Roth IRA vs. Traditional IRA After the SECURE Act: Why Roths Win for Heirs

Why a Roth IRA Can Be Worth Far More Than an Upfront Tax Deduction

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!

When a Roth IRA Beat a Traditional IRA Before the SECURE Act

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:

• You’re young, with a modest income, and likely to move to a higher tax bracket by retirement.
• You have a large amount saved up in traditional IRAs already, and want to minimize your Required Minimum Distributions (RMDs).
• You have a very high savings rate and can afford to pay taxes now in order to maximize how much you have available in retirement.

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:

• The highest current federal tax rate, at 37%, is lower than at almost any time since the 1930s. In fact, the highest rates were above 70% through much of the 1930s, 40s, 50, 60s, 70s, and 80s!
• The US national debt, at over $22 trillion, is more than 107% of the $20.5 trillion size of our economy. This is a higher percentage than those of the other three dozen members of the Organization for Economic Cooperation and Development (OECD).
• This debt is growing fast due to an annual federal deficit of more than $1.1 trillion!

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.

When a Traditional IRA Beat a Roth IRA Before the SECURE Act

The following are the situations where T. Rowe Price suggests a traditional retirement plan might be a better fit for you:

• Your current income puts you in a higher tax bracket than your likely bracket in retirement.
• You can’t afford to set aside enough to get the full employer match into your 401(k) plan unless you get the current tax benefit of deducting those contributions.

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.

How Ending the Stretch IRA Hurts Middle-Class Heirs, Not Just the Wealthy

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 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%)!

Roth vs. Traditional IRA After the SECURE Act: Why Inherited Roths Come Out Ahead

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.

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.

Roth IRA Rules to Know: Income Limits, Withdrawals, RMDs and Medicare

As detailed by CNBC, Roth accounts offer several important benefits.

• Like a traditional IRA, the Roth’s contribution limits are in addition to those of a 401(k) plan (though differently than a 401(k), if you earn too much you’re not allowed to contribute directly to a Roth IRA).
• Now that the SECURE Act is in play, you can continue to contribute to a Roth or other IRA beyond age 70½, as long as you have earned income.
• You can withdraw your contributions from a Roth tax-free at any age, if the account has been open for 5 years. That’s why you should consider opening a Roth as soon as possible even if you can only put in a bit of money. Note that withdrawing earnings is subject to tax and penalties in most cases if you’re younger than 59½.
• Having more of your retirement money in Roth accounts instead of traditional ones reduces your RMD, and thus your taxable income. This could save you a lot of money in Medicare Part B premiums, which could jump by hundreds of dollars if your taxable income crosses a threshold by even a single dollar.

The Bottom Line: A Roth IRA Is Now a Stronger Estate-Planning Tool

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.

Frequently Asked Questions