by Dave Kutcher
Taxes, taxes, taxes … nobody likes paying taxes, but the methods and strategies to minimize taxes are numerous and can be confusing and to be honest, for the most part, you are going to pay taxes one way or another when considering your choices for retirement savings during your working years.
Pay me now or pay me later is more the consideration when trying to figure out if using a ROTH as your standard IRA alternative or ROTH 401(k) as an alternative to the traditional 401(k) plan account is a savvy move in terms of the taxes you will pay on your retirement dollars.
When considering ROTH vs traditional retirement savings plans, your grasp on whether tax rates for your household income will be higher or lower in the future is really what will determine your value in using a ROTH vs. traditional plans.
In traditional plans, contributions to an IRA or a 401(k) plan are made with PRE-tax dollars. This means the contribution you make avoids taxation today and will grow tax-deferred until you begin your retirement distributions. ROTH plans are funded with After-tax dollars and so you agree to pay your income taxes today for the benefit of never paying taxes on the growth of your ROTH monies ever again.
When considering ROTH vs. Traditional plans, there really are two considerations to make … one is for new contributions you may be making still for future savings and one for existing traditional plans where you can convert those savings that were previously made on a PRE-tax basis to a ROTH plan today.
The latter requires that you recharacterize that money by paying taxes on the converted funds today. While that may look appetizing on paper, the idea of forking over thousands of dollars today to pay tax on something you avoided previously is not necessarily an easy decision to make. Your consideration of such a strategy needs to be thought out carefully and should include detailed tax calculations to determine how smart a decision this may be for your situation.
In a tax neutral and investment return neutral environment the decision really is a decision of “do I want to pay them now or pay them later”. Let’s look at an example in a tax and investment return neutral environment and a tax bracket of 40% remaining constant over the next ten years. So, if we assume a 2024 pre-tax contribution of $1,667, the equivalent After-tax contribution to ROTH would be $1,000. ($1,667 X 60% after tax = $1,000) If we assume these funds were invested in the same type of investment and the return over the next ten years resulted in doubling of your contribution, the traditional IRA plan would have a pre-tax balance of $3,333 and the ROTH would have an after-tax value of $2,000. If we then distribute these funds to you at retirement, the $3,333 after-tax of 40% yields spendable income to you of $2,000 and the ROTH After-tax distribution would be the same, $2,000.
The real question, as I alluded to previously, is whether we think tax rates will change in the years ahead. Will they be more or less than today and will your income during your working years be significantly different than when you decide to retire and begin distributions. There actually are more considerations than this … discussing in detail some of those additional considerations is beyond the scope of this article today, but considerations beyond the tax math include comparing the rules applied to each of the different types of plans, ROTH or Traditional IRA.
The rules governing distributions from traditional IRA’s and 401(k) plans are not getting more friendly. In fact, the government doesn’t want to wait any longer than it needs to in order to get the tax revenue for your pre-tax dollars, particularly if you are leaving these funds to a non-spouse at your death … the rules tighten quickly and require that your plan distributes your funds no longer than over the next ten years. So, you die in your 80’s leaving your IRA to your children who are in their peak earning years from age 50-65 and they will then have to distribute that money to themselves over a maximum of ten years, likely pushing their taxable income into higher brackets and resulting in significantly reduced after-tax income for their inheritance than would have been the case under prior rules.
We don’t expect this type of rule to change for the consumers good in the foreseeable future. The pressure to increase tax revenue to try and balance a budget that is skyrocketing out of control will likely lead to higher income taxes for everyone. Either the rates themselves will rise from their current levels or the brackets will shrink forcing you into a higher bracket sooner than it does today and thus resulting in a higher effective tax rate down the road than you are paying today, all else being the same.
In fact, both changes above could be enacted simultaneously … meaning they shorten the brackets AND increase the rates in those brackets, resulting in significantly higher taxes when compared to what you might pay today.
So, the math equation above is easy if we understand our assumptions … if we expect to be in lower tax bracket later, when distributing money at retirement, the pre-tax traditional IRA or 401(k) plan makes sense. If we expect we will be in a higher tax bracket situation at retirement, the after-tax ROTH plan will prevail as a better choice.
Now let’s consider some factors beyond the tax math…
REQUIRED MINIMUM DISTRIBUTIONS (RMD)
Your IRA or traditional 401(k) plan is going to mandate that you leave your money until at least age 59 1/2 and you will be required to begin distributions at age 73. This positive change from the prior rules of RMD’s beginning at age 70 ½ is a welcome change but it is still a hard rule that results in huge penalties if you are not in compliance.
ROTH IRA’s and ROTH 401(k) monies do NOT have this mandatory distribution for years 2024 and later. (Note that people may still be required to take distributions for designated ROTH accounts for 2023, including those with a required beginning date of April 1, 2024.)
At death, the traditional IRA will be considered income in respect of the decedent and be includable for both income and estate taxes. As long as a ROTH plan meets the basic 5 year rule inherent in ROTH plans, the funds at death will be left tax free to your beneficiaries, even if they are required to distribute the funds over the next ten years … the tax free status eliminates complicating your beneficiaries’ situation in terms of unnecessarily increasing their taxable income and forcing them into higher tax brackets on all of their income.
We can help with our consideration of these various retirement vehicles. Be smart and plan. Your decisions today impact your results later. Minimizing taxes can be as valuable as reaping excess returns on our investments.
My name is David A. Kutcher, a retired Marine Corp Captain. My business partner in the lower 48 is Richard C. Scott, CLU, LUTCF. For nearly 40 years we have been helping folks with their personal retirement decisions. We encourage you to make an appointment and get ahead of your concerns as early as is possible. You can catch us on the radio every Saturday morning, “Retirement in the Last Frontier”, 8:30-9:30 on AM 650, Keni Radio and on Tuesday mornings, KFQD News Talk Radio AM 750 and FM 103.7. Frontier Retirement, 10928 Eagle River Road; Eagle River, AK 99577, (907) 795-7452.
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