Are you properly alerting your clients to all the uncertainties that are present regarding the traditional vs. Roth (and Roth conversion) decisions?
- The choice of whether to place new savings in taxable, tax-deferred, or tax-free accounts – where all three are available – is surprisingly complex. A lot of assumptions are required about future income tax rates, and even the existence of future income taxes. Some excellent academic articles exist on traditional vs. Roth IRA funding strategies, and on Roth IRA conversions. And a number of articles espouse different decumulation strategies when different types of accounts are present. However, the assumptions made in these articles are numerous, and even more assumptions are implied – especially as to future tax policies.
- Asset placement by type of account (general rules)
- 1) Place equities, especially foreign equities, in taxable accounts
- Non-realization of gains to defer taxes (thereby increasing returns). This has been made easier with the rise of tax-efficient equity ETFs, and the tax loophole that permits low-basis stock within ETFs to be shunted off to accumulation units that are redeemed by nontaxable entities. (A change to this tax loophole was proposed by Congress in 2017, but was quickly sidelined.)
- Ability to use tax lot selection
- Ability to harvest tax losses during sales of securities
- Stepped-up basis upon death to eliminate capital gains (unless Congress changes the tax-favorable treatment here, which has been proposed in the past)
- Ability to secure long-term capital gain and qualified dividend treatment, for federal income tax purposes (unless Congress acts to eliminate the tax-preferential treatment provided through LTCG and qualified dividend treatment, as has been proposed in the past)
- A KEY: Foreign tax credits or tax deductions may be available for mutual funds and ETFs holding foreign securities. But you only secure these if the mutual fund and/or ETF is held in a taxable account (i.e., not held in a tax-deferred or tax-free account).
- 2) Generally, after allocating foreign equities to taxable accounts, place the asset class with the highest expected long-term returns in the Roth accounts. Then place the more tax-efficient equity ETFs or tax-managed/tax-aware equity mutual funds in taxable accounts.
- 3) Generally, allocate fixed income investments to tax-deferred accounts.
- Upon withdrawal, you are going to be taxed at ordinary income tax rates. Better to reduce the growth in tax-deferred accounts, as a result, while seeking maximum growth in Roth accounts, followed by growth in taxable accounts (which can receive, at least in part, long-term capital gain and qualified dividend treatment).
- Special Note on Use of H.S.A.s.
- Due to potential tax benefits, if client has a high-deductible health plan (HDHP), fund their Health Savings Account (H.S.A.) account to the limit, before funding other traditional 401(k)/traditional IRA accounts (except as necessary to secure employer matches).The ability to secure an income tax deduction going in, possess income tax deferral, and then use the funds for a broad variety of qualified medical expenses, is one of the most tax-advantaged provisions of the Internal Revenue Code, and it exists for H.S.A.s.
- Even when on Medicare, while H.S.A. accounts may not be funded anymore at that time, accumulated H.S.A. balances can be used to pay deductibles and co-pays and co-insurance payments. As well as dental work, hearing aids, and eyeglasses – currently not covered by traditional Medicare. The H.S.A. balance can even be utilized to reimburse the taxpayer for Medicare Part B, Part D and Medicare Advantage premiums.
- The tax policy uncertainties are numerous …
- Will Medicare continue to have higher premiums under Parts B and D? Might Medicare even be replaced with a different (single-payer) system?
- If the longevity of a single client, or both married clients, is low, one might consider the marginal tax rates of the intended heir of a traditional IRA.
- If a significant charitable bequest to be made at the end of one’s lifetime, then the traditional IRA becomes more palatable as the vehicle to effect same, and Roth IRA conversions may be more limited.
- Will we even have an income tax in the future? Witness the move by some in Congress to abolish income taxes for most taxpayers, and replace it with a national sales tax or value-added tax (V.A.T.)
- Through calendar year 2025, taxable ordinary income earned by most individuals is subject to tax rates of 10%, 12%, 22%, 24%, 32%, 35% and 37%. In 2026, absent legislation by Congress, the rates revert back to the pre-2018 rates of 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.
- Will federal income tax rates go even higher in future years, as the federal government wrestles with lower economic growth (due in part to a decline in the rate of population growth in the U.S.) and significant burdens from the growing national debt?
Will Roth IRAs Be Ended by Congress At Some Future Time?
- Contributions to Roth accounts rather than traditional qualified retirement plan and IRA accounts benefits the federal budget today, as revenues are increased.
- (Various provisions in the SECURE 2.0 Act required Roth accounts, and/or expanded their availability, as a means of raising revenue in the short-term.)
- But Roth account contributions cause a huge hit to federal budget in future years, as Roth IRA assets are excluded from the income tax base.
- This results in a loss of flexibility to federal government in raising tax rates in the future, to tax this source of retirement income. The revenue losses hit most when baby boomers are aging and placing greater and greater demands on the federal government for support. Assuming a 33% tax rate, a contribution to a Roth account shelters 50% more income from tax than a contribution to a traditional retirement account. (Tax Policy Center report, 2019).We’ve already seen the end to stretch IRAs (with exceptions).
- Unlike many other existing tax provisions found in the Internal Revenue Code, there is no immediate, significant tax burden if all of a Roth IRA account were required to be distributed by year following date of death. Eliminating inherited Roth account distributions over 10 years is likely at some future point, in my view.
- While the removal of tax-favored provisions often results in “grandfathering” – and this may well occur if Roth account contributions are ever done away with by Congress – it remains possible that Congress, if under severe fiscal pressure, could terminate all Roth accounts (i.e., force their distributions, during a person’s lifetime, into taxable accounts).
On the benefits of Roth IRA conversions in early retirement years
- Retirees: While both partners of a married couple are alive, Roth conversions prior to taking social security benefits may serve to dramatically decrease the survivor’s taxable income after the death of the first spouse, which can substantially reduce not just income taxes (by avoiding higher marginal tax rates) but also reduce the survivor’s Medicare premiums
- For lower-income retirees, when social security retirement benefits are received, and a Roth IRA conversion takes place, may increase income sufficiently to cause taxation of social security benefits – crossing the threshold of provisional income results in a “tax torpedo” – effectively higher marginal tax rates than those set forth in the tax brackets b/c of the amount of social security benefits (50% or 85%) also now subject to income taxes. This is a disappearing issue – higher social security retirement benefits, no increase in thresholds for taxation of social security benefits since 1984, resulting in more and more low-income Americans having 85% of social security retirement benefits subject to taxes.
Where will your clients reside in retirement? (state and local income tax considerations)
- A planned move to a state with no state income taxes (Texas, Florida, Tennessee, etc.) can lead to considerations to do contributions to traditional QRP and IRA accounts today, as combined federal/state/local taxes might be lower after the move.
- Note that some states without state income taxes have much higher sales tax rates, and much higher real property (ad valorem) taxes.
- Many of those who move to another state return soon, due to disconnect from their family and others in their community.
- Note also that some states with state income taxes have exclusions from state income tax for certain amounts of pension and/or qualified retirement account distributions (such as Kentucky, with $31,110 exemption). Note also that Kentucky’s state income tax rate is 4.5% in 2023 and will likely decrease further over time.
IN SUMMARY
Generally, advise clients who have just begun their careers, if they are in lower income tax brackets, to load up on Roth accounts. Invest aggressively in such accounts, for the very long term.
H.S.A.s – for those with HDHP – should not be overlooked.
A mix of tax-free (Roth), tax-deferred (traditional defined contribution and traditional IRA), and taxable accounts may be optimal to leverage against the inherent uncertainty brought about by changing tax policies.
Asset placement decisions, among different types of accounts, remains critical to supercharging net-of-tax returns, over the long term.
When discussing the decision on whether to fund tax-free, tax-deferred or taxable accounts, acknowledge to the client the inherent uncertainties brought about by changes in tax laws.