CLEVELAND, Ohio - Would you like to pay your tax bill now or later when it comes to a retirement plan?
Deciding what’s best can be tricky. It often comes down to choosing between tax-free investments knowing that the bill will come due when the money is withdrawn (traditional 401(k) plans and IRAs), or paying now but being tax free later (Roth accounts).
Whether you choose one or the other, or a mix of the two, a periodic review is a good idea.
Tax laws change. So do the forecasts for what the future holds.
Consider today’s environment during the coronavirus crisis. The stock market has been rocky. Government borrowing is up.
Will the federal and state governments maintain income tax rate cuts made in recent years? If you don’t think so, it may make sense to pay the tax bill at today’s rates if you can afford it, and convert a traditional IRA or old 401(k) to a Roth plan. Future gains under current law would not be taxable.
That’s one option that should be under consideration, according to Jill Garvey and Dan Griffith, senior vice presidents with Huntington Private Bank’s wealth team. They say that with the increase in the federal deficit, few experts believe that tax rates are likely to be lower in the future.
Retirement plans, however, are individual in nature. Here’s some of what to consider:
Investment diversification
“We recommend clients have different buckets for different types of tax liabilities,” said Garvey, senior wealth strategist at Huntington.
Consider the flexibility someone has in retirement if money is split between accounts for which withdrawals will be taxable or not.
Currently, the cutoff between the 12% tax bracket and 22% bracket is $80,250 of taxable income for those married and filing jointly. A couple close to the threshold could tap the tax-free (Roth) money to avoid the 22% rate altogether. This could be a bigger deal after the the death of one spouse; the cutoff for single filers between the 12% and 22% brackets drops to $40,125.
“It’s a great strategy to build up a tax-free bucket,” Garvey said.
Check if you have a Roth plan at work
The 401(k) plans with money invested before taxes traditionally have been the most common, but Roth options are gaining popularity.
Consulting company Willis Towers Watson found in a 2018 survey that 73% of the employers offering defined contribution plans included Roth options within their 401K plans, up from 46% in 2012.
“What employers are looking for is ‘How do I attract and retain young employees.’ If you are an employer who has 40 employees, having a Roth 401(k) is another arrow in your quiver,” said Griffith, director of wealth strategy at Huntington.
But Griffith said he’s found a lot of employees don’t explore the added Roth option even when it is offered.
“People aren’t aware of the fact that they have the ability to make Roth IRA contributions. That’s something that they need to look into,” he said.
Contribution limits
There are different annual contribution limits for different plans. Here are the 2020 updates from the Internal Revenue Service.
* Traditional 401(k) – An employee may place $19,500 a year of pre-tax income in a 401K, or $26,000 for those age 50 and older, regardless of income. Investing the money before taxes lowers the person’s taxable income.
* Roth 401(k) – Same as the traditional 401(k) but post-taxes, $19,500 and $26,000, depending on age, with no income limits. The contribution limits for each of these, however, are per individual, not per plan. So if an employee has both a traditional 401(k) and Roth 401(k), the limit is for the total investment between the two.
* Traditional Individual Retirement Account (IRA) – $6,000 limit for those under the age of 50, and $7,000 for older people. But higher earners are not entitled to the tax deduction if they also have a retirement plan at work. For people with retirement plans at work, a single person’s modified adjusted gross income must be below $65,000 to contribute the full limit, then it is phased out completely at $75,000. For a married couple filing jointly, the phase out is from $104,000 to $124,000 a year.
As for people who don’t have a retirement plan at work, there is no income limit to make this $6,000 (or $7,000) contribution to an IRA. For joint filers where one spouse has a retirement plan at work and one does not, the deduction is available with modified AGI of up to $196,000, phasing out at $206,000.
* Roth IRA – The same $6,000 and $7,000 cutoffs for contribution limits apply. But there are different income-based rules for who is eligible. The full contribution is permitted for single people with AGI of up to $124,000, then it is phased out at $139,000. For married filing jointly, the full contribution is permitted with incomes up to $196,000, phased out at $206,000.
Required withdrawals in retirement
This is where the flexibility of a Roth is beneficial.
The government has already collected the tax money from you for a Roth, so taking the money out is not required during your retirement years. Draw it out as you please, instead of on a set schedule with minimums. (If the money is in a Roth 401(k), it needs to be rolled over to a non-401(k) Roth to avoid minimum withdrawals.)
But for traditional IRAs and 401(k) plans, distributions for retirees must begin at age 72 – a change this year. For those who reached 70.5 by Jan. 1, 2020, age 70.5 remains the starting point.
The IRS has two formulas that set minimum withdrawals. The formula used for most people means a 72-year-old must withdraw roughly 3.9% of the balance from the previous Dec. 31. For an 80-year-old, it’s 5.3% of what’s left on Dec. 31. For a 90-year-old it’s 8.8%. Make it to age 100, and you have to withdraw 15.9% of the remaining balance that year.
A different formula applies when your spouse is the sole beneficiary and is at least 10 years younger.
What’s the difference in dollars?
Determining which investment option will yield more money depends on your tax bracket, now and during retirement, and how your investments perform.
But consider this example, calculated by Garvey. It assumes a steady top tax rate of 22% over the next 20 years, $10,000 available to invest each year and a 6% annual rate of return.
The $10,000 placed in a taxed-deferred 401(k) annually would amount to $210,000 in contributions from this year through 2040. After investment gains, this fund would be worth $423,923.
If instead this money was used for a Roth plan, paying the taxes up front of $2,200 each year at 22% would leave $7,800 to invest annually. This total investment of $163,800 would grow to $330,660 by 2040, assuming a 6% annual rate of return.
So why might $330,660 in a Roth actually be worth as much as $423,923 in the tax-deferred plan?
There is no tax bill to withdraw the Roth money. Paying 22% taxes on that $423,923 would reduce the value after-taxes to $330,600.
If tax rate is higher at the time of withdrawal, the Roth becomes more valuable in comparison to the money in a traditional IRA or 401(k) account. But if the tax rate is lower, the reverse could be true.
For example, currently the 22% tax rate is applied only to taxable income from $40,125 to $85,525 for individuals, and from $80,250 to $171,050 for married couples filing jointly. The next bracket below that is 12%.
This is where the strategy Garvey mentioned of having “different buckets for different types of tax liabilities” becomes important. A combination of withdrawals could be made between traditional and Roth accounts to stay within lower brackets.
No one knows for sure what the tax structure will look like in 2040. But it’s good practice to map out your anticipated income needs in retirement to see where you would fall in the current tax brackets. Remember when thinking about income, this is the adjusted amount, after standard deductions, which in 2020 are $12,400 for individuals and $24,800 for couples.
For inheritance, the Roth benefit
If you looks at your investment accounts as something that will be passed down to family members, recent tax changes enhanced the value of the Roth over traditional retirement accounts.
Since taxes were paid up front, there is no income tax liability on the Roth withdrawals for those inheriting the money.
For traditional IRAs and 401(k) plans, the IRS notes that beginning this year “fewer beneficiaries … will qualify to receive distributions over their lifetime. Many will need to withdraw all assets within 10 years after death of the IRA owner or retirement plan participant.” (The old rules still apply for deaths before 2020.)
This is one reason why many investment counselors, including those at Huntington, say that parents wishing to their leave their children tax-free assets would benefit most from converting traditional retirement accounts over to Roth IRAs.
On the conversion question, Garvey says she likes to ask three questions. Yes answers are pluses for converting to Roths.
* 1. Do you expect to have excess cash when you die?
* 2. Do you expect to be in the same or higher tax bracket in retirement than currently?
* 3. Can you cover the tax bill for making the conversion of the Roth without dipping into the retirement account for the tax money?
So is the Roth the way to go, given an option?
“It depends a little bit,” Griffith said. “For the most part, I think it is fair to say that we would lean toward the Roth option.”
More firm is this piece of advice common among financial experts, including Griffith and Garvey: if an employer offers a match for your 401(k) plan, do what’s necessary to get the full match before choosing other retirement investments.
Rich Exner, data analysis editor, writes cleveland.com’s and The Plain Dealer’s personal finance column - That’s Rich! Follow on Twitter @RichExner. See other data-related stories at cleveland.com/datacentral.
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