Taking a Firm Stance On Which IRA Should Be the Cornerstone
By CHM on Jan 15, 2008 in Featured, Financial Planning, Retirement, and Now!, Roth IRA Rules
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Every time I’m on the internet or watching TV I hear much of the same investment rhetoric over and over and over.
I’ve written about this kind of thing in the past, in a post titled CNBC and Me. Well, in this post I’d like to peek into the retirement arena, where the needle seems to be stuck on repeat; specifically the Roth vs Traditional IRA debate.
When it comes to IRA planning, commentators are always delivering the same soggy, watered down message, often speaking out of both sides of their mouth. Here’s a good example of something you might hear…
‘When it comes to picking an IRA, sometimes investing in a Roth IRA makes the most sense, and sometimes investing in a traditional IRA makes the most sense.’
Want some visual evidence? Please take a minute to watch the above video produced by Vanguard and you’ll see what I’m talking about.
Freedom vs.
It’s no wonder people are so confused about where to start investing their retirement money. It’s so hard to get a straight answer anywhere, everyone’s always hedging their bets, including me. But I’m tired of it and it’s time to take a stand. Much like the Robert of Earl from Braveheart, I want to Believe!
So, I stand before you and give you the following Earth shattering statement…
If you’re serious about planning for retirement and your risk profile is moderate to growth oriented, then get your money into a Roth IRA, somehow, someway and make investing in a traditional IRA secondary!
Here are 4 reasons I believe wholeheartedly in that statement:
It’s always best to control your own destiny. When people argue that a traditional IRA may make the most sense their stance is always centered around two things:
- your future tax bracket
- and future tax rates.
They argue that in retirement, since you (probably) no longer earn a full time wage, your taxable income will drop. That stance is usually followed by a statement along the lines of, ‘maybe tax rates will be lower in the future as well‘ or ‘who knows where tax rates are going to be in 30 years.’
Well, I certainly have no idea where future tax rates are going to be, nor do I really care. The only way you will ever be free from the clutches of the tax man is by taking him out of the equation. I refuse to allow someone to have that kind of influence over my future.
Control your own destiny by taking all this gray area out of the equation. Don’t be held hostage by something you can’t control in a far off time. Get your hard earned monies into a Roth IRA and focus on building a well diversified portfolio that you can contribute to on a yearly basis.
If you do the right things, in 20 or 30 years, you will be able to enjoy the fruits of your labor. It won’t matter if the average Joe is paying 10% in taxes or 90% in taxes… your Roth money is TAX FREE!
Believing your future tax bracket (or future tax rates) are going to be lower is someone else’s opinion, not a fact.
I think a healthy assumption here is to believe there’s going to be little to no change in taxes paid when you cross over from pre-retirement to retirement. Why do I say that?
For starters, it’s based on my experiences with clients. Although it’s true many people no longer have mortgages or children to take care of, they replace those expenses in different ways.
They have pensions, taxable retirement distributions, social security, capital gains, other forms of passive income, etc. I’ve dealt with clients that have worked very hard to build large retirement accounts, only to see their distributions mercilessly taxed as ordinary income when they finally take their money out.
I think a real life example would be useful to drive the point home:
John Fenwick is just turning 70 years old and receives $3,200 a month in pension benefits. John is very frugal and, because of that fact, has never had to take a distribution from his regular IRA. Because of John’s age he is now required by law to take his RMD (required minimum distribution). Let’s assume John’s retirement account is worth $1,236,616.
What? You think that’s too much, not really. If John were to contribute $5000 a year for 35 years (and not contribute from age 65-70), earn 8%, then that’s what the account would be worth.
John’s required minimum distribution would be somewhere in the neighborhood of $44,000. On top of which John earns another $20,000 from social security. Let’s not forget the $38,400 in yearly pension benefits, as well as, his wife’s social security income of $7,000. Without going into dizzying detail, at this level of taxable income, John’s social security benefit is 85% taxable, as well.
So you tell me whether or not having a Roth IRA is worth it?
If this account was a Roth IRA that $44,000 distribution would have been tax free, and better yet, he wouldn’t be required to take it. Remember, with a Roth IRA there is no forced RMD. Sounds pretty good now, ha.
For arguments sake
Let’s imagine John’s account is a Roth IRA and he decides to take the $44,000 distribution to buy a new BMW, what the heck. This distribution is 100% TAX FREE.
Because this $44,000 is not included as taxable income, he and his wife’s social security benefits are taxed at a reduced rate (down from the 85% mentioned above), not to mention, his overall tax burden is far more manageable.
Because there is no required minimum distribution for a Roth, the owner can elect to leave the account untouched.
The account can be passed on tax free to his (or her) spouse, retaining it’s tax free status for the new owner. That’s huge! If one of your goals is to create a legacy to pass down for a generation, a Roth IRA is an excellent estate planning vehicle.
Why do you think iconic American families like the Rockefeller’s or Vanderbilt’s preserve so much wealth from generation to generation? I’d say a big part of it has to do with top notch legacy and estate planning; minimizing the slippage that usually comes in the form of income and estate tax.
Consistent yearly contributions into a well diversified, periodically re-balanced equity portfolio, will yield a bountiful harvest.
If your Roth is worth a lot of money someday, then you will have successfully avoided paying a bundle in taxes during your retirement years.
In conclusion
At the end of the day, what I’m saying in this post goes back to what I always say around here. If you take the necessary steps and begin aggressively planning your future (with the Roth being the cornerstone), then IMHO, there’s no way a traditional IRA can compete with the Roth, irregardless of future tax levels.
Stay committed to creating the future you want and have no doubt that the Roth is the vehicle that will take you there!
A bit of housekeeping
I said above in the Earth shattering statement… ‘make investing in a traditional IRA secondary!‘ Well, if you need to make non-deductible contributions now, in order to eventually convert to a Roth IRA, then I’m all for putting it into a regular IRA to get the ball rolling…
(Please read my disclaimer before leaving this post)
Tags: 2010 Roth IRA Conversion Event, required minimum distribution, RMD, Roth IRA Conversion
The Happy Rock | Jan 17, 2008 | Reply
New subscriber here. You have a great looking site, nice job!
Thanks for the insights in this article. I am also one that prefers dealing with the here an now rather than speculating decades in advance.
PS - I don’t see a video or a link anywhere.
CHM | Jan 17, 2008 | Reply
Happy,
Thanks for subscribing, trying to get the word out. I’m glad you agree with me, I figure I’d get a few people disagreeing but so far quiet.
The video should be at the top, where the opening image appears in all my other posts. Works on my PC’s, if you still can’t see it, could be a browser or computer issue.
Let me know… I can always fire you the link. Thanks
Mrs. Micah | Jan 18, 2008 | Reply
I started my first Roth IRA today!
Not much, but it’s a start…and I look forward to not having to pay taxes when I pull it out.
CHM | Jan 19, 2008 | Reply
Congrats Mrs.Micah. You are way ahead of the game based on your age, shhh;)
Might want to take a look at this article, which may compliment your decision… http://chancefavors.com/2007/12/3-ways-to-build-a-model-investment-portfolio-using-etfs/
Dan | Feb 5, 2008 | Reply
A few comments.
First, John would not have $1,236,616 in his Roth IRA unless he contributed $5,000 per year after taxes. To keep the same impact to his take-home pay, he will only contribute $3750 per year to the Roth if he is in the 25% bracket. This will make his tax-free nest egg worth $949,462 at age 70. He would still have the benefit of not subjecting his social security benefits to taxation, though.
Second, it is important to note that the money analysis is based in the past. Contributing $5,000 per year 35 years ago is equivalent to contributing $16,277 per year today.
Third, I agree that no one knows what their tax rate will be 35 years from now. I’ll add that no one knows what the policies on required minimum distributions and taxation of social security benefits will be 35 years from now. I split my retirement contributions between Roth and deductible plans to manage the risks of the unknown future.
Finally, your #4 argument has no basis. Show your math on how taxes have been saved. If you had contributed to a deductible plan, you would have contributed more, so your taxable nest egg would be even larger than in the Roth (as illustrated in my first point). This is a mathematical equation: contribution X investment gain X tax. Deductible plans put tax at the end, Roth plans put it at the beginning. It does not matter where you put tax, the result is the same. a X b X c = abc; c X a X b = abc.
CHM | Feb 25, 2008 | Reply
Dan,
Doing a little house keeping tonight, before I get ready to write a post about a similar subject to this (except dealing with 401k’s) and wanted to address a few of the points:
Yes he would have $1,236,616 in his Roth IRA account in 35 years based on the assumptions… it’s a simple future value of money equation. When you make that Roth contribution the check says $5000, not $3750, as you so often allude to. You don’t need to tell me what the taxable equivalent contribution is, there’s still $5000 real dollars going into the account.
Your second point is not relevant. I was trying to make the article digestible for readers, regardless of the numbers you reference, my point is still the same.
In the last point you referenced I did go back and change some of the wording because I think my point wasn’t clear, which I think lead you to write what you wrote. (So I understand that)
To conclude, I’ve seen your argument before about how everything equals out (after taking the tax equivalent contribution) and it all depends on future tax rates and to tax diversify (and that’s fine).
If you take out the positive psychological benefits of a Roth, no RMD benefit of a Roth, estate planning tool benefit of a Roth, then it’s more of a level playing field between the two.
Using your math, it comes down to which is more valuable: getting a current tax deduction (after tax equivalent of $1250) or the power of socking away the full $5000. Well how do you measure that?
Using any Roth v Traditional calculator you (as I’m sure you know) take the $1250 and grow it out in a taxable account for all these years and add it to the traditional IRA totals in 35 years from now. Inevitably, it always falls short due to the taxable nature of the account where the $1250 resides.
The only reason to favor a traditional IRA over a Roth IRA (assuming you already know you wont care about forced RMD’s and estate planning 35 years from now) is if you know you’re future tax bracket is going to be significantly lower than the one your in today.(which I argue you can’t and I say take it off the table completely)
All in all, taking everything into consideration I still think when it comes to IRA’s… the Roth is definitely your #1 option and the first place you contribute.
Reinhold | Feb 27, 2008 | Reply
I fall in between the two contestants (Dan and CHM). I side with CHM in prioritizing my RIRA over my IRA — the distribution flexibility can’t be beat, and the inheritability features are superb. But I also side with Dan in that the trad. IRA cannot be ignored — one can go too far in seeking a tax-free retirement, because the IRS gives everyone the standard deduction and no one should forfeit that. I intend to have a trad. IRA of about $125k so that my RMDs will fully offset my standard deduction. (I may have to adjust that figure in a decade or so, once I get some feel for about where the standard deduction will inflate by the time I’m 70.5 — in 2040.) I won’t give an estimate of my RIRA, but I intend it to be severalfold that of my trad. IRA balance.
As with most things complicated by the guv’mint, I think there are more “depends” clauses to the debate than covered by the contestants above. If your earned income is so low that you don’t have enough of it to offset both your standard/itemized deduction and the IRA deduction, then you would contribute to the RIRA instead. (Of course, you might be scraping to come up with much of a contribution.) If your earned income is high enough to offset your deductions but is not above the IRA deductibility thresholds, then you should contribute at least some to the traditional IRA. But once your earned income is above the IRA deductibility threshold yet below the $100,000 RIRA threshold, then of course you’re back in RIRA contribution land again. I like to look for the sweet spots in the loopholes; this year it’s in the 0% dividend and L-T cap gains rates for those in or below the 15% bracket break in the tax table. Going to use my standard deduction to fund a tax-free (yes, Dan, TAX-FREE) conversion rollover from my IRA to my RIRA.
CHM | Feb 27, 2008 | Reply
Rheingold… thanks for the comments and welcome.
Like most subjective topics, there is plenty of room for debate here. You can support most any argument you want, what you can’t support (with numbers) are the positive psychological benefits from a future tax rate of 0% on a portion of your assets.
I think tax diversification is smart (because like you said who knows what happens in the future with the laws) but a Roth IRA and Roth 401K should be the cornerstone and first option.
Also from a tax standpoint it’s hard to imagine taxes not being higher in this country 25 years from now, but like I say in the original post… take that off the table by funding accounts that bring a 0% future tax rate.
Reinhold | Feb 27, 2008 | Reply
Yes, I think it reasonable to imagine tax rates higher during the next secular bull market (like when Clinton’s 90s raised taxes during the boom to pay for Reagan’s 80s lower taxes during the Cold War and pre-1984 economic conditions). But 15 or 20 years out, who can say? You are a brave man for making a 25 year prediction. Maybe we’ll still be here to call you out on it. ;-\
Since this is an IRA topic, I thought I might ask a question, to be answered by you at your convenience, either in these comments or in a post. I have a parent who has a traditional IRA (rollover from a 401(k)), all deductible contributions no 8606s to worry about. The parent is about 65. Presumably there is no legal problem with partial conversions from the IRA into a RIRA through age 70. But at age 70.5, then RMDs kick in, is there a further prohibition against Roth conversions? I thought I had heard or read it, but cannot find any reference to that now. And I did rifle through IRS Pub 550 (I think it was) a bit and could find no such prohibition. The only qualification I could find was that the RMDs themselves could not be Roth converted. But any amounts above that each year could be converted even past age 70.5. Do you concur? Any other snags that might apply in this kind of — not so uncommon I’d imagine — situation?
Thanks for your input. I hope you don’t think this is a test. ;-\
CHM | Feb 27, 2008 | Reply
Hey Rhein… don’t think it’s a test:) Not making future tax rate predictions but these guys are… http://chancefavors.com/2007/07/future-tax-rates/... be sure to open the report.
Also will have to get back on the meat of the question, just so swamped at the moment. But check here for answers on tricky IRA questions, pose a question in the forum if need be… http://irahelp.com/
Let me know what you find.
regards,
C
CHM | Feb 28, 2008 | Reply
Rhein - quick follow up… should have wrote this yesterday but you know how it goes some time.
You can take your after tax dollars and contribute to a Roth IRA at any age (even after 70.5). If these monies comes from your RMD, sure why not… keep in mind taxes are due on the RMD, but you can take those (now) after tax dollars and make a Roth contribution.
Actually about 2 months ago, had a client who had to take his RMD. He did. He turned around and made a contribution to a Roth for both he and his wife, he’s 71, she’s 75.
As far as doing a large Roth conversion after 70.5, I’d check with your CPA
Reinhold | Feb 29, 2008 | Reply
That’s good to know about the Roth IRA. I was wondering about that. I almost had myself convinced that RMDs were not considered earned income for the purposes of determining ability to contribute to (any) IRA. Or was the 71 year old client allowed to make the Roth IRA contribution because he had other earned income to justify it, and his after-tax RMDs just happened to be the source of his Roth IRA contributions?
Thanks for the irahelp.com link. I’m still digesting the board threads there.
By the way, I don’t have a CPA. I don’t do anything too exotic, so I feel safer going it alone. (I would hire an attorney to look things over were I to have a real estate or other large transaction.)
CHM | Feb 29, 2008 | Reply
The 71 year old did need to have earned income, which he does. His wife’s Roth IRA was a spousal IRA based on his income numbers.
And yes the after tax RMD just happened to be the source of his Roth IRA contribution.
TFB | Mar 9, 2008 | Reply
First of all we are talking about people who can make a *deductible* contribution to a traditional IRA here because Roth beats non-deductible IRA for sure. No argument.
If they can indeed contribute more if they use a Roth versus putting the equivalent pretax dollars into their 401k’s, that requires them to max out their 401k’s too. That’s $31k a year for a two-income family. So you are talking about a couple who saves at least 30% of their income toward retirement in their 401k’s and IRAs. No many people can do that.
So we are back to looking at Roth on one hand and traditional IRA plus more money into their traditional 401k on the other. You can’t assume the tax savings from traditional must go into a taxable account.
Unlike the clients you are dealing with, people making this Traditional vs Roth decision today likely don’t have a defined benefit pension. Nor will they have sizable taxable investments because they can’t even max out their 401k’s. Without defined benefit pension or sizable taxable investments, they won’t have much problem with RMD because they would’ve already tapped their IRAs for retirement income before they get to age 70.
IMO Roth is clearly better if you can’t deduct the contribution to a traditional IRA. For people who can deduct, the case is far from clear. As far as the psychological benefits go, to use an extreme example, it doesn’t make sense to pay $2 in tax today in order to save $1 tax tomorrow. Back to guessing about future income and tax rates …
CHM | Mar 9, 2008 | Reply
@TFB - thanks for dropping by. I agree it’s far from clear and each person’s situation is different, but as a rule of thumb I believe a Roth should be prioritized over a deductible traditional IRA contribution.