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The two certainties in life are death and taxes. While we have little control over the first, we have significant control over the second.
The common tax strategy for investors in the United States is to contribute the lion’s share of their savings to a tax-deferred IRA or 401(k). The perceived benefit of this strategy is that savers can look forward to retiring on a large pool of assets that they’ve built up over the course of their earning years. While having a strategy for retirement is better than not having one, this particular strategy may backfire.
One alternative to contributing to the tax-deferred IRA or 401(k) is to consider contributing to a Roth IRA or Roth 401(k). By choosing this route, taxpayers may put themselves in a position to pay less taxes over the course of their lifetime.
This is the first of a three-week series where we will be addressing the potential benefits of the Roth IRA. We are beginning the series this week with why you should consider switching contributions to this powerful tax-saving vehicle.
1. Tax-Free Growth and Distributions
There are three buckets that investors can put their savings in when preparing for retirement. Each of these buckets plays an important role in how your tax bill is determined over the course of your lifetime.
Bucket 1 assets are your tax-deferred investments, such as your IRA, 401(k), 457(b), and 403(b). This bucket provides a tax deduction in the year the contribution is made. And this is why so many people contribute to tax-deferred accounts today, because they see the tax savings immediately.
The problem with the “Pre-Tax” Money bucket is that you are not eliminating your tax burden, you are simply kicking it down the road. With tax rates poised to be higher in the future, taxpayers may be kicking a snowball downhill by taking a deduction at a lower tax rate to eventually be taxed at a higher tax rate when they take the money out of the IRA in retirement.
Bucket 2 assets are your taxable money, such as bank accounts, brokerage accounts and most real estate investments. Money in this bucket is taxed every year as the accounts earn interest, dividends, capital gains or rental income. There is no deduction for putting money into bucket 2, and additional taxable income is created each year when assets are held in the Taxable bucket.
Finally, bucket 3 assets are your “Never-To-Be-Taxed again” dollars, held in accounts like Roth IRAs, Roth 401(k)s or cash-value life insurance. While you don’t receive a deduction for putting money into these accounts, pulling money out of these accounts is entirely tax free. That means that if you have $6,000 to contribute to a Roth or Traditional IRA today, having 6% earnings on that account over 25 years could provide valuable savings if tax rates were to increase.
Account Type | Amount Contributed | Tax Rate | Amount Contributed After Tax | 25 Years @ 6% Interest | Tax Rate | Net Effect |
Traditional IRA | $6,000 | 22% | $6,000 | $25,751 | 30% | $18,026 |
Roth IRA | $6,000 | 22% | $4,680 | $20,086 | 30% | $20,086 |
| | | | | Net Savings | $2,060 |
2. No RMDs with Roth IRAs
With traditional IRAs, you are forced to take a certain percentage of the account out at age 72, even if you don’t need the funds. The RMD rules empower the IRS to capture the income tax that was deferred during your earning years. For wealthy retirees who have other sources of income in retirement and don’t need income from their retirement accounts, this could cause a larger tax burden.
At age 72, roughly 4% of the account value will need to be distributed from the tax-deferred account, and this percentage climbs higher every year. This means that a 72-year-old person living on a pension and social security with $1,000,000 in bucket 1 assets will be required to pay income tax on an additional $40,000 of income, even if you don’t need that income. And the percentage required to distribute from the tax-deferred account will increase every year for the rest of your life.
Roth IRAs, on the other hand, have no required distributions. That’s because the government receives no benefit when you distribute the assets from your Roth IRA. And that’s also why the Roth IRA works as a good source of funds in retirement, because they will not increase your tax bill.
Need to pull some money out to buy a new car or make a home improvement? If you have a traditional IRA, you will need to pull out both the cost of the car or the home improvement, as well as the amount needed to pay the tax on the total distribution. If you need $70,000 to purchase a new car, you may need to pull $100,000 from your IRA (creating $100,000 of taxable income) to net the $70,000 needed to purchase the new car. With the Roth IRA you only pull out what you need, because there is no tax liability created when you pull the money from the account (assuming age 59 ½ years old, with a 5-year holding period completed).
3. You can use your Roth like an Emergency Fund
With a traditional IRA, any funds you put in are locked up until age 59 ½. That is the age where you can take funds out penalty free. Taking a distribution before the age of 59 ½ will cost you an additional 10% tax on top of the ordinary income tax owed on the distribution.
A Roth IRA, on the other hand, gives you some freedom to pull funds out if you need access to the cash before 59 ½. That’s because a Roth IRA allows penalty-free withdrawals on contributions. Since you’ve already paid the taxes on the contribution, there’s no additional tax on the withdrawal. This means that if you contribute $6,000 to a Roth IRA each year for 10 years, you can pull $60,000 from that Roth without incurring penalties. Withdrawals above your contributions would be subject to any income taxes and the 10% early withdrawal penalty if taken before age 59 ½.
4. One of the Best Accounts to Leave as an Inheritance
The final benefit of the Roth IRA is the value it holds as an inheritance tool. Even if you are in a low-income tax bracket in your retirement years, your children or grandchildren who inherit your accounts may be in their prime earning years and in higher income tax brackets than you when they inherit the funds.
By inheriting a traditional IRA, a beneficiary may be forced into an even-higher income tax bracket, and this could diminish the impact of the inheritance. With the 2019 passing of the SECURE Act, non-spouse beneficiaries are now required to pull out the entire balance from an IRA within 10 years.
This means a $1,000,000 IRA with no growth over 10 years would require the beneficiary to pull out $100,000 every single year for the next 10 years or the entire $1,000,000 balance at the end of the 10-year period. And that requirement creates another $100,000 of taxable income each year to the beneficiary of the traditional IRA or $1,000,000 of taxable income if they wait until the end of the 10-year window.
Summary
With the current low tax rates enacted by the Tax Cuts and Jobs Act set to expire in 2025, there is a shrinking window of opportunity to take advantage of today's low tax rates. This shrinking window allows us to lock in today’s historically low tax rates and never pay tax on those assets again.
Taking advantage of today’s low tax rates and positioning retirement assets in an account that the US government will never tax again can not only dramatically reduce your lifetime tax liability it can significantly increase your likelihood of a safe and secure retirement.
Stay tuned over the next two weeks as we build out the case for the Roth and how to execute this timely strategy in a way that will benefit you for years to come.
This article is a general communication being provided for informational and educational purposes only and is not meant to be taken as tax advice, investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions, inflation or US tax policy. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.
LEGAL, INVESTMENT AND TAX NOTICE. This information is not intended to be and should not be treated as legal, investment, accounting or tax advice.
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