Will Budget Proposal Affect Roth IRA?
I’ve heard time is the only thing that can’t be replaced. I am not sure if I fully agree, but I suppose in some ways that is true. A few recent events reminded me of how precious time is and how quickly it can pass. The fact we are getting older…other than those celebrating their 29th birthday…again…isn’t a surprise. But, I think it is easy to forget how time impacts many of our life decisions, which include financial choices.
There are a few obvious time discussions when considering financial plans. This week, I want to review a strategy that will be impacted by time…particularly if past proposals become law.
Obama’s 2015 budget proposal revealed a couple of potential changes to the Roth IRA that would impact our view on Roth IRA contributions and more importantly, conversions. No changes yet and no recent chatter, but is it time to take notice?
We contribute or convert to Roth IRAs when we anticipate your tax rate to be lower today than in the future. Remember, you pay tax today on Roth conversions and/or contributions which is different than a Traditional IRA. As we decide whether to convert or contribute to a Roth IRA, we consider taxes…at contribution and at withdrawal.
When withdrawing from a Traditional IRA, distributions are taxed at your current ordinary income tax rate. Traditional IRAs are often referred to as “tax-deferred.” You are deferring the taxation of both contributions and growth until a later time.
Withdrawals from a Roth IRA are not taxed. Roth IRAs are often referred to as “tax-free.” Of course, you paid taxes on the contributions, but qualified withdrawals are free from taxation. Understanding the difference helps us determine if a Roth or Traditional IRA is best for you. Note this decision tends to change throughout your plan.
Roth IRA conversions or contributions are favorable when you are projected to pay lower taxes today than you will in the future AND you have time to recover the cost of current taxation. The first point is straight forward. If you could make contributions to a Roth today while in the 15% marginal tax bracket and you expect to be in the 25% marginal tax bracket when taking distributions, the choice to pay 15% today rather than 25% later makes sense in most cases. You may be wondering why you would have a difference.
The first common example is that you are either in transition or starting your career. At this point, you find that your income is lower today than you expect it to be in the future. The other most common scenario is the transition period after you retire but aren’t yet receiving Social Security or Required Minimum Distributions (RMDs) from your Traditional IRA. Remember, your RMDs are treated as taxable income as is a portion of your Social Security benefits.
Why does time matter to Roth IRAs?
When you contribute (or convert) to a Roth IRA, you have a fixed cost…today’s taxation. For simplicity, let’s assume you are contributing $1,000 and pay 15% in taxes today. You paid $150 in taxes so you now have $850 available to “grow.” The idea is the growth over the period invested will outweigh the initial cost. If you have no growth in the account, you will not recover the initial cost. You’ll have $850 to withdraw.
The other option is to invest the same $1,000 into a traditional IRA. You pay no taxes today. If you expected to remain in the 15% bracket (and for simplicity assume no growth), you would pay $150 on the withdrawal and keep $850. As you can see, with no growth and the same tax cost, both choices are equal (with my extreme simplification).
Historically, investors have been paid to accept risk. This usually takes the form of a greater percentage of stocks in the portfolio. We also know that history reveals periods in which you weren’t compensated for taking risk. Longer periods have offered a higher probability of being compensated for risk.
Shorter window for growth?
One of the reasons Roth (especially conversions) are successful is the ability to hold long term (no RMD requirement). Many earmark this asset as the last spent or is targeted as an inheritance (more on that later).
The proposed requirement of distributions (assumed like Traditional IRAs), would shorten the holding period, especially for those converting later in life. While accepting risk has historically worked in the long term, we have plenty of periods that would have failed given a shorter holding period. If Roth IRAs required a distribution at age 70 ½ (like Traditional IRA), it seems time is no longer on our side and we might reconsider a Roth conversion plan.
Even when there was little (or sometimes no) tax benefit for the current owner, we often considered a conversion if we knew there was a high likelihood of passing the account to the next generation. The reason to consider this is the ability to “stretch” the tax-free growth of the account.
Currently, the new account holder (after inheritance) must take distributions based on their life expectancy (not yours). Imagine inheriting or leaving a Roth IRA to a 40 year old. He or she could take distributions based on their life expectancy. The extended life expectancy equals smaller distributions and preserves the tax-free status of the remaining assets.
The proposal would require the account be fully distributed within five years. Basically, eliminating the “stretch.” With less time comes less potential benefit.
Why the proposals?
First, it is important to recognize no one is proposing taxation on the withdrawals from a Roth IRA (provided guidelines are met). If the government isn’t receiving taxation on the withdrawals, how would the proposals benefit the budget? The answer is simple…get the assets out of the tax-free bucket.
If you are forced to distribute from your Roth IRA, you have basically two choices…spend or reinvest. If you spend the withdrawal, taxes are collected…arguably from multiple points. You may pay sales tax (dependent on domicile). Corporations will sell more product which will be subject to taxation. The additional corporate profit is reinvested. The list goes on. But, what if you don’t spend your withdrawal?
If you reinvest your withdrawal, you will likely invest in a taxable (brokerage account or savings account). The new investment is now subject to taxation on capital gains and dividend/interest.
Either way…the tax free asset has now become a taxable asset.
Why Thinking About Time?
My week began with a visit from a friend I’ve known for 42 years. His name is Mike or “Z”. He was on my first little league baseball team. His father was the coach; the local liquor store sponsored us. Can a little league baseball team be sponsored by a liquor store these days? No idea.
He had a layover on a trip from Atlanta to Hawaii. We hadn’t seen each other for years. As we reminisced, it was scary to think we are in the year of turning 50…he already turned, my day is coming soon. Wow…how time flies.
We talked a little about the past, but more about our current lives. We talked about the challenges and rewards of raising kids. We agreed we wouldn’t let our kids do what we did. But, we also considered how some of those challenges made us stronger today. We laughed that we thought our parents didn’t know what we were up to most of the time or maybe better said…we think we have control (false security) over our children. Interesting discussion.
Mid-week, I spoke with my dad back in Buffalo. His health seems to be failing quickly. Time…
The week ended with Stephanie and me attending a 75-year celebration for a dear friend. I won’t get into the emotional impact of the celebration, but I will say I was glad Stephanie came with me. It is always interesting to see how she responds to situations. I can’t help but wonder what her 75-year celebration would look like…
Steph and I were on our way to participate in National Burrito Day (who knew?). On the way, we passed a baseball field. I said… “I don’t think you are going to be a sport chick.” She responded… “Did you just call me a chick?” Then… “I think I am going to be a sing and dance girl.” I agreed. Then she asked… “Do sing and dance girls do good with the boys?”
Really? You are ten years old. Let’s keep your focus on singing and dancing rather than boys. As I write this, I realize I should review the paragraph above referring to how we think we have control…can’t someone make time slow down?
Time affects many of our planning decisions. The proposal to change rules regarding the Roth IRA may become an important one. I haven’t heard a repeat of this proposal since initially discussed. It may never come to fruition, but once the cat is out of the bag, I can’t help but wonder can it really be put back in?
I don’t think changing the Roth IRA is high on today’s political “to-do” list. But, if tax reform is next on the list, politicians will need new sources of income if they want to lower taxes.
For now, I think the strategy of Roth conversions remains a strategy worth reviewing, but we need to consider how the proposal might impact our choices.
If the proposal becomes law, the benefit of contributing early becomes increasing important. You likely start your careers with a relative lower salary. Time provides experience and increased knowledge which increases your marketability and paycheck.
We would like to have a balance between Roth, Traditional and taxable assets during retirement. If Roth conversions become less favorable, I would argue the benefit of Roth contributions while in lower brackets increases. This is something to consider when advising younger clients.
Thank you for your time (sorry…I had to). If you have questions about how time affects your plan, please let me know. Next week, I consider a common piece of investment advice based on time that I struggle with. Or at least how it is often phrased…