Those of you who already work with Planning with Purpose understand that we are huge proponents of Roth accounts. Do you really understand the reasons why?
Pre-tax is normally what is used to describe 401(k), 403(b) and 457 contributions when the contributions are made in a tax-deferred way. Many individuals wonder where the names 401(k), 403(b) and 457 come from. These are the IRS code sections that contain the rules and regulations for these plans.
When you sign up for pre-tax contributions, you are requesting that your current gross wages be reduced by the amount you are putting into the retirement account. If you request a 10% pre-tax contribution, your paycheck will be reduced by the contribution and no taxes will be paid currently on the amount going into the plan.
For example, say a 55-year old wage earner makes a pre-tax weekly contribution of $125 for a total of $6,500 during the year. If the taxpayer is in the 22% tax bracket, it would mean a current annual tax savings of $1,430.
The contributions are pre-tax. Again, no taxes have been paid on them. When the funds are later withdrawn, taxes will need to be paid on both the contributions and the earnings on those contributions.
If instead, you elect after-tax contributions the taxes are paid on the gross amount. After-tax contributions, more commonly known as Roth contributions today means you do not reduce your current taxes today. Some individuals believe you have to pay additional taxes; this is not the case. You are not getting the tax deduction today in order to avoid having to pay taxes later on those retirement contributions.
Like pre-tax contributions made to employer retirement plans, you as an individual can make contributions to a Traditional IRA. When you make contributions, normally individuals can take a tax deduction on their income tax return for the contributed amount. This reduces the current tax liability. For example, say a 55-year old makes the maximum annual contribution of $7,000. If the taxpayer is in the 22% tax bracket, it would mean a current annual tax savings of $1,540.
Each year the individual makes that pre-tax contribution at work or makes that Traditional IRA contribution on her own, she saves tax dollars in the current year. The earnings on the contributions both in the retirement plan at work and in the Traditional IRA grow tax deferred.
Fast forward 10 years and pretend it is time to retire. During that time frame lets assume the $6,500 retirement plan contributions or the $7,000 Traditional IRA contributions have each grown to $20,000. If you take that money out of the tax-deferred plan, you must pay taxes on the entire amount. If your tax rate has not changed and you are still in the 22% tax bracket, you would have to pay $4,400 in taxes.
Question: Does it make sense to pay $4,400 in taxes later in order to save $1,540 in taxes today?
We cannot know for sure that it will be $4,400. Maybe the account grows to more than $20,000 which means the tax amount could be more. Maybe the account only grows to $14,000 or $16,000 which means it could be less than the $4,400, but it would still be more than the $1,540 tax savings up front.
We often hear: “I will be in a lower tax bracket when I retire”. When I first started doing taxes in 1986, there were lots of different tax rates. Every change of a few thousand dollars was a different tax rate. It would have been quite easy to reduce your tax rate by a few percentage points just by having your taxable income decrease by $5,000 or $10,000.
Currently there are only 7 tax brackets. The tax brackets have much wider ranges. For example, for a single individual the 22% tax bracket goes from a range of $39,476 to $84,200 in 2019. If your pre-retirement income was $75,000 and you want to maintain the same lifestyle, you will need retirement income close to that. This would mean you would most likely be staying in the 22% tax bracket.
If you are at the lower end of a current tax bracket, it is possible that you would drop into the next tax bracket down. I believe in most cases the growth of the pre-tax contributions would still create a tax savings. It seems likely that the tax on the growth would be greater than the tax savings on the drop in the top tax bracket. It is worth pointing out again that you are paying taxes not only on the original pre-tax or tax-deferred contribution amount. You are also paying tax on the earnings.
There is what I consider another big reason – the uncertainty of where tax rates will be during your retirement years. I cannot help but be concerned as we are in the middle of this pandemic about the trillions of dollars being spent to maintain our economy today. At some point, those trillions of dollars plus the trillions the United States government already had in debt prior to this time will need to be paid back. While improvements to the economy and individuals having more income would increase taxes being paid, I do not think that will be enough. I believe there will need to be an increase in tax rates to help pay down debt.
Having funds in Roth accounts would mean not having to pay taxes on those dollars. While you might see an increase in your tax rate, having less taxable income would decrease the impact a rate increase.
Having less taxable income during retirement can benefit you in other ways also. Medicare premiums are tied to the income reported on your tax return. Having tax-free Roth distributions may allow you to pay less in Medicare premiums.
Depending on your income situation, your Social Security benefits may or may not be taxable. Having money in Roth accounts versus traditional or pre-tax may allow you to avoid having your Social Security be taxed.
In NYS, EPIC medical premiums and the ability to qualify for the enhanced STAR are based on the income reported on your tax return. For lower income individuals, it may impact the ability to qualify for HEAP assistance or other low-income assistance programs. Some programs will count the Roth distributions as income and some will not, meaning it may or may not make a difference.
Roth accounts do not have mandatory required minimum distributions. This means if you do not need the funds, you can continue to allow them to grow tax-free within the retirement account. If you do not use all the funds during your lifetime, it means the funds will pass to your beneficiaries tax-free.
I am often asked, what does a Roth IRA earn? Whether the funds are in a Roth IRA, a Traditional IRA, a 401(k), a 403(b), a 457, a Simple IRA or any other number of retirement plans, these types are the registration for the account. Each name tells you what the rules are regarding that registration. It tells you the maximum contributions for a year. It provides what the withdrawal requirements are. It tells you what the exceptions are to avoid an early distribution penalty. The rules and regulations can be different depending on what registration type it is.
Regardless of which type of account, or more accurately the registration of the account you choose the investments that the funds going into the account are invested in. You can choose to invest in mutual funds, annuities, individual stocks and bonds, certificates of deposit, etc. The registration type does not determine “how much you earn”; the investments that you chose determines what the account will earn.
Another often asked question “Should I do an IRA or should I do the plan through work?” The answer depends on a number of factors.
• Does your employer offer a match at work? If they do, make sure to contribute to the employer’s plan at least enough to get the full match amount. It is very difficult to beat free money. For example, if your employer matches 50% of every dollar you put in for the first 5%, make sure that put your first 5% in retirement contributions here to get that match.
• Find out if your employer offers a Roth plan? Many employers do. However, there still are some that do not. If your employer does not, consider asking them if they would be willing to add it to their plan. It will require some initial administrative work; once set up, it is not difficult to maintain.
• If there is no Roth option within the employer plan, we recommend after meeting the employer’s match that you put your next retirement contributions into a Roth IRA. If you are over 50 and below the income limits, you can contribution $7,000 each year. If you are under 50 and below the income limits, you can contribute $6,000 each year. If you are over the income limits, consider contributing to a non-deductible Traditional IRA. Look for next week’s post regarding Roth conversions to show you how to make this a Roth IRA after-the-fact.
• If you still have dollars to contribute and you maxed out your IRA, go back to your employer’s plan. Add the additional dollars there. It will be in a pre-tax account and you will have to pay taxes upon withdrawing the funds; it is probably your best option at this time.
• If your employer’s plan has a Roth option, you can choose to put the retirement dollars all in the plan or fund the IRA and come back to the employer plan. Some individuals do not like the investment options within the employer’s plan and want more investment choices; this would be a reason to fund the IRA first. Oftentimes, the fees with individual plans are greater than within the employer’s plan, this would be a reason to stay within the employer’s plan. There are pros and cons for using the employer’s plan and for going to the IRA. You need to determine which is most beneficial to you.
We believe in most instances a Roth account registration works better than a Traditional or pre-tax account. Making sure that you are saving for retirement is probably the most important factor. Starting to save as early as possible in your career is better. If you need the assistance of a financial advisor to help decide how to invest, be sure to seek the advice of one. Do not let lack of understanding prevent you from getting started.
