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What could sweets, alcohol, and deferring taxes have in common? Plenty. All three are fun to enjoy in moderation, but when overdone, they all come with consequences.
Today, Americans saving for retirement have the option of either Traditional IRA/401k/403b accounts or Roth IRA/401k/403b accounts. Most people default to the Traditional option over the Roth, because a bird in the hand is better than two in the bush. That saying sounds perfect for weighing the benefits of the Traditional options against the Roth options, but is it?
Let’s start by examining the difference between the two. In a Traditional account, a deposit reduces income for tax purposes in the year that it is made, and it becomes taxable income when withdrawn. In a Roth account, deposits are not tax-deductible in the year that they are made, but they are 100% tax-free when withdrawn. Most people assume the Traditional option works best because taxation is deferred during high-income years and withdrawn during low-income tax years in retirement. If only our tax system were that simple.
If the tax laws simply required the first $100,000 to be taxed at 15%, the next $200,000 at 20%, and anything over that to be taxed at 30% with no exceptions, then Traditional would be wiser, if retirement income is expected to be lower. However, the first obvious problem is no one is guaranteeing not to raise the tax rates. Republicans or Democrats raise taxes for most Americans, even when they claimed to have reduced them (which may only be clear if you understand the tax laws to the depth of a tax professional). For example, do you know what the alternative minimum tax rates are? It is a distinctively different tax calculation that is run on every tax return, and you get to pay the higher of the two amounts. When George W. Bush took office and claimed to have lowered taxes for so many, he also raised taxes for others through the Alternative Minimum Tax, and most people never knew it (I saw it). President Obama raised taxes supposedly only on the rich with significant Medicare tax expansions. Are the people paying these taxes rich? The word “rich” is very difficult to interpret on a year-by-year income basis. President Trump supposedly lowered taxes, not with the higher standard deduction for many, especially in states with high state income tax, and those who, like Marylanders, were stuck with unusually small standard deductions. Every new tax law has winners and losers. For example, take the new Maryland retirement tax credit of $1,000 for singles and $1,750 for married couples; it is only good if singles make less than $100,000 and married couples make less than $150,000. Just $1 of Federal Adjusted Gross Income (AGI) over the Maryland limit results in losing the whole $1,000 or $1,750 tax relief. As another example, how about the Medicare surcharge with the dubious acronym IRMAA (Income Related Monthly Adjustment Amount)? Just $1 of AGI over any limit results in Medicare part B premium increases anywhere from $70 up to as much as $400/month. The grandaddy of all tax snakes is the calculation for Social Security Income that will be taxable as income. For singles, this starts at $25,000 of Modified AGI (MAGI), and for married couples, it starts at $34,000 of MAGI. Those amounts of $25,000 and $34,000 were set in 1982 and have not been adjusted at all for inflation in 40 years. Today’s equivalent to those 1982 amounts would be in the $80,000 range. That tax law in 1982 knowingly took seniors and put them in the tax pot and turned the heat up with inflation slowly; today, almost all Americans are finding that their Social Security Income is taxable. In 1982, very few seniors counted any Social Security as taxable.
This list of tax landmines is very long. The point of this article is that a bird in hand (deferring taxes) may be a vulture, and the two in the bush (getting future income tax free) may just be two juicy turkey gobblers. Roth income has no impact on the tax return, period, at least for now. I would much rather take my chances with a sound Roth strategy than defer and defer with a Traditional option until those low-income and tax retirement years. This is what our firm understands, with our significant emphasis on tax planning wisely using Roth contributions and conversions. The key word here is WISELY, because there are situations in which a Traditional option is preferable, but it requires wise discernment to recognize them.
If you have colleagues, friends, or family that have IRA and 401K/403b accounts worth over $500,000, then give them this article and let them decide if they need an independent, comprehensive, fee-only, tax-oriented, fiduciary financial advisor.
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Financial Consulate aims to help lessen the worry and burden of wealth management and enhance financial wellness so our clients can pursue relationships and true fulfillment. Choose the professionals at Financial Consulate as your Certified Financial Planners™ (CFP®) to take advantage of our educational, ethical approach to financial planning. Our services are comprehensive, including tax planning, investment planning, retirement planning, estate planning, and more. We operate completely independently and offer fee-only services to keep your vision in line with our recommendations at all times. While we have offices in Hunt Valley, Maryland, Fernandina Beach, Florida, and Gettysburg, Pennsylvania, we serve clients across the nation. To begin your partnership with a trustworthy wealth advisor, please contact Financial Consulate today.