To Roth or not to Roth?
While the appeal for lifetime tax-free growth from a Roth may be appealing, the reality is that the Roth is not always the winning choice, and there are many myths and misunderstands about Roth accounts that make it difficult to know which is best. The reality is that there are four (and only four!) fundamental factors that determine whether a Roth will or not will be more effective than a traditional pre-tax retirement account. Some factors are always in favor of the Roth account, but others can work against the Roth account; in fact, blindly choosing a Roth and ignoring the relevant factors can actually lead to wealth destruction! By knowing the four factors and avoiding the Roth myths, you can be assured of making an effective wealth-building decision.
The Four Factors
There are only four factors that impact the wealth outcome when choosing between a Roth or traditional retirement account. They are: current vs future tax rates, the impact of required minimum distributions, the opportunity to avoid using up the contribution limit with an embedded tax liability, and the impact of state (but not Federal) estate taxes. Some of these factors solely benefit the Roth, but others can benefit the pre-tax account; failing to evaluate the situation properly can turn a Roth decision from a wealth creator into a long-term wealth destroyer!
Current Vs Future Tax Rates
By far, the most dominating factor in determining whether a Roth or traditional retirement account is better is a comparison of current versus future tax rates. Current tax rates means the marginal tax rate that will be paid today (or the marginal tax rate on the deduction that would be received) by contributing or using a pre-tax retirement account versus contribution or converting to a Roth account. Future tax rates means whatever tax rate would apply to the funds in the retirement account when withdrawn in the future - ostensibly in retirement, or possibly even by the next generation if the retirement account is not expected to be depleted during the lifetime of the owner.
The principle of this equation is remarkably straightforward - the greatest wealth is created by paying taxes when the rates are lowest. If rates are low today and higher in the future - e.g., for the young worker, or someone in between jobs - go with the Roth and pay taxes at today's low rates. If rates will be lower in the future - e.g., for someone whose taxable income will drop in retirement, or where the retirement account may be spent by the next generation at their lower personal tax rates - the traditional retirement account is the winner. Getting the tax rate equation wrong can result in a significant destruction of client wealth, by unnecessarily paying taxes at high rates!
Impact of RMDs
One important distinction about Roth IRAs (although not Roth 401(k) accounts) is that they are not subject to required minimum distributions (RMDs) during the lifetime of the account owner, while traditional IRAs are. The net result is a slight benefit in favor of the Roth IRA, for the simple reason that it allows more dollars to stay inside their tax-preferenced wrapper. This is an outright benefit for Roths, compared to the traditional IRA that slowly self-liquidates from RMDs, forcing money into taxable accounts where their future growth will be slowed by ongoing tax drag.
Notably, though, this benefit applies only as long as the IRA owner is alive! After death of the owner, all retirement accounts have required minimum distributions for beneficiaries, and the exact same rules apply whether it's an inherited IRA or an inherited Roth IRA (the RMD is the same, even though the tax treatment of the RMD amount may be different). Accordingly, the benefit of avoiding lifetime RMDs applies only as long as the IRA owner is alive, and likewise applies only if the IRA owner actually lives past age 70 1/2 when RMDs begin! Otherwise, the avoiding-RMDs benefit is actually a moot point.
Contribution Limits and the Embedded Tax Liability
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.
For example, imagine a you are in the 28% tax bracket. If you have $1,000 in an IRA, the reality is that you actually have $720 in the IRA for yourself, and $280 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 your share grows to $1,440 and the IRS's share grows to $560; the IRS still has 28% of the account earmarked.
In general, this isn't necessarily a "problem" as the benefit is 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 you wish to make a maximum $5,000 contribution, now it's a problem. Because you can't make a full $5,000 contribution; in practice, you make a $3,600 contribution for yourself and a $1,400 contribution on behalf of the IRS. On the other hand, if you make a Roth contribution, the entire $5,000 amount is held for yourself, because the IRS' share is paid with outside investment dollars. So as long as you intend to contribute the limit, it's better (all else being equal) 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.
State Estate Taxes
The final factor that can favor a Roth IRA is estate taxes, for the simple reason that it's bad news to pay estate taxes on a retirement account when part of it isn't even yours in the first place - it's earmarked for Uncle Sam!
For example, someone with a $1,000,000 traditional IRA and a $1,000,000 investment account has to report $2,000,000 on his/her estate tax return (combined with any other assets); however, he or she who converts the account has a $1,000,000 Roth IRA and only a $650,000 investment account (assuming a 35% tax rate on the conversion), for a total estate value of $1,650,000. At a 35% estate tax rate, making $350,000 of value "disappear" can result in $122,500 of estate tax savings!
The caveat is that such conversion strategies don't necessarily help for Federal estate taxes, because of the Income in Respect of a Decedent (IRD) deduction, which allows beneficiaries to deduct any estate taxes attributable to the IRA from the income they must report when they take withdrawals from the IRA. The net result is that whether the IRA is converted before death (reducing estate taxes due by paying the income taxes) or is passed on as a pre-tax IRA (reducing the income taxes due by paying the estate taxes), the heirs end out with the same amount of money.
However, that's only for Federal estate taxes. Most states that have a state-level estate tax do not have a state IRD deduction. As a result, people who are exposed to state estate taxes will find that the Roth allows them to leave more money for the next generation, at least to the extent of the 6% to 16% estate tax rate applicable in most states who have such a tax. Of course, people should be cautious not to push up their tax rate so far with a big conversion that the adverse income tax impact outweights the state estate tax savings!
The Bottom Line
In the end, avoiding lifetime RMDs, state estate taxes, and paying IRA tax liabilities with outside dollars are all benefits of using a Roth IRA over a traditional IRA. However, the reality is that the driving force on wealth creation - or destruction - is still a comparison of current versus future tax rates. As a result, even with all the other factors working favorably, a Roth can actually still be a wealth destroyer if future tax rates were going to be much lower for that individual client when the funds are withdrawn (either by the client in retirement, or by heirs in the next generation).
So while the Roth IRA may be favorable in many situations, it's hardly automatic in all of them! It's important to evaluate the details of your situation, and look at each of the four factors, to determine whether and to what extent each will have an impact, and make a decision accordingly.
While the appeal for lifetime tax-free growth from a Roth may be appealing, the reality is that the Roth is not always the winning choice, and there are many myths and misunderstands about Roth accounts that make it difficult to know which is best. The reality is that there are four (and only four!) fundamental factors that determine whether a Roth will or not will be more effective than a traditional pre-tax retirement account. Some factors are always in favor of the Roth account, but others can work against the Roth account; in fact, blindly choosing a Roth and ignoring the relevant factors can actually lead to wealth destruction! By knowing the four factors and avoiding the Roth myths, you can be assured of making an effective wealth-building decision.
The Four Factors
There are only four factors that impact the wealth outcome when choosing between a Roth or traditional retirement account. They are: current vs future tax rates, the impact of required minimum distributions, the opportunity to avoid using up the contribution limit with an embedded tax liability, and the impact of state (but not Federal) estate taxes. Some of these factors solely benefit the Roth, but others can benefit the pre-tax account; failing to evaluate the situation properly can turn a Roth decision from a wealth creator into a long-term wealth destroyer!
Current Vs Future Tax Rates
By far, the most dominating factor in determining whether a Roth or traditional retirement account is better is a comparison of current versus future tax rates. Current tax rates means the marginal tax rate that will be paid today (or the marginal tax rate on the deduction that would be received) by contributing or using a pre-tax retirement account versus contribution or converting to a Roth account. Future tax rates means whatever tax rate would apply to the funds in the retirement account when withdrawn in the future - ostensibly in retirement, or possibly even by the next generation if the retirement account is not expected to be depleted during the lifetime of the owner.
The principle of this equation is remarkably straightforward - the greatest wealth is created by paying taxes when the rates are lowest. If rates are low today and higher in the future - e.g., for the young worker, or someone in between jobs - go with the Roth and pay taxes at today's low rates. If rates will be lower in the future - e.g., for someone whose taxable income will drop in retirement, or where the retirement account may be spent by the next generation at their lower personal tax rates - the traditional retirement account is the winner. Getting the tax rate equation wrong can result in a significant destruction of client wealth, by unnecessarily paying taxes at high rates!
Impact of RMDs
One important distinction about Roth IRAs (although not Roth 401(k) accounts) is that they are not subject to required minimum distributions (RMDs) during the lifetime of the account owner, while traditional IRAs are. The net result is a slight benefit in favor of the Roth IRA, for the simple reason that it allows more dollars to stay inside their tax-preferenced wrapper. This is an outright benefit for Roths, compared to the traditional IRA that slowly self-liquidates from RMDs, forcing money into taxable accounts where their future growth will be slowed by ongoing tax drag.
Notably, though, this benefit applies only as long as the IRA owner is alive! After death of the owner, all retirement accounts have required minimum distributions for beneficiaries, and the exact same rules apply whether it's an inherited IRA or an inherited Roth IRA (the RMD is the same, even though the tax treatment of the RMD amount may be different). Accordingly, the benefit of avoiding lifetime RMDs applies only as long as the IRA owner is alive, and likewise applies only if the IRA owner actually lives past age 70 1/2 when RMDs begin! Otherwise, the avoiding-RMDs benefit is actually a moot point.
Contribution Limits and the Embedded Tax Liability
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.
For example, imagine a you are in the 28% tax bracket. If you have $1,000 in an IRA, the reality is that you actually have $720 in the IRA for yourself, and $280 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 your share grows to $1,440 and the IRS's share grows to $560; the IRS still has 28% of the account earmarked.
In general, this isn't necessarily a "problem" as the benefit is 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 you wish to make a maximum $5,000 contribution, now it's a problem. Because you can't make a full $5,000 contribution; in practice, you make a $3,600 contribution for yourself and a $1,400 contribution on behalf of the IRS. On the other hand, if you make a Roth contribution, the entire $5,000 amount is held for yourself, because the IRS' share is paid with outside investment dollars. So as long as you intend to contribute the limit, it's better (all else being equal) 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.
State Estate Taxes
The final factor that can favor a Roth IRA is estate taxes, for the simple reason that it's bad news to pay estate taxes on a retirement account when part of it isn't even yours in the first place - it's earmarked for Uncle Sam!
For example, someone with a $1,000,000 traditional IRA and a $1,000,000 investment account has to report $2,000,000 on his/her estate tax return (combined with any other assets); however, he or she who converts the account has a $1,000,000 Roth IRA and only a $650,000 investment account (assuming a 35% tax rate on the conversion), for a total estate value of $1,650,000. At a 35% estate tax rate, making $350,000 of value "disappear" can result in $122,500 of estate tax savings!
The caveat is that such conversion strategies don't necessarily help for Federal estate taxes, because of the Income in Respect of a Decedent (IRD) deduction, which allows beneficiaries to deduct any estate taxes attributable to the IRA from the income they must report when they take withdrawals from the IRA. The net result is that whether the IRA is converted before death (reducing estate taxes due by paying the income taxes) or is passed on as a pre-tax IRA (reducing the income taxes due by paying the estate taxes), the heirs end out with the same amount of money.
However, that's only for Federal estate taxes. Most states that have a state-level estate tax do not have a state IRD deduction. As a result, people who are exposed to state estate taxes will find that the Roth allows them to leave more money for the next generation, at least to the extent of the 6% to 16% estate tax rate applicable in most states who have such a tax. Of course, people should be cautious not to push up their tax rate so far with a big conversion that the adverse income tax impact outweights the state estate tax savings!
The Bottom Line
In the end, avoiding lifetime RMDs, state estate taxes, and paying IRA tax liabilities with outside dollars are all benefits of using a Roth IRA over a traditional IRA. However, the reality is that the driving force on wealth creation - or destruction - is still a comparison of current versus future tax rates. As a result, even with all the other factors working favorably, a Roth can actually still be a wealth destroyer if future tax rates were going to be much lower for that individual client when the funds are withdrawn (either by the client in retirement, or by heirs in the next generation).
So while the Roth IRA may be favorable in many situations, it's hardly automatic in all of them! It's important to evaluate the details of your situation, and look at each of the four factors, to determine whether and to what extent each will have an impact, and make a decision accordingly.
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