When planning not to run out of money in retirement, there is a lot more to consider than the current year’s tax deduction, which is the most common method for people preparing for retirement.
What are the vehicles and how do they work?
Individuals who are determining how invest for retirement are often proposed 2 options: Roth or Traditional Retirement Accounts. These 2 options usually come to the forefront of retirement planning because of the tax incentives that are associated with each. In this blog I will address the 2 types, a loophole in the IRS code, as well as the 3 things to consider when trying to determine the right option for you and your plan.
What is the difference between ROTH and Traditional?
When discussing both types of accounts, we must identify that these accounts can be either in a employee sponsored 401k or an Individual Retirement Account (IRA). The basic tax benefits are the same with a few slight differences in contribution limits as well as the 401k not having income limitations like the IRA. If making the decision in a 401k, although some of the nuances are different, the tax rules and considerations are the same.
ROTH is an account that is available to US taxpayers to help them ready for retirement. There are some basic differences that the ROTH has versus the traditional.
- ROTH accounts have tax free benefits, unlike its Traditional counterpart. With the ROTH, the participant takes dollars in which they earned in the current year and contributes those dollars after tax to a retirement account. Those dollars can then be invested, most often using stocks, bonds or funds and grow tax free. Here you pay the taxes today for tax free distributions in the future.
- The ROTH has income limitations when in an IRA (when in a 401k there are no income limitations). For a single person, the limit is $137,000 in gross income for the year 2020. For a married tax filer, the total household income cannot be more than $207,000 in 2020. If you make more that those amounts, you will be unable to contribute to a ROTH IRA. If you do not qualify because your income is too high, you may find benefit in a ROTH conversion, or a loophole in the IRA rules (see conversion).
Traditional IRA is also an account that is available to US taxpayers as an alternate way to prepare for retirement. Traditional IRA’s are treated differently by the IRS than its ROTH counterpart.
- Traditional IRA’s are accounts in which the participant will contribute for retirement in an account that is tax-deferred. The idea is that any contributions that you make in the current year will be reduced from your income on your tax filing for the year of contribution, thereby lowering the amount of income you have to pay taxes on for that year.
- Income limitations are a bit different from the ROTH. With the IRA, if you or your spouse have an employer plan available, the participant will phase out from being able to take a deduction, ultimately leading to no real benefit. Most individuals that have an employer-based plan cannot contribute to both plans, regardless if income. If there is no employer plan, there is a full deduction up to your limitations. See www.irs.gov for the different rules based upon how you file your taxes.
For both plans, they follow the same contribution limits. The maximum annual contribution for 2020 is $6000. There is a special catch-up contribution that you can make if you are over the age of 50 in the amount of $1000, totaling $7000 for individuals over 50 years of age. until the participant reaches the age 59 ½.
NOW – What are the 3 things to consider when choosing which is right for you
- Longevity – Taxes is the biggest wealth killer in your plan. So you may have to use more than you think you will, especially if taxes are higher in the future. Given the deficit and all that is going on with COVID-19, do you feel taxes will be higher, the same, or lower in the future? Before we get into forecasting, let’s take a look at how taxes work on the money you earn, in a very basic format. We have a tiered tax system, meaning that your tax rate changes as you go up in tax brackets. If we look at 2020 tax brackets on that money, if you make $200,000, then your taxes will look something like this if you file married:
$0-$19,750 @ 10%
$19,751-$80,250 @ 12%
$80,250- $171,050 @22%
$171,050 – $200,000 @ 22%
What that means is you pay a different rate as you go up in earnings, you don’t just jump up to 22% on all $200,000. When you look at retirement, if you need to have $200,000 in order to pay your lifestyle, how do you get that money? If you are taking social security plus all tax deferred retirement accounts, all of your income is taxable, and you have to take more out on an annual basis than you thought.
But what if you had another account, like a ROTH. That leads us to…..
- Weighting – How much you currently rely on your tax deferred dollars? In the above example, what if you could save the 22% on the $28,950 (200,000-$171,050) on an assumed distribution in 2020? Then in retirement, you have to pull out $6,369 (the 22% taxes on $28,950) less that can stay in your tax deferred account. Those are the dollars that we want to pull out in the lowest brackets, saving you on taxes. If you are contributing to a retirement account, these tax brackets play a huge role in how much to contribute to a traditional account.
A different way of looking planning which retirement account to contribute to is to consider the future possible tax rates. If we are at 22% on those dollars in 2020, what if rates go back to the year 2000’s tax brackets. If you take a 22% break today, to pay a future rate that mimics 2000, then your tax bracket would be $132,000-$200,000 @ 36% tax rate. That’s 14% additional in taxes. Perhaps taking the break today in the current environment may not be as beneficial as you thought? The good news and bad news……the current tax rates are due to sunset in 2025, meaning in 2026 we go back to the same brackets in 2015 or a new tax bracket based upon that future administration. Good news is to take advantage of the low taxes today, bad news is that those rates are not here forever. In the future, taking the deduction may be more appealing. So how can we contribute to a ROTH IRA considering above you had mentioned we cannot if we make too much money?
ROTH Conversion – The IRS has a loophole that allows you to take existing IRA dollars and convert them into a ROTH account, paying the taxes today for future tax-free distributions. Something that you should consult your financial advisor and tax advisor to see if it makes sense for your plan.
- Inheritance – The SECURE Act was passed in December of 2019 and changed the inheritance rules around IRA’s. (Currently, and in the past, the spouse can inherit the IRA and use it as though it is theirs, so this does not apply to a spousal inheritance). In the past, a beneficiary, or the person that inherits the IRA, could take distributions based upon their life expectancy, depending on how old the decedent was at time of death. This was called a stretch-IRA, which allowed the beneficiary to draw down dollars under circumstances that could be more tax advantageous than their other 2 options; draw down in 5 years or take in one lump sum. Under the current rules, a beneficiaries longest stretch option is only up to 10 years to take the distributions to bring the account to $0. If that is a child with an already high income, those dollars get added to their current income level, possibly giving more to the IRS and less to that beneficiary. From an inheritance standpoint, tax deferred dollars are the worst to leave behind.
There is a lot to take into consideration when planning for retirement. If you have any questions on how to plan for your retirement, please reach out to schedule a free consultation with Bobby. If we are a fit for one another, we can help you to determine a map through your retirement to help you meet all of your goals and make your dream retirement a reality.