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.
Everyone has been on the edge of their seats.
And, after months of anticipation with a “two-track” process of infrastructure and separate tax legislation, it has happened: The American Families Plan is here. And few people saw what was coming.
Democrats on the House Ways and Means Committee defied expectations!
On September 13, 2021, they released their tax proposals. The legislation touches on a wide range of tax issues:
Over the next few weeks, I’ll be discussing the impact of this legislation on a variety of issues.
We’ll be looking at it all with an eye towards what’s most likely to pass. That way, you can consult and anticipate what you might do a) before year end, and b) over the next few years.
Right now, let’s look at what did happen and what could be happening.
Some of the rumored measures didn’t appear.
There are no measures related to equalizing the top ordinary income and capital gains rates. Nor is there anything related to eliminating the step-up in basis.
We could be losing several retirement plan strategies for high-income individuals.
The compression of tax brackets and increased tax rates are a big deal. But the most highly notable and widely effective piece would be the end of several retirement plan strategies.
Most remarkable among these relates to backdoor Roth IRAs and mega backdoor Roth IRA conversions. If enacted, Section 138311 of the proposal would prohibit conversions of after-tax dollars held in retirement accounts.
Limiting conversion of after-tax retirement plan contributions to Roth dollars began during the Obama administration.
Legislation proposed these conversions be banned. It also proposed adding required minimum distributions (RMDs) to Roth accounts. It proposed eliminating stretch IRA’s, which extend tax-deferred IRA benefits inherited by a non-spouse beneficiary. And, there was a proposal for preventing contributions to retirement accounts with balances over $3.4 million.
The Stretch IRA was eliminated in the 2019 SECURE Act.
Instead of the original lifetime schedule, beneficiaries must now complete distributions over a 10-year period. With that historical result in mind, it seems like the backdoor Roth is certainly on the chopping block by the end of 2021.
The remaining proposals provide some indication of what else could be on the chopping block, given the large ticket Infrastructure Bill going through Congress that requires a “revenue offset” to cover its cost.
If enacted, we need to take a fresh look at the convert-or-not decision for savers with after-tax dollars in retirement accounts.
The provision is not in its final form, but it looks like it’s going to be enacted. Many investors, particularly IRA owners, have been waiting for the optimal time to make a conversion. But the choice may soon be now or never, at least with respect to the after-tax dollars in their account.
And section 138311 goes beyond simply banning the conversion of after-tax amounts.
For high-income taxpayers with Adjusted Taxable Income in excess of an applicable threshold, the measure would prohibit Roth conversions altogether.
But this won’t happen right away. If it goes into effect, you may have until 2032 for this decision.
Nuances and obstacles abound.
We’re going to have a lot of strategic examination coming in the very near future. Stay tuned for more analysis of the new regulations and what they’ll mean for your retirement wealth planning.
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.