 72. This offers an advantage: the funds could stay in a tax deferred status longer. It’s even possible they can pass on to the next generation. This is a distinct advantage over an IRA that, over time, is forced to self-liquidate. And for larger IRAs, this self-liquidation can result in significant distributions and significant taxes.
But this advantage is not enjoyed by the beneficiaries of these accounts, those receiving the proceeds at the death of the account owner. In fact, beneficiary IRAs, both regular and Roth, must be liquidated, over a 10-year period. So, the benefit of avoiding RMDs is only an advantage while the owner is alive and only applies to IRA owners if they live past age72, otherwise the accounts to beneficiaries look the same, both pre-tax and Roth. So, the advantage of avoiding RMDs is only enjoyed by the owners.
Another factor that favors the Roth IRA is the interaction between the IRA contribution limits and the future tax liability of a pre-tax account. That is that the full value of the account contribution accrues to the account owner rather than having part be theirs and part an IOU to the IRS. So, for account owners trying to maximize their contributions to their accounts this can mean that their contributions are not being crowded out by future tax liabilities.
For example, imagine a client in the 22% tax bracket. If the client has $1,000 in an IRA, the reality is that the client has $780 in the IRA for themselves, and $220 in the IRA that's "on hold" for the IRS and the Federal government in the form of future taxes. If the IRA doubles to $2,000, then the client's share grows to $1,560 and the IRS's share grows to $440; the IRS still has 22% of the account earmarked.
In general, this isn't necessarily a "problem" as the future taxes still grow on the IRS' share before they have to be paid (that's the benefit of tax-deductible contributions). The goal is simply to pay the IRS its share whenever the tax rate is lowest, as noted earlier.
However, if the client wishes to make a maximum $6,000 contribution, now it's a problem. Because the client can't make a full $6,000 contribution; in practice, the client makes a $4,680 contribution for themselves and a $1,320 contribution on behalf of the IRS. On the other hand, if the client makes a Roth contribution, the entire $6,000 amount is held for the client, because the IRS' share is paid with outside investment dollars. So as long as the client intends to contribute the limit, it's better (all else being equal, especially tax rates) to contribute to a Roth and pay the taxes with outside dollars, than contribute to a traditional where the IRS' share crowds out some of the contribution limit, while tax-inefficient dollars are still growing on the side. Notably, the same effect applies for a Roth conversion where the tax liability is paid with outside dollars; just pretend that the current balance of the traditional IRA is effectively the "contribution limit" to a Roth.
Taxes play a big role both before retirement and after. One of the greatest expenses to us as savers, even in retirement, will be the taxes we pay.
Great wealth can be either created or destroyed regarding the decisions we make about when we choose to pay our taxes. Good forward-thinking planning can help us make the right choice.
Want to know more about how to navigate the Roth/non-Roth waters or charting other courses to retirement? Feel free to contact SJ Boyle Wealth Management by visiting our website or asking us a question.
You may have heard about The American Families Plan. It’s a major overhaul to our system in terms of infrastructure and social safety nets. It has been proposed as an “investment in the foundation of middle class prosperity education, health care and child care.” And the proposed price tag is in the trillions of dollars.
Alongside the agenda is proposed tax reform. In many ways, this reform is a reversal of many of the tax giveaways of the 2017 tax law. The hope is that the resulting revenue will pay for the American Families Plan’s investments.
The tax proposal will impact certain American Families. It will be raising their tax liabilities through increases in a) income, b) capital gain and c) transfer taxes. This post is the first in a series of three explaining each of those aspects.
The piece of the American Families Plan that has garnered most attention is the increase in tax rates of those earning more than $400,000. But these tax policies are very nuanced, and attention to the detail is worth the time and effort.
The most startling piece of the bill is the return to the ordinary income tax bracket. It goes back to 39.6% from 37%. And it does so at a significantly reduced income level of $400,000 for single and head of household, and $450,000 for joint filers.
The current 37% top ordinary income tax bracket kicked in for married taxpayers filing jointly at $628,300 taxable income in 2021. The proposed bill would impose the top ordinary income tax rate of 39.6% at “just” $450,000 of taxable income in 2022.
Similarly, the current 37% ordinary income tax bracket does not begin to impact single filers until they have more than $523,600 in 2021. But in 2022, the top rate of 39.6% would be applied to taxable income more than $400,000 for those same filers. To say it another way, the most impact for single filers with taxable income of over $400,000 and joint filers with taxable income of over $450,000 will be a tax rate increase from 35% to 39.6%. That’s a 4.6% increase on incomes from $400,000 to $523,000. Hitting this group the hardest will be the compression of tax brackets.
You might also note that the “marriage penalty” has increased. It allows only $50,000 of joint income over the single taxpayer. In other words, because of the way our tax system and tax brackets work, some married couples who each earn under $400,000 would be subject to a higher tax, as compared to their single counterparts earning the same amount. In this instance, being unmarried and single is better — for tax purposes anyway.
Let’s do the math, assume you have a couple (not married) each making $399,999. These taxpayers would not have reached the highest bracket for an unmarried individual. Each individual would be taxed at the 35% bracket. Using this year’s tax bracket for single filers, this results in approximately $132,989 in federal income taxes. (Or, a total of $265,978 combined for both individuals.)
If instead this couple decides to marry, they will now have a combined income of $799,998. That puts them in the highest tax bracket (39.6%) as married filing jointly. This translates to an estimated $284,412 in federal income tax, which is $18,434 more in taxes (or about 6.9%) than compared to a situation if they were single. The other option of married filing separately will yield the same result.
This will lead to all kinds of new scrutiny for some couples. I expect we’ll see a lot of tax planning around filing status and income threshold management. There will probably be detailed analyses and projections to evaluate the optimal filing status for married couples. They’ll be looking at where certain deductions, tax credits or planning opportunities would be more beneficial if applied to one spouse over the other.
In extreme cases, could this factor into one’s marital decision? In my financial planning circles, there’s been a lot of discussion about this, and about divorce. I don’t believe we should be making life decisions around taxes. But the reality is that taxes hit the bottom line, and that impact is real.
If you’d like to know more about how to navigate the coming changes with an updated wealth planning strategy, feel free to contact SJ Boyle Wealth Management by visiting our website or asking us a question.
Sally J Boyle
Sally Boyle is committed to being high-net worthy. A certified financial planner, she believes the single most important part of any wealth planning process is her conversation with you.