Roth or Not Roth, This Is the Retirement Question!

This is the full-length version of my LinkedIn post https://lnkd.in/evM2KjbC published on June 27, 2023, quoting an excellent article on Forbes entitled “Retirement Account Taxes: Should You Pay Now Or Later?” by Tolen Teigen on December 14, 2022. I promised to write a longer post on my WordPress site and now it comes.

The Takeaways:

1. Two retirement investment strategies are to invest for retirement using pretax money or after-tax fund. The former is called #TaxDeferral while the latter #TaxNow.
2. #TaxDeferral says we should always delay paying taxes as much as possible for as long as possible. The financial products or the investment vehicles that fit this approach include traditional IRA and 401(k), both are funded by pretax (i.e., skipping tax or paying $0 tax on the current year) money in contribution.
3. #TaxNow goes the other way by saying we should pay contribution taxes today and become worry-free for the future when we take our money out, typically during retirement ages. The financial products or the investment vehicles fitting this approach include Roth IRA and Roth 401(k), both are funded with after tax (i.e., not skipping tax) money in contributions.
4. If there were no Roth retirement accounts, the Tax Deferral approach would remain popular forever, because not many income or contributions are deemed “qualified” by IRS.
5. One fundamental difference between Roth and non-Roth (i.e., traditional) retirement accounts is the time when taxes are levied. Tax deferral saves on contributions today, while tax now saves on distribution later.
6. Contribution, distribution and conversion are the three crucial timepoints all with direct tax consequences. Contributions come before distribution, while conversion happens in between the two.
7. Tolen Teigen argues that the only key factor to consider whether to invest in Roth or in traditional retirement accounts is the tax brackets you will be in now and in the future. To the extent that retirement means lowering tax brackets, we should invest in traditional retirement accounts.  
8. My own model adds two more factors: expected future income after retirement and possible tax law changes on Roth accounts. Both favor investment in the Roth accounts.
9. Working- or middle-class people generally rely on active income through employment, and retirement marks a turning point toward lower income; while high net worth individuals are more likely to have active, passive and portfolio incomes and retirement may mean a harvest time with higher income than before. These people will benefit more from Roth accounts (Roth IRA & Roth 401(k)).
10. The uncertainty in future tax law further encourages investment into Roth accounts as much as possible and as early as possible.

Tax Deferral vs Tax Now

Teigen asks a meaningful question of whether we should follow the #TaxDefferal or #TaxNow strategy to save on taxes. In truth, the two tax strategies apply to many different incomes and investments but since Teigen limits himself to retirement savings and investments, let’s do that as well.

Deferred taxation (#TaxDeferral) approach basically says if possible, we should always delay paying taxes as much as possible for as long as possible. The financial products or the investment vehicles that fit this approach include traditional IRA and 401(k), both are funded by pretax money in contribution.

#TaxNow goes the other way by saying we should pay our taxes today and become worry-free for the future when we take our money out, typically during retirement ages. The financial products or the investment vehicles fitting this approach include Roth IRA and Roth 401(k), both are funded with after tax money in contributions.

The two approaches do not have the same popularity or the number of followers. #TaxDefferal is without a doubt the dominant strategy. If there were no Roth accounts (Roth IRA and Roth 401k), #TaxDefferal would remain its dominance forever. The reason seems to be obvious: Not many types of income are deemed as “nontaxable” by IRS or more accurately tax “deferrable.” So why not take advantage of that rare opportunity and legitimately skip paying taxes?

The Crucial Timepoints for Tax Savings

One fundamental difference between Roth and non-Roth (i.e., traditional) retirement accounts is the time when taxes are levied. Let me first introduce the #ThreeTimepoints of #Contribution, #Distribution and #Conversion, which all trigger direct tax consequences.

There is a clear sequence among the three: Everyone’s retirement investment starts from contribution, which is when you add money to your retirement account, typically while you still work. But contributions can be made anytime throughout lifetime, even after retirement. All retirees can contribute to traditional IRAs if they earn income, retirees can also contribute earned income (e.g., salaries, wages, tips, or bonuses but not capital gains, dividend or investment interest) to a Roth IRA indefinitely.

Contribution is just one side of the retirement story. At one point of your life you must take the money out to better enjoy your retired life, whether through lumpsum (e.g., in a life insurance policy) or stream of periodical payouts (e.g., in an annuity). This is called distribution or withdrawal. Contribution must happen first, and distribution must follow contribution.

Finally, conversion can happen anytime between contribution and distribution. For example, one can convert a traditional IRA to a Roth IRA and that is a taxable event in the eyes of IRS. This post does not talk much about conversion but only contribution and distribution.

Rules Governing Distribution

Both contribution and distribution are governed by tax rules. For distributions one rule is called the “Required Minimum Distribution (RMD),” which applies to traditional IRAs, SEP IRAs, SIMPLE IRAs, and retirement plan accounts such as 401(k), 403(b), and 457(b) accounts. RMD demands that at certain age (72 now for most retirement accounts) one must take retirement money out, and if one does not withdraw at all, or withdraw less than the RMD amount, you may still be subject to a penalty.

Let’s say you have a traditional IRA with a balance of $500,000 at the end of 2022, and you turn 73 in 2023. Now, according to the IRS life expectancy table, your life expectancy factor is 24.7, which basically says on average you have another 24.7 years to live.

To calculate your RMD, divide your account balance by your life expectancy factor: $500,000 ÷ 24.7 = $20,243.90, this is the minimum amount you must withdraw from your IRA for the current year to meet the IRS requirements.

And if you failed to withdraw that $20,243.90, the IRS has the authority to take 25% out of your account, which comes to roughly $5,061.

But if you take out anything less than $5,061, IRS can still punish you. For example, say your RMD is $50,000 and you only take $30,000, you’d be short $20,000 and could owe a penalty of $5,000 (i.e., 25% of $20,000) to IRS.

(Note the RMD penalty used to be 50%, but it has been reduced to 25% starting in 2023 with the passage of the SECURE Act 2.0, effective in 2023.)

Importantly, funds in the Roth accounts are not subject to RMD during the account owner’s lifetime, adding another attractive feature to Roth, which is not only tax-free for distribution but RMD free.

Crucial Decisions Require Conscious Attention

The common feature shared by contribution, distribution and conversion is consciousness, meaning they don’t just happen but require one’s full attention and conscious decisions.

Consider “investment earnings” for a comparison, which also have tax consequences just like contribution, distribution and conversion but don’t require conscious decisions because they work in the background, more or less automatically, much like interest earnings from depositing money in the bank. Investment earnings also occur continuously, not a discrete event.

How Are Crucial Timepoints Related to Tax Strategies?

Now that we know the #ThreeCrucialTimepoints above, #TaxDefferal is the #SaveOnContribution strategy, while #TaxNow is #SaveOnDistribution strategy.

Contributing without paying taxes (e.g., traditional IRA, 401k) is like parking your car head in first: It’s convenient and you are not required of paying any tax. Later on, however, after you are done with shopping you want to leave the parking lot. At that point you do have to pay taxes on the distribution of your earlier contributed money for retirement. This is like backing out of the parking lot with tails first.

On the other hand, #TaxNow or #SaveonDistribution approach corresponds to “Backing in, driving out” parking method. Since you have taken the trouble of parking your car with tail in first (i.e., paid your tax for the retirement investment), after you finish shopping you can hop into the car and drive off smoothly, knowing you have no tax to worry about.  

Teigen vs. “Wooster” Models

Of course, #TaxNow and #TaxDeferral differ not just by convenience but by financial payoff, which is the whole point behind Teigen’s discussion and mines.

Teigen’s core idea is very simple: It considers which #TaxBracket you are (and will be) during different stages of your life. By this factor #TaxDeferral (i.e., #SaveOnContribution) makes a lot of sense as most people will enter a lower #TaxBracket during #Retirement than they are working. #TaxNow or #TaxOnDistribution makes sense only if no change in #TaxBracket or even increase to a higher bracket, such as when someone just begins working vs 20 years later with several promotions in their career.

My model adds two more factors to Teigen: expected future earnings and possible tax code change with Roth accounts (Roth IRA and Roth 401k). I call it the “Wooster” model as my friends back in college called me “Wooster” even though my real last name is “Wu.”

The Wooster model is more complete and will make substantial differences when we take three dimensions into consideration at the same time: #TaxBrackets, #FutureEarnings and #TaxCodesChangeOnRoth.

Overall, my model will tip the balance toward #TaxNow or #SaveOnDistribution, in favor of using — or converting to — the Roth accounts as the main retirement investment vehicle, especially for high income earners.

For the rest of us, putting money in a regular 401(k) or regular IRA is fine. As a general strategy, I agree with Teigen that we can and should use both strategies, meaning investing in both traditional IRA and 401k and the Roth accounts.

Why Future Earnings Matter

Focusing on tax brackets has a logical problem: The tax bracket is determined by income. For the 2023 tax year, we have the following brackets with the corresponding incomes (for single filers):

• 10%: $0 to $11,000
• 12%: $11,001 to $44,725
• 22%: $44,726 to $95,375
• 24%: $95,376 to $182,100
• 32%: $182,101 to $231,250
• 35%: $231,251 to $578,125
• 37%: $578,126 or more

Focusing on tax brackets but ignoring potential changes in future (retirement) income is like reading the odometer without understanding where the driver went and how far away the destination was. It is the trip plans and patterns of traveling that drive up the odometer, not the other way around.

That sounds fair enough but if income determines tax brackets, what determines income? The answer depends on how — and what — incomes are earned by whom.

For many if not most middle class people, income depends heavily on #ActiveIncome throughout their working lives. This means, among other things, retirement marks a significant turning point in their personal and social lives — but also in the amount and structure of income. After retirement they will no longer receive active income from employment. Many of them will fall into a lower tax bracket, for example from 22% (i.e., for an active income between $44,726 and $89,050) to 12% (i.e., with a retirement income between $10,276 and $44,725).

For high net worth individuals the story is different. Their income comes from three sources of active, passive and portfolio incomes (I will discuss these concepts in another post). Unlike their working or middle class counterparts, retirement makes a smaller income difference. In fact, to the extent they have typically invested in long term growth financial products, retirement ages are the “harvest time” potentially with even higher earnings.

Here is a real life example of how investing in long term stocks can build fortune. According to Motley fool.com, if one had invested $10,000 in Apple stock on September 16, 1997, when Steve Jobs returned to Apple, one would have $2.5 million today. Better still, for all the years in between, as long as one does not sell the stock, one owes no capital gain tax because the gain is “unrealized” while the stock is kept growing in value. You don’t have to be a rocket scientist to figure out which saves more on taxes: Paying taxes at the contribution time in 1997 or paying tax at the distribution time today.

Knowing this picture of expected future earnings in retirement helps us understand why high income earners favor Roth accounts, which allow them to pay taxes on a smaller amount of income early on for contributions but walk away tax-free later with higher income for distribution, matching the “backing in, driving out” method in parking.

The Tax Treatment of Roth Accounts

The tax codes have been generous to Roth accounts, essentially making them tax-exempt, unlike other tax deferred accounts like traditional IRA and 401(k). However, there are two issues with Roth accounts we must know.

The first issue concerns contribution: Roth 401(k) and Roth IRA are (largely) funded with after-tax dollars. I say “largely” because Roth 401(k) is not the same as Roth IRA, the former is employer sponsored just like traditional 401(k) is, while the latter self-administrated.

Having an employer sponsored plan makes things more complicated. Like in a traditional 401(k), employers can choose to make voluntary matching contribution using pretax money, while employee’s own contribution always uses after-tax money. The money from the two sources must be separated, and the employer’s pretax money will be placed in a regular, tax-deferred 401(k) account.

Important Note: With the SECURE 2.0 Act, which was passed in December 2022, employers can now make matching contributions to employees’ Roth 401(k)s with after-tax money.

This new contribution rule solves the second issue concerning distribution. Before the new law: Roth IRA and the part of Roth 401(k) money contributed by employee, are tax-free in distribution, while the part of Roth 401(k) contributed by employer with pretax money will be taxed just like in traditional IRA or traditional 401(k).

Now with the new law, employers can contribute Roth 401(k) with after-tax fund, then employees won’t have to pay taxes on the money when they withdraw it later on.

There are two minor conditions to be satisfied by Roth accounts before tax-exempted distribution can happen: The money must wait for at least five years after the Roth IRA owner established and funded their first Roth IRA, and the Roth IRA and Roth 401(k) holder is at least age 59½ when the distribution occurs, otherwise the distribution will be subject to a 10% tax penalty. They will be treated differently at the time of distribution.

For a hypothetical example, say you had your first Roth IRA account in 1995 when you were 55, and your second Roth IRA in 2000, when you would be 60, you would be qualified to take tax-exempted withdrawal in 2000 because you are older than 591/2 and your Roth IRA money has been sitting in the account for 5 years.

These two conditions for distribution are not particularly demanding, therefore we expect most people would have no problem to receive their money tax free, penalty free and RMD free.

What we might have a problem with is in the future.

The Potential Change of Tax Codes

There is a possibility that Congress may change the tax law for Roth accounts some days in the future, especially with the national debt at such a high level. This is another reason why people may want to take advantage of Roth accounts today, because even with future changes the existing accounts are likely to be exempted.

To be sure, there are people arguing that future changes involving Roth accounts, especially Roth IRA, are unlikely to happen. An interesting article by Investopedia lists five reasons for that. For example, since Roth IRA is funded with after-tax money, withdrawals should be tax free in order to avoid double taxation. Furthermore, having tax sheltered retirement plans like Roth IRA encourages investors to buy government debt. There are already tax-deferred retirement plans like traditional IRA and traditional 401(k), so if we change the tax-free withdrawals in Roth accounts, we will “almost certainly kill the program.” The fourth reason is that Roth IRA accounts are generally small with the contribution limit of $6,500 for those under age 50 and $7,500 for those above 50.

The last reason offered by the Investopedia article is that even with future taxes on Roth account withdrawals, the new taxes will apply to new accounts. The current Roth accounts will be exempted. This is not exactly a reason for no tax change, but rather for preparation of changes in the future.

This in my opinion is exactly why we should invest in Roth accounts as much as possible and as early as possible. After all, you never know what may be coming in the future for sure. One may argue that although Roth IRA and Roth 401(k) are funded with after-tax money, the government may still charge taxes on capital gains at the point of withdrawal on any portion of earnings above and beyond the original contributions.

This is just like your investment in the stock market: Say you bought and hold the Apple stock using your after-tax money, you still must pay capital gain tax — not every year but at the year when you sell the stock. Worse, if you hold the stock for less than a year, your capital gain tax rate is just regular income tax rates of 10% to 37%.

True, such a hypothetical new tax on distribution or withdrawal will kill Roth accounts as we know them today, and turn them into one of the investment accounts. For now it seems highly unlikely. But remember, the only thing not changing is change itself.