As with many areas of financial planning, there is not a blanket statement I can…
“But in this world, nothing can be said to be certain, except death and taxes.”
– Benjamin Franklin to Jean Baptiste Leroy, November 13, 1789
As the federal deficit of the United States rises ever higher, the more likely we are to rephrase Benjamin Franklin’s famous quote to “except death and ever higher taxes.” With the potential for increased taxes, tax planning becomes progressively critical to one’s financial strategy. Unfortunately, many financial advisors have no training in taxes and/or they are not allowed to address tax issues, based on their brokerage firm’s rules. Therefore, you often see the disclaimer, “Seek your tax advisor for advice” on documents sent by advisors. Going forward, many Americans are going to realize that their financial advisor and their tax advisor cannot be different and distinct. Warren Buffett once compared wealth accumulation to a snowball: the more you roll it without losing pieces along the way, the bigger it gets. Buffett understood 60 years ago the negative impact of taxation on his plan to accumulate wealth and has been an avid tax planner over his 70-year career.
As the tax laws get more and more complex, so does tax planning. Roth investment retirement accounts (IRAs), health savings accounts (HSAs), traditional IRAs, deferred compensation, life insurance, annuities, 401(k), 403(b), 457(b), 457(f), 401(a), 401(h), simplified employee pensions (SEPs), simple IRAs, and individual 401(k) accounts are just some of the tax-preferred savings plans you can participate in to minimize taxes. Even if you are familiar with all your tax preference savings plan options, determining which is best for you requires both tax knowledge and an economic understanding of investments. In addition, it requires a fiduciary to minimize economic bias, as advisor compensation may be driving a recommendation that has some tax benefits, but not the ones best for you.
The title of this article is “A Roth Strategy” because the Roth IRA is a powerful defensive and offensive tax planning tool. It is important to understand what a Roth retirement plan is and how it differs from a traditional retirement plan. In a traditional retirement plan, a tax deduction from income is allowed for contributions, but future withdrawals are taxed as ordinary income. The government allows you to reduce current income to plan for retirement, with an assurance that a required amount will be withdrawn and taxed when you are older than 70 years of age. Most people save pretax in their company retirement plans because they enjoy the immediate benefit of an income tax deduction for the contribution.
Roth retirement plans reverse everything. When you put the money in a Roth plan there is no tax deduction, but when you withdraw, the funds are tax-free. No matter how much money you make in the Roth, it is tax-free and a Roth IRA can be invested in the same ways as a traditional IRA: through stocks, bonds, mutual funds, certificates of deposit (CDs), annuities, or real estate. Roth IRAs also have no required minimum distributions until inherited by a non-spouse beneficiary.
In a traditional retirement account, I pay no taxes today, but pay taxes in the future. In a Roth account, I pay taxes today, but no taxes in the future. Determining whether it is better to pay taxes today or tomorrow depends solely on your current tax bracket versus your expected tax bracket at the time when you begin withdrawing from the account. Some individuals assume the taxation in the future will be lower because they will have lower income, but this may be a poor assumption and for that reason, NOW is the time to develop a Roth strategy and become accustomed to paying taxes on the Roth for the benefit of tax-free growth tomorrow. If you expect to be in a lower tax bracket in the future, it may be wise to defer taxation. However, if you expect to be in the same or a higher tax bracket in the future, paying your taxes today may be the better option. The Roth IRA is advantageous when an individual expects to be in either the SAME or a higher tax bracket in the future, and this is the case for many individuals.
Determining your tax bracket is not always as simple as one may think. The definition of a tax bracket is the income tax charged on the last $1,000 of income and as we will see in the following examples, a small change in income can have a significant impact on one’s tax bracket. In one actual instance, a client’s income was $170,076. If their income had been $169,099, their tax liability would have been $1,800 less than it was at their actual income level of $170,076. Therefore, $77 of income caused an $1,800 increase in tax, which put them in a 2300% tax bracket. The tax laws are littered with these kinds of income limit landmines and many individuals do not know they exist. Earned Income tax credits, American Opportunity Credit, Maryland state exemptions, Social Security income taxation, Income Related Monthly Adjustment Amount (IRMAA) surcharge, child tax credit, student loan interest deduction, premium tax credit, retirement credit, qualified business income deduction, and the adoption credit are just a few of the potential tax bombs. Some are phased in as income increases, which is like a slow boil. However, some are immediate and take effect when income is $1 too much, like being thrown right into the boiling water. The POINT is: even if your income may be lower in the future, it does not mean you will be in a lower tax bracket, as Congress pours more of these undercover tax increases into the massively complicated tax laws.
The reason a Roth Strategy is so important is because Roth distributions do not count toward any calculation of your tax liability. A traditional IRA distribution (which is pre-tax) impacts every possible tax bomb in the current tax laws. Every single income threshold is impacted with every extra dollar you take from your traditional IRA/401(k)/403(b). A common way this impacts retirees is through the taxability of Social Security income received. Simply put, Social Security starts to become taxable income if your taxable income, plus half of your Social Security, exceeds $25,000 for a single individual, or $32,000 for a married couple. Assume you are a single individual, and you have $20,000 of taxable income and half of your Social Security is $12,000, making a total of $32,000. You are over the $25,000 single phase-in limit, and another $1,000 of income can cause $500 of Social Security to be taxable instead of tax-free. In this illustration, $1,000 of a pre-tax IRA distribution caused $1,500 of taxable income, $1,000 of IRA taxation, plus $500 of phantom Social Security taxation. A Roth distribution has no impact on Social Security taxation and not one of the tax bombs mentioned above is impacted with a single dollar of Roth distributions.
It takes tax knowledge to develop a Roth strategy. For example, two of our clients, a married couple over 50 years of age, had no Roth options in their 401(k) or 403(b), and their income was higher than the $200,000 Roth IRA threshold for married taxpayers’ contributions. Using various tax approaches, we were able to get $26,000, plus $7,000 per spouse, into a Roth for a total of $66,000 in year one. These clients anticipate working another 10 years, so we should be able to accumulate almost $850,000 in the Roth retirement accounts, assuming just a 5% rate of return.
Too many people work with financial advisors who solely work to make them a good rate of return on investments instead of working with financial advisors who also incorporate tax planning into their strategy. Tax planning, estate planning, personal finance education, and financial issue alerts are just some of the services one should expect from a professional financial advisor, in addition to making returns on investments.
Talk to your Consulate Advisor if you need to develop a more aggressive Roth strategy. Ask your friends, family, and colleagues if they have a Roth strategy and if their advisor is as passionate a tax planner as the team of advisors at The Consulate. We greatly appreciate the referral of your colleagues, friends and family and will do everything possible to assure you are thanked by them for the referral to the Consulate.