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In a previous article, I mentioned how I wish the Roth IRA would have been available when I started saving for retirement in the early 90s. Back then, I lived in Texas, where there are no state or local income taxes, and my annual income of $31k meant that my marginal federal tax rate was only 15%!
There’s no argument that the $150 ($262 after adjusting for inflation) deduction I got for my modest $1000 IRA contribution was very helpful then.
However, that $1000, assuming S&P 500 index returns (reinvesting dividends), would today be worth $6700. Projecting 10 years until I expect to retire, using data from Yale’s Case and Shiller, that could grow to $12,700 (adjusting for expected inflation).
Had that been in a Roth IRA, it would be tax-free.
Given that it’s in a traditional IRA, it would be worth $8900 after tax. This also assumes tax rates stay constant, which they’re not likely to as I explain below.
In other words, the $262 inflation-adjusted tax benefit I got back then probably cost me over $3800 in today’s dollars – almost 15-fold more!
According to a recent letter I received from T. Rowe Price, they calculated who would most benefit from a Roth IRA vs. a traditional one. Their conclusions show the Roth would be better for you if:
I’d add to that one more element – taxes are far more likely to increase over the coming years, possibly by a lot. Here’s why:
At some point, something’s gotta give, and that something’s likely to be our future selves through higher taxes. If tax rates go up, having large balances in tax-free Roth accounts will be far more valuable than the taxes you have to pay now to contribute into them.
The following are the situations where T. Rowe Price suggests a traditional retirement plan might be a better fit for you:
I’d add another element here too. If a wealth tax that hits people with as little net worth as $1 million and/or a consumption tax (e.g., a value-added tax or a national sales tax) are enacted, the advantage of a Roth account would shrink.
As I described here, last month Congress tucked several important changes to the tax law as it applies to retirement account into a must-pass $1.4 trillion spending bill. The president signed the bill into law on December 20.
The so-called “SECURE Act” made impossible a technique known as the “stretch IRA,” used by the wealthy to maximize the after-tax value of their bequests. This same technique allowed a middle-class parent to do the same for her or his kids, if s/he left them a large balance in an IRA.
In an example there, I showed how much inflation-adjusted after-tax draws would be possible from a $1 million stretch IRA left to a 45-year-old man making the median income in Maryland.
It came to $3.7 million!
With the SECURE Act in place, this dropped to under $1.2 million (shrinking by over 67%)!
With the stretch IRA technique gone, IRAs inherited starting in 2020 must be drained within 10 years. This is true for both traditional and Roth IRAs.
However, there’s an important difference between those two cases. Accelerated draws from a traditional IRA are likely to force inheritors into higher tax brackets.
Not so for inherited Roth accounts, since those draws aren’t subject to income tax.
As a result, a $1 million inherited Roth could provide a $2 million draw 10 years later, with zero tax consequences. This compares favorably with a $1 million inherited traditional IRA, which may only be worth $1.2 million.
Having said that, prior to the SECURE Act, a $1 million stretch Roth IRA might have been worth as much as $5.3 million. Thus, here too the SECURE Act costs you millions of dollars.
This brings us back to my story about my own traditional IRA, above.
If you plan on leaving large balances in your retirement accounts, Roth accounts just became even more important.
The Roth contribution limit is just $6000 ($7000 if you’re over 50). Thus, the tax benefit you forgo by contributing to a Roth aren’t huge. Over a 40-year career, the majority of the Roth’s value will come from its investment returns, not from the after-tax contributions.
Considering that an inherited Roth will likely give your kids an extra 67% in after-tax benefit, that’s probably the best way to go.
As detailed by CNBC, Roth accounts offer several important benefits.
Roth IRAs have always been a sweet deal for most people (though only ~10% of IRA balances are in such accounts). However, with the SECURE Act just implemented, Roth accounts offer an even more important estate-planning tool.
By paying a bit more in taxes each year during your own working life, you could benefit your kids as much as 67% more.
This, even if tax rates don’t change, which is unlikely. It’s far more likely that tax rates will increase significantly in the coming years and decades, making balances in Roth accounts even more valuable.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.