“More investment sins are probably committed by otherwise quite intelligent people because of ‘tax considerations’ than from any other cause.”
This article reflects Boston Research & Management’s understanding of rules and tax consequences relating to Roth IRAs. The article is not intended to be formal tax advice. Please consult with your tax advisor before implementing Roth IRA tax strategies.
Following a nearly year-long recovery, volatility returned to equity markets in Q3 2023, with all three major indices posting a quarterly loss for the first time since Q3 20221 (S&P 500 -3.6%; DJIA -2.6%; NASDAQ -4.1%).
Pressure came from all sides, accelerating toward the end of the quarter as labor strikes, rising energy prices, the threat of a government shutdown, and uncertainty surrounding the future path of interest rates—exacerbated by the Federal Reserve’s vacillation on monetary policy—gripped investors’ attentions. With talk of a recession creeping back into headlines, the market’s course ahead is rife with uncertainty. That said, while it is vital to consider what markets may do in the coming months, it is also important to review how investors’ assets can be structured to most efficiently capture returns and weather volatility.
Since its passage in 1913, our graduated personal income tax system (PIT) has come to dominate fiscal policy and, in turn, plays a large role the shape of the US economy.2 So, it is not surprising that tax-aware investment vehicles are attention grabbers. Nonetheless, while much has been written about the advantages of accounts with “Roth” tax status, they still prove to be underutilized by investors. Many are confused about eligibility, while others do not fully understand how these tax shelters can improve their overall retirement strategy. Let’s dig into these issues.
Officially written into tax codes in 1998, the Roth IRA debuted with a maximum annual funding limit of just $2,000 and income eligibility caps of $95,000 single/$150,000 married, and thus was passed over by many. Yet as the years have passed, these rules and limits have changed. For 2023, Roth IRAs have an annual funding limit of $6,500 ($7,500 for those 50 and over) with income caps increased to $153,000/$228,000 for single and married tax filers. To fund an IRA, there must be earned income, but if filing married, both spouses can fund a Roth using a “spousal contribution” even if there is only one income in the household. The ability to potentially contribute up to $15,000 into Roth IRAs each year comes as a surprise for many investors.
In 2006, the IRS began to allow “Roth” 401(k)s, supercharging this tax shelter in two ways. Most significantly, 401(k)s do not have income eligibility limits—if a company offers a 401(k) (and has updated it to allow for Roth elections) then any employee can take advantage of this regardless of their income. Secondly, 401(k)s have much higher contribution limits. In 2023, each employee can contribute up to $22,500, with an additional $7,500 “catch-up contribution” for those 50 and older. Thus, a married couple who each have a 401(k) can contribute up to $60,000/year to their Roth 401(k)—and if they meet the income requirements, another $15,000 into Roth IRAs. Additionally, a 2010 amendment to the original Roth IRA rules removed the $100,000 annual income limit on “converting” IRA assets to a Roth IRA. Suddenly, an entirely new planning strategy became available. Still, many look at the tax liability associated with making the conversion and balk at the notion. So, who should be considering this strategy and what are the advantages?
To take a step back, let’s consider the different types of investment accounts from a tax perspective.
Taxable Accounts: Included here are individually or jointly held brokerage and bank accounts. Each year, these accounts tend to generate taxable income in the form of dividends and/or interest. Additionally, if an asset increases in value and is then sold, the resulting capital gain is also taxed. Funded with “after-tax dollars”, the tax burden from these accounts can weigh quite heavily on investors. That said, there are no limits on how much money you can put in, take out, or how long it must remain there.
Qualified Retirement Accounts: Numerous types of accounts fall into this category, including IRAs, 401(k)s, 403(b)s, and 457 plans to name a few, but all share the same tax characteristics. Contributions to these plans are typically tax-deductible and are thus funded with “before-tax dollars.” Such deductions reduce the taxpayer’s liability in the year the contribution is made. Any income or gains realized in these types of accounts are sheltered from taxes when they occur. Upon withdrawal, however, every dollar is added to the taxpayer’s gross income and taxed accordingly at ordinary income rates.
Roth/529 Accounts: The newest of the tax shelters, these accounts include characteristics of both taxable and qualified accounts but with an added feature. Money going into these plans is still taxed in the year it is earned—there is no tax deduction, similar to adding money to a savings account. Yet like the qualified plans above, income/growth is not taxed as long as it remains in the account. But the real showstopping benefit comes at withdrawal: assuming the investor is at least 59.5 years old and the account has been open for 5 years, funds—including all prior income and growth as well as principal—can be withdrawn entirely tax-free.
Does this make a Roth IRA a good choice for eligible investors? This question almost always comes up, and rightly so! Investors are often pitched all manner of products promised to be the “end-all, be-all” solution, only to unnecessarily complicate tax returns, reduce liquidity, or charge egregious fees. The innate beauty of the Roth concept is that this is not a product, rather just a type of ownership. As such, it can hold just about any security. So, when an investor is identifying a potential addition to their portfolio, thought should be given to how to best “own” this position to maximize after-tax returns.
It is good practice when considering any financial instrument or strategy to identify what problem (if any) they are designed to solve. To do this, we should reconsider long-held beliefs and assumptions around tax rates. For many generations, retirement started at 65 and frequently included a pension. At the time, it was standard to switch investments to a conservative allocation so as to not outlive the funds. Life expectancy was less than 70 years until the late 1960s, meaning assets had to last just 5 years on average. Taxes were never much of a concern. Today, many Americans are retiring much earlier or switching careers to work at a reduced capacity for longer. Life expectancy tables have also significantly increased, and many retirees are still thriving well into their late 80s. While this is clearly favorable, there are substantial financial differences between today’s retirement and that of prior generations.
Even with the discontinuation of most employer-sponsored pension plans, retirees are finding themselves in higher tax brackets than they ever expected—sometimes even higher than in their working years. But why? For one, retirees may have larger taxable accounts that generate greater dividends, interest, and capital gains. With their kids out of the house and mortgages paid off, retirees may also have fewer tax deductions available to them. Then there is the unfortunate impact of having to switch to the higher “single” tax bracket after the passing of a spouse. Still, the largest factor driving tax brackets higher during retirement is most often the Required Minimum Distribution, or “RMD.”
RMDs are the government’s way of extracting as much tax revenue as possible from tax shelters during the owner’s lifetime. They do this by applying an annual factor based on age to determine the portion of the Qualified Account (such as a 401(k) or IRA) that must be withdrawn each year. Since any distribution from these accounts is taxed as ordinary income, this effectively increases taxable income each year. As we know, higher taxable income also triggers knock-on effects, such as increasing the taxable portion of Social Security, higher capital gains rates, higher Medicare premiums, and reduced deductibility of medical expenses. Because 401(k)s have largely replaced pensions for most corporate employees, balances in qualified plans have ballooned. In turn, RMDs—previously not much more than an annual inconvenience—have become the largest single tax liability for many families.
How can Roth regulations help with this? Well, as previously mentioned, the $100,000 income limit on Roth conversions has been removed. As such, investors can carefully and strategically maximize their annual tax brackets by converting assets from a traditional IRA to one with Roth status; there is typically a sweet spot for doing so in the years between an investor’s retirement and the start of their RMDs. Under the new rules, this period often lasts 10 years or more since many are not required to take RMDs until age 75. Taking advantage of those very low income years by undertaking substantial Roth conversions can help in a number of ways.
First, by lowering the balance of the accounts subject to RMDs, investors are effectively lowering their taxable income in future years, which can have a favorable impact on income eligibility-based programs and benefits (such as Medicare) down the line. While taxes need to be paid at the time of conversion, only the amount converted will be taxed, and any future appreciation or income will be enjoyed free of all taxes. RMDs also do not apply to Roth IRAs, and this same favorable tax treatment is granted to surviving spouses and other beneficiaries. Therefore, a Roth IRA can be a very efficient way to pass dollars to the next generation (children do need to liquidate the account within 10 years of the year of original owner’s death, but it will all be tax-free). Finally, during retirement, it can be tremendously valuable to have a bucket of money with zero tax liability, which can fund the purchase of larger assets (property, additions, vehicles, etc.) as well as increase available spending money without incurring additional taxes.
However, perhaps the most overlooked advantage to having substantial Roth assets is the ability to cater the investment selection to the account type. Knowing that RMDs are based on age and year-end IRA values, those accounts—in a perfect world—would hold conservative/stable investments as to not increase taxable income unnecessarily. Tax-unfriendly assets that are expected to both generate income and appreciate in value could then be placed in the Roth, allowing the investor to keep 100% of the gains. Income earned from Roth IRAs also does not factor into modified gross adjusted income (MAGI) calculations and therefore has no impact on MAGI-based benefits and programs, including Medicare premiums. This then leaves taxable joint/trust accounts, which can be paired with a tax-free municipal bond strategy to create tax-free income and regular liquidity events in the form of bond maturities.
To summarize, today’s retirees often find themselves with little to no control over their taxes. Updates to Roth IRA regulations now present an opportunity to incorporate a level of tax planning that was previously unavailable. Roth IRAs can be a tremendously powerful tool when used properly; please reach out to our team at Boston Research & Management and your independent tax advisors to explore if they are prudent for you and your family.
1 The NASDAQ turned slightly negative in Q4 2022 as well, while the S&P and DJIA remained in the black.
2 According to the Bureau of Economic Analysis, PIT receipts amounted to roughly 57% of total tax receipts and 41% of the US’s total receipts in 2022. Prior to 1913, the US relied on other tax regimens, chiefly ad valorum and specific unit-of-account taxes.