Could a future tax system foil my Roth IRA?
No one can predict what the future holds, so you might be better off hedging your retirement by tax diversifying.
Question: I’m 33 and have invested in a Roth IRA for 13 years. This is my only retirement account as I don’t have access to a 401(k). With all the talk of a flat tax and other tax reforms, it seems possible that by the time I retire the income tax could be less of a hit than it is currently. So do you think it would make sense for me to split my IRA contributions between traditional and Roth IRAs? —Michael, Portland, Oregon
Answer: Let me start by saying that I have no special insights into what type of income tax regime a future administration might propose and that Congress might enact.
I suspect that given how entrenched the current tax system is and how many different interest groups have a stake in keeping the status quo that the chances for a radical overhaul are slim. And given the looming shortfalls in programs like Social Security and Medicare, I would also expect that if we do stick with the current system that tax rates would more likely rise than fall in the future.
But I freely admit that I could be underestimating the will for changing a system that is far too complicated, subject to all sorts of manipulation and, perhaps worst of all, wastes an astounding amount of resources when you consider all the time and energy spent by people either trying to comply or evade its provisions.
So for all I know, maybe we could eventually end up with a flat tax with a lower rate than many people pay today but with fewer deductions. Or perhaps we’ll get the “fair tax” system that taxes consumption. Or maybe Congress will pass a “Just send us your paycheck, we’ll take what we need and send you back the rest” tax. (Okay, I made that last one up.)
But even if some crystal ball could tell you what sort of system we’ll have in the future, I doubt that it would also be able to foretell all the details that will eventually determine the rate you’ll pay - what sorts of exemptions and exclusions might apply or what length of transition period we might have.
So what does all this mean for your situation?
Well, as I’ve noted before, although there are some additional wrinkles involved in deciding between a regular IRA and a Roth (or a regular 401(k) and a Roth, for that matter), you’re generally better off doing a Roth if you expect to be in the same or higher tax bracket when you withdraw your money, while the regular IRA is generally the better deal if you expect to be in a lower tax bracket at withdrawal compared to when you put your money in.
But given how difficult it is to forecast future tax rates, I wouldn’t want to put all my money behind the assumption of higher or lower rates. Which is why I advocate “tax diversification.” The idea is that, come retirement time, you want some money in tax-deferred accounts that will be taxed at ordinary income rates. Some in Roth accounts that will be tax-free. And while you’re at it, I think it’s a good idea to have some investments in taxable accounts that are subject to the long-term capital gains tax rate.
I’m not saying this strategy is foolproof. I don’t for a minute underestimate Congress’s inventiveness when it comes to ways of squeezing more revenue out of us. But you can’t cover every contingency, and I believe the approach above is a reasonable one given your options. All of which is to say that I think your instinct to hedge your bets by having money in both a Roth and a traditional IRA is a good one.
There are any number of ways you might pull off this strategy, and I’ve laid out one method in a previous column. In the case of a person like you who is young and presumably has decent prospects for a rising income, I’d probably be more inclined to stick to the Roth for now on the theory that you still have plenty of time to build tax-deferred accounts. You can always fund a regular IRA later if you’re in a higher tax bracket. Or you may have an opportunity to fund a tax-deferred 401(k) later on if you switch jobs.
But if you’re anxious about having your entire retirement stash in a Roth and would like to start this process of diversifying your tax exposure sooner, I think that’s a perfectly reasonable decision as well. Essentially, it’s a judgment call.
Ultimately, you have no control as an individual over what tax system or tax rates you’ll face in the future. But you do have control over how much you save.
So whatever you do, make sure that you continue to fund some sort of IRA to the max every year. Otherwise, your nest egg may not be large enough to support you in retirement whatever your tax rate turns out be.
Responding to the comments about the
Roth IRA and Roth 401-K being a contract with the gov. not to be taxed;
I think the same concept was applied to
social security. It didn’t last. We are
now taxed!
If you no access to a 401k due to self employment, look into another vehicle such a SEP IRA. Though the Roth is a great way to place funds in to access a lower tax bracket, why not get a small kick today as well and get a tax deduction. The game is no longer about how much you make, but rather what you can LEGALLY write off. Sometimes, putting more into your 401K will help lower your tax bracket. Always check with your tax advisor before making such changes.
What I don’t like about Roths is if you die, your children have to put them in their own 401k or IRA account. They can’t be cashed until they retire.
That is what I have been told, correct me if I am wrong.
I’m sure everyone would like to be able to fund some sort of IRA to the max every year, but that’s not an option for those of us who earn too little to make ends meet. I would love to see even one article addressed to people who earn less than $22,000 per year, have high medical costs even with insurance, and whose food cost is three times higher than the average population because of a medical condition. This is not sour grapes…truly, I would be so interested in an article that could help those of us I describe - and there are more people in this category than you might think.
Some people are in favor of a flat tax, some are against the Alternative Minimum Tax. hey guys, the AMT is a flat tax. If you are now subject to the AMT, you will pay less with a flat tax, if you are not subject to the AMT, you will pay more with a flat tax.
Just a point of information, not a moral judgement.
Congress will raise taxes - count on it. That said, I don’t know anyone who has a higher income in retirement than when they worked. In all likelihood, you will have a lower tax rate in retirement for this reason. A mix of traditional IRAs (saving taxes now) and Roth IRAs (saving taxes later) seems reasonable to me.
Why not put a higher tax on whatever is most detrimental towards the enviroment…such as styrofoam cups, etc., or even things that are negative towards society as a whole, such as cigarettes or gambling?
I agree that the Roth IRA is a great way to save for retirement. However, it has been widely reported that 70% of retirees are in a lower tax bracket than when they were working. The best savings scenario is more likely a split between a deductible IRA and a Roth, not 100% into a Roth.
As Roth IRA’s have only been in existence since 1998, how was Michael able to contribute to one 13 years ago?
Roth IRAs and 401ks can be have significant advantages in the right situation, however, when in doubt err on the side of paying tax later rather than paying tax sooner.
The ROTH IRA is the best financial decision the Average American should make concerning their retirement! Taxes will go up! The stock market will go up and down and you dont have to withdraw in down times in a ROTH IRA but you do in a Traditional IRA
You are correct in the assumption that Roth IRA’s will be taxed because the Criminals in Government will never stop taking your money & give it to people who they determine to need it more that you. The thought of “Tax diversidfication” is one that I cuurently employ with all of my financial clients. If you believe that they would never double tax imoney that you have invested your dead wrong. Just look at the Social Security System, you are taxed when you make it & contribute into the system & then thanks to Billy Clinton you are texed to 85% of it when you collect, but when it was set up it was never going to be taxed.
Our country is all about having fun, spend and lead a luxurious life. This is all because of Strong dollar.Always Spend, drink and fun whenever get a chance. Noone see a party without a beer. There is a need to improve spirituality and having fun or spending funnily. Everything need to be done responsibly, but not for fun. This is so far is a strong country in the world and is called one of the super powers. But how many years this will go on with sinking dollar, prices to raise to the top of McKinley, No life without Health Insurance. There should be a great change in all the policies. Insurance companies are eating like anything, by makiing people panic about their death. Not a good thing for average salary people. We must need a great change. Mid 45s and under should lead the country instead of those on 60s. 60s should only advise but not rule. Hence elect a great president who can change all the poilicies.
SS Multiple Taxing
As a recent retiree, the more important issue of how one diversifies your retirement income (IRA, Roth, Capital Gains) has to do with how you will withdraw the money to avoid being taxed double/triple on Social Security benefits.
Your can avoid paying taxes on less than 50% or 85% of SS benefits. When you retire and withdraw to pay tax on SS (double tax), you also withdraw to pay taxes on the tax on SS (triple tax).
By diversifying properly, you can minimizing the amount you withdraw that is not counted as income (already taxed) and stay below the SS taxable thresholds.
PS -I post this for the benefit future retirees
Mike,
My understanding of the Roth 401(k)s is that the employer is not allowed to match with after tax dollars but must instead be putting the money into a traditional 401(k) that is then taxed upon withdrawal. Having said that, it is still a very cool option when available.
Hi Walter,
I’m in the position where I pay no tax at all. When things tanked in 2000 I converted some of my my traditional IRA funds to a Roth. My remaining traditional IRA contributions are now being distributed monthly, but the $9000.00 total is not enough to trigger an income tax liability. It looks like all of those tax free contributions are still tax free, and I haven’t tapped any of the Roth IRAs yet.
The best of both worlds, eh?
Duncan
Mike in Potland:
Company matching funds are usually put in on a pre-tax basis, irreguardless of you making Roth or traditional 401(k) contributions.
I would make it a point to be very clear with your HR and 401(k) provider on this point. While it is possible your employer is paying the tax on your match, its unlikely.
Without getting into politics, the Clintons floated the idea of a one time 10-15% tax on IRA accounts (Back in Bill’s presidency). Whether Hillary actually gets elected or not, the idea of taxing IRA’s before retirement is on some people’s minds (That would pretty much defeat the purpose of having an IRA in the first place, wouldn’t it!)
Mike in Portland,
Your understanding of a Roth IRA is correct, but I think you got the matching part wrong. The company match goes into the traditional 401k bucket. You will have to pay taxes on that when withdrawn.
**************
How would a fair tax affect someone who has saved their money over the years? It taxes them…on everything they spend. Now, THAT is double taxation!!! You paid taxes as you earned it over the years, and now (if the fair tax is enacted), you can pay taxes on it again as you spend it.
*****************
Maybe this is another hint that the more Government we get, the less we get. Perhaps instead of creating all sorts of programs and tax this and that and manipulation of markets, we should allow our market to return to a free one. Stop making messes that are harder to fix down the road.
Roth contributions can never be taxed. Even if Congress changes laws completely removing the concept of a Roth, it still has to honor all pre-existing accounts. Plus, taxing Roth distributions is the prime example of double-taxation. You already paid tax on that money. One of the advantages of it is that you never pay tax on the interest you make.
If you’re doing a Roth 401k (as I am), check how your company does it’s calculation. If I elect to contribute 10% of my salary to either a Roth or standard 401k, the amount that gets put in my account is the same. The only difference is whether the tax on that is taken out of the rest of my paycheck or not. Also, if your employer matches, you don’t pay the tax on that now or ever, unless that’s simply because my employer pays that tax for me.
Marduck in Boston. Your baseball analogy did not make any sense, but since you think a fair tax means taking more money from people that work the hardest and produce the most then the current tax code is perfect for you. But then again you are from Taxachusetts and have no clue how ridiculously unfair the current system is or who is really paying all the bills…
Marduk, perhaps you need to learn more about the Fair Tax. It’s an excellent solution to our current tax situation. Granted it isn’t perfect, but it’s much better than the system we have today.
I would just cap a Roth IRA, and anything beyond that, perhaps put it into a traditional.
The idea that the gov will start taxing Roths is a little far fetched. With a Roth you basically have a contract with the gov to not tax your distributions. Breaking a contract is a lot harder to do then just rasing taxes which there is no contract.
If you’re making the maximum IRA contribution each year, the Roth option lets you invest more, since the tax you pay upfront isn’t counted against your contribution limit, whereas with the traditional IRA, part of your $5000 contribution is going to be taken out as tax later, thus making the tax part of your contribution limit. If you aren’t making the maximum contribution, it’s just betting whether or not the tax rates will go up in the future.
“Or perhaps we’ll get the “fair tax” system that taxes consumption”
Referring to a consumption tax as a “Fair Tax” is like refering to a strikeout as a “Fair Ball”.
I’m still in my 20’s, but I’ve been reading a lot about retirement accounts lately. I’m currently enrolled in a Roth IRA, but I’m trying to debate if I should go to a Traditional IRA. I’ve been having a real difficult time trying to figure out what my taxable income would be during retirement. Would it just be taxable assets sold in a year along with the tax-deffered amount taken out of a 401K? Thanks!
Certainty has a value. So I would always invest in after-tax retirement vehicles when possible. You’ve bought yourself a guarantee that what you see is what you get. People who don’t use Roth products, always have to guess at their portfolio’s true value. So at worst, taxes go down and you’ve bought yourself some certainty, at best taxes go up and you have the best of both worlds.
Now, I wish they would fix AMT so I could follow my own advice.
You are still at towards the beginning of your career and look forward to the prospect of rising income. If the objective is to minimize tax, why not contribute to a deductible IRA until your decutibility phases out. Once your deductibility phases out, contribute to a Roth IRA until your eligibility phases out. Once your eligibility phases out, then contribute to a non-deductible IRA. That way, you’re getting maximum benefit short term and long term and do not miss out on any tax deductions now.
The US is the wealthiest nation in the world, with the highest GDP in the world. We also enjoy the highest standard of living in the world. If that’s a sinking ship, then I’m happy to go down with it.
Regardless of what you do, make sure you try to keep tax-inefficient investments in tax sheltered accounts (e.g., either flavor of IRA) and tax-efficient investments (e.g., index funds) in your personal account. Who knows what the future brings, but you know for certain what the tax rate is today, so arrange your assets across your accounts in the most tax effective way. Accordingly, I’m not sure why anyone would put gold or a similiar commodity that doesn’t throw off taxable income on a yearly basis in any type of IRA.
I was following along with Kieth until his last sentence. If the US is in fact a sinking ship, it won’t matter what or where you have invested your money, it will all be worthless. Let’s have a little American optimism, please.
The idea of “tax diversification” is brilliant and well worth considering.
Another aspect of this would be in the area of “rules diversification”. All retirement progams comes with a multitude of rules for what we can and cannot do with our money. Since they differ from plan to plan, it would be a good idea to have multiple plans in the hope that at least one of the plans would allow us to do what we want to do, when we need to do it.
In a typical 40 year career, it would be good to have a Roth IRA for the 1st half when our salaries are low and the tax bite small and a traditional IRA later on when a tax deduction is more useful.
The thing most people overlook is that the tax rates for people who pay meaningful taxes at all will be going up in the future, probably by a lot. Those enormous deficits, “stimulus packages”, and of course Social Security and Medicare have to be funded from somewhere. Government spending only goes up, and with boomers retiring and debt at astronomical levels there is no reason to believe you will be taxed at a lower rate when you retire even if your retirement distributions will be dramatically lower than your current salary. I expect to see the middle-class brackets move from 25/28% to the 40/50% range within 25 years. Unless you intend to retire in a house that’s already paid for and take distributions that are insignificant (no more than, say, $30k a year), you’re all but certain to pay higher tax rates when you retire than you do now.
That argues for a Roth-centric strategy, but only if you believe the tax consequences of the three strategies will remain basically the same. Congress could at any time make all retirement withdrawals fully taxable, eliminate or reduce the advantage of ordinary IRAs and 401(k)s, or eliminate the tax breaks on long-term gains (indeed, the break on dividends is set to expire soon). I assume many or all of these things will happen in addition to increases in rates, so I see little point in using these methods to save for retirement beyond what you have to do to get any employer-paid matching funds. The author’s suggestion to tax-diversify makes sense, mostly because the benefits of any one approach are subject to complete destruction at any time without rhyme or reason.
Instead of focusing solely on taxes, which can be changed on a whim by Congress, it is better to focus on the strategic investment choices you can control. The US dollar is weak and while there may be short-term reversals, the fundamentals are awful and weakness will only get worse in the long run. Inflation is sky-high, the trade balance is horrible, government debt is out of control, monetary policy is grossly irresponsible, and most individuals have more debt than they’ll ever be able to repay. These are the same fundamentals that will force taxes higher. As such, the number one priority in saving for retirement has to be protecting against dollar losses (either relative to other currencies or in absolute terms as a result of inflation). The best ways to do this are to buy top-quality assets denominated in better currencies such as NOK and CHF. There are good stocks out there traded in these currencies. Also consider foreign paper and stocks in multinationals receiving most of their revenue in non-dollar currencies. Oil is always a good bet, and gold and silver belong in every long-term portfolio. Since you should be tax-diversifying, it makes sense to allocate these assets to accounts for which the tax advantages that exist today have the greatest impact. For example, gold belongs in Roth IRAs. This way, if any of the tax advantages do remain, you’ll be able to use them to maximum effect. Finally, if you can find legal ways to do so, shelter some of your wealth abroad. The US is a sinking ship; don’t be the guy without a life jacket.
I’m confused, how could this person have put money into a ROTH IRA for 13 years, hasn’t the ROTH only been around for 10?
Another variable to keep in mind is that considering the current and future levels of the federal debt, it’s almost certain that Roth IRA withdrawals will be taxed in the future.
For example, if you have more than a certain amount saved across multiple retirement accounts (e.g., Roth IRA, SEP IRA), your Roth IRA withdrawals will be taxed in order to fund retirement benefits (e.g., via Social Security) for those who saved little or nothing. And any citizen or Congressperson who complains will be called greedy.
I know you were kidding with the “send us your paycheck and we’ll send you back the rest” comment but I wonder how far off the mark the comment really is. Between what I pay in taxes and spend for all insurance, I’m lucky if I have 40% of my pay left over. And that’s before I pay my “consumption tax” in Tennessee where, while we don’t have an income tax, we’ve got a whopper of a sales tax. It’s sad there’s little incentive in our country to save and so much incentive to spend. I guess I’ll just go off and learn Chinese since they already own us!
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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).
Does Anyone know if there is an option revalue your rollover to a Roth for tax purposes during the year of conversion i.e. if I convert in June and the value is 100K but before year end the FMV drops to 75K, do I get a 1 time FMV adjustment for tax purposes or is it on the date of conversion in June?