By Dr. Jim Dahle, WCI Founder
Most white coat investors know what we're talking about when we use the word, “Roth.” Roth, from Senator William Roth in the 1990s, refers to a tax-free retirement account to differentiate those accounts from their more common cousin—the tax-deferred (traditional) account. You have likely already made the decisions about whether to contribute to a traditional IRA or a Roth IRA (usually a Roth IRA via the Backdoor Roth IRA process) and whether to contribute to a traditional or a Roth 401(k), 403(b), or 457(b) (usually the traditional during your peak earnings years unless you're a supersaver).
However, there are five uses of Roth contributions and conversions that you may not have thought about before. Today, we are going to discuss them. Remember as you read today that I carefully selected the links in this article. If you have not already read every one of these classic posts, you should do so today as you go through this piece.
Additional Benefits of Roth Contributions and Conversions
Roth contributions and conversions can be used to hedge your tax bets, protect from tax drag, nudge your behavior, improve estate planning, and protect your assets. Let me explain each in turn.
#1 Hedge Your Tax Bets
As a general rule, most doctors will pull money out of their tax-deferred retirement accounts at a lower tax rate than they saved when they put the money into the account. This is not only due to having less income in retirement (because they need less income to live) but because of the effect of filling the brackets. Unless you're a supersaver, this is generally a winning move. However, one nice thing about putting money into a Roth account, whether by contribution or conversion, is that you hedge your bets against a massive rise in taxes or massive future success in your life. Critics may argue that tax rates can also fall (and they're right, nobody expected the 2018 tax cut) or that if you are very successful in your life, then a little extra tax planning doesn't affect whether you run out of money (and again, they're right.) However, it is a great use of Roth.
#2 Behavioral Nudge
When running the numbers, I (and most others in this space) assume you are a cold, calculating homo economicus. However, the data is very clear that none of us are. Behavior matters, and it probably matters more than math. For example, if you are faced with a decision of whether to save in a tax-deferred or a Roth account and your marginal tax rate is 33%, the true decision is whether to put $10,000 into a tax-deferred account or $7,500 into a Roth account. However, your lizard brain doesn't necessarily see that, and the contribution limits for traditional/Roth retirement accounts aren't adjusted for that. Your stupid brain says, “I'm going to save $10,000; should I put it in a traditional or a Roth account?” Well, $10,000 in a Roth account is a lot more money after-tax than $10,000 in a tax-deferred account. By using a Roth, you've nudged yourself to save more money. Unless you are in the small club of people who have trouble spending their money, that's a good thing.
#3 More Protection from Tax Drag
Due to the ability to put post-tax money instead of pre-tax money into a Roth account, your ratio of retirement savings to taxable savings increases if you use a Roth account. This means more of your money is protected from the tax drag inevitable in a taxable account as it grows.
#4 Estate Planning Advantages
There are numerous estate planning advantages of Roth contributions and, particularly, conversions. The first is that a Roth IRA (unlike a traditional IRA, 401(k), 403(b), or 457(b)) does not have any Required Minimum Distributions (RMDs). So, that money can stay in the account until your death, providing more protection from tax drag. More of your money will also pass directly to your beneficiaries without having to hassle with probate or a trust. Your heirs can also stretch more of your money for an additional 10 years.
However (and perhaps most importantly), if you are wealthy enough to have an estate tax problem, you can shrink the size of your estate in the eyes of the IRS. The IRS is stupid when it comes to traditional/Roth accounts. It doesn't adjust how much you can contribute to the account if you choose Roth, and it doesn't automatically adjust the estate/gift tax exemption for Roth. Imagine your exemption is $12 million and you have $15 million, including a $10 million tax-deferred account and $5 million in cash. To keep things simple, let's assume both you and your heirs have a 40% marginal tax rate. If you died, your estate would owe around $1.2 million in estate tax. You decide to do a Roth conversion of that $10 million traditional IRA. It costs you $4 million in taxes. Afterward, you have a $10 million Roth IRA and a $1 million taxable account. Now, if you died, your estate would not owe ANY estate taxes. Yet your heirs still receive the same amount of money on an after-tax basis.
There actually is a solution to this issue. It's called “income in respect to a decedent.” Basically, the inheritor of the IRA can take a deduction equal to the amount the decedent paid in estate taxes on that tax deferred account. However, your heir has to know about this deduction and use it. I bet it gets missed a lot.
#5 Asset Protection
Increasing the ratio of your money in retirement accounts to taxable accounts not only reduces tax drag, it also improves your asset protection. In this regard, Roth conversions (and, to a lesser extent, Roth contributions) help protect your assets from creditors in the event of an admittedly very unlikely above policy limits judgment. Let's assume your retirement accounts are 100% protected from creditors in your state. Imagine you have a $5 million tax-deferred account and $2 million in cash. If you had no insurance and there was a judgment against you for $5 million, you would declare bankruptcy and your creditor would get the cash. You would start over with your $5 million tax-deferred account. However, if you had done a Roth conversion of that $5 million account a couple of years ago (long before injuring someone else), then you would have a $5 million Roth IRA and no cash. Now, you can declare bankruptcy and lose nothing or, more likely, incentivize the creditor to settle for pennies on the dollar.
None of these reasons are necessarily an argument to go 100% Roth all the time. But you should keep these additional benefits of Roth contributions and conversions in mind when making your decisions about contributions and conversions throughout your life.
What do you think? Which of these reasons have motivated you to make Roth contributions or conversions?
I think #2 behavioral nudge should read
‘ the true decision is whether to put $6,600 into a tax-deferred account or $10,000 into a Roth account’ (if assuming a 33% marginal tax rate)
Or am I missing something?
The order in the article seems correct, although mentally since the contribution limits are the same, I’ve always though the comparison should be $10k into Roth vs $10k traditional + $X into taxable to account for the money saved with the tax deduction.
Yes, less in Roth = more in tax-deferred. The order is fine. The way JustPlainDoc describes it is also correct, but seemed more complex and confusing to people in my view. Who knows whether my view on this is right though.
I guess in my mind I am always thinking that by putting equal amounts in the traditional IRA vs a Roth IRA, I am effectively getting MORE money into the retirement account by using a Roth (obviously not counting the extra that I will pay in taxes on the back end)
Something like:
Roth IRA $7000 (my money)
Traditional IRA $4666 (my money) and $2333 (governments money)
Obviously this is exclusive of extra taxes on the Roth IRA
So I can always stuff more money that is mine (not the governments pre tax money) into a Roth vs traditional IrA
You’re absolutely right that that is the way it works.
You are correct.
Very few people explicitly invest the taxes saved from tax-deferred contributions.
Not too mention, how many people think of their savings rate in after-tax terms.
you are correct. $10k marginal earnings in IRA, or $6700 after tax in Roth. Marginal rate should be applied against the $10k, not the inverse on the $7500. Else $10k after taxes to get to $7500 is a 25% marginal rate
Re #4 Estate Planning Advantages, I’m not sure I understand the math presented in the example. In the first case, there’s an estate tax due of $1.2m (i.e., 40% estate tax due on the $3m above the $12m estate tax exemption). This leaves the inheritors with a net of $13.8m (i.e., $15m – $1.2m).
However, in the second case, after the Roth conversion, the inheritors receive only a net $11m after payment of the $4m tax due on the conversion.
So, yes, no estate tax due in the second case, but the net amount received is $11m vs $13.8m. What am I missing? Income taxes on the tIRA RMDs in the first case?
It might be that for about the first million dollars over the exemption, the tax rate is actually less than 40%. But it’s been many months since I wrote this so I don’t recall doing this math and it’s entirely possible I did the math wrong.
Trying to figure this out myself. I think it’s because then the traditional 10mil IRA still gets taxed at 40% when inheritors withdraw…. So your tax would be 1.2mill plus 4 mill… in a sense you’re double taxed. WCI was saying there’s a solution that your inheritors deduct the 1.2 mil but that most don’t know to do so? I think. That’s how I interpreted it.
Yup. You’ve got it.
It obviously makes sense to hedge unknown tax brackets and the other factors mentioned by having both types of IRAs. But 1 additional consideration against Roth conversions is that we are paying tax now using today’s dollars – but the tax savings of the Roth account each year going forward are in future, inflation-reduced dollars with the longer time periods to ‘break even’ (using unknown assumptions, a necessity) having less and less tax savings each year in future dollars, so effectively takes much longer than the usual mathematical models to ‘break even’ with Roth conversions, using whatever other assumptions.
…that is during our own lifetime, for our own tax savings as opposed to legacy-only considerations. For legacy, the previous point re: lessened real value of Roths is diminished considerably and our heirs will ‘break even’ (with $ they never previously had, so not exactly ‘breaking even’!!) and then some over their lifespans assuming they don’t raid the $ right after burying us.
That pretty much evens out with the additional dollars. It really is all about tax rates. “Will your rate later be lower than it is now?” is the question. You pay less in tax if you pay it up front via Roth contributions, but you might end up with less after-tax later doing that.
I don’t understand the example in number 5. If you do a Roth conversion of the 5 million dollar tax-deferred account, how does that bring you from 2 million dollars in cash to “no cash”?
Cash is consumed by taxes on the Roth conversion, that’s assuming a 40% tax rate. 5mil x 0.4 = 2 mil.
Because you used the $2 million outside the retirement account to pay the tax bill on the Roth conversion. There is no longer $2 million exposed to potential creditors. That $2 million in after-tax dollars is now inside the Roth IRA.
I got one (even though we shouldn’t use it this way): you can also use a Roth as an emergency fund. Specifically, you can withdraw the principal (even though you shouldn’t!) in a pinch if you need it… if, for instance, you (1) use up all of your emergency fund for some bad reason and need more money, (2) while you build back up your depleted emergency fund, or (3) if you never had one to begin with (early in your career). Also, it is an asset protected faux emergency fund?
Again, not the best idea, but still counts as reason #6.
Yup, especially if it isn’t invested aggressively.