Pay More Tax Today! Those are words you never thought you would hear from a financial planner, right?
With another round of stimulus being discussed in Congress and the COVID-19 crisis in what I think is only the third inning, there are two things that Gen X and Gen Y savers must recognize: tax rates are going to have to go up in the future.
It is highly likely that Social Security payouts will be lower in the future than they are now. As a result, planning for 30, 40, or 50 years from now takes on a different dimension. While the old playbook included using 401(k)s and traditional IRAs, which use pre-tax money to fund retirement vehicles, knowing these two likely facts can change the playbook to using more after-tax money, through Roth 401(k)s or Roth IRAs. Further, for those of you who have accumulated some traditional IRA money, 2020 may be the right time for you to consider converting part or all of your traditional retirement account balances to Roths.
What’s the Difference?
The primary difference between traditional IRAs and 401(k)s is the tax treatment of deposits and withdrawals.
When you contribute to a traditional IRA or 401(k), the amount you contribute is deductible from your income for tax purposes. When you take your money out of a traditional IRA, it is taxed as regular income and, if you take the money before age 59 1/2, it may be subject to a 10% penalty as well.
Alternatively, when you make a Roth contribution, you contribute after you have already paid income taxes. As a bonus, the Federal government lets that money grow and be withdrawn tax-free when you need it subject to certain restrictions.
Typically, if your earnings are low, the going advice is to make Roth contributions. If your earnings are low, your taxes are low, so tax avoidance benefits are minimal. Beyond that, the share of your account “owned” by the government (in terms of future tax payments) is zero.
What about Social Security?
While you are young, Social Security is likely not on your mind. Heck, your parents might not be on it yet. But the truth is that the program is running out of money. Payouts to Social Security recipients are based on current receipts from payroll taxes. Years ago, there were more than four taxpayers paying payroll taxes for each Social Security recipient, so Social Security was able to gather up some excess money. But the problem now is that there are fewer than two workers for each retiree. As a result, that excess is running out. It is believed that these excess reserves will run out in the next several years. When it runs out, experts say that Social Security benefits will decline by about 25% immediately, and with current demographic trends, they may decline further by the time you are old enough to collect from the program.
Between the trends in Social Security and the likely increase in tax rates, it’s going to be up to you to fund much more of your retirement than your parents and grandparents have. Politics matter too; if the polls are right, Democrats may be voted into power in November. Democrats have already said that they would like to increase taxes on many Americans, particularly those with higher incomes.
So What’s the Opportunity?
COVID-19 has been awful for many financially. But those of you whose incomes have been unaffected have been granted a unique opportunity. Throughout the year, you have been spending less, in part, because you have been staying home and have been unable to travel or participate in entertainment events. As a result, many of you are sitting on excess cash. While it certainly makes sense to have a larger emergency fund than usual due to the uncertainties, you can take advantage of the current situation to create a better life in retirement for yourself down the road.
How?
Even if you are a high-income individual, if you have enough cash to convert all or part of your IRA to a Roth IRA, 2020 is likely the best chance you’re going to get. This fall’s election may end up leading to higher rates beginning in 2021, so taking advantage of low rates now can lead to lower tax payments. Further, if markets again fall due to COVID-19, you get a discount. This was hard to do in March when markets were at their lows. Still, another period of volatility this fall may just provide the optimal conditions for a conversion, as a lower balance at the time of conversion will lead to lower taxes due next year.
Over time, the compounding of these converted assets can yield significant tax savings for you. For example, if you are married, 40 years of age, and earn $200,000 this year you would be in the 24% tax bracket. When you convert $50,000 of traditional IRA to a Roth IRA, you will have to pay approximately $12,000 in additional federal taxes (this does not count any state or local taxes that may be due on the conversion). If the account earns 7% per year over the next 30 years, your account would be over $380,000. If tax rates return to 2017 rates, before the most recent tax changes, you could save tens of thousands of dollars compared to leaving it in the traditional IRA.
Based on that, it leads to the advice to pay more taxes now while rates are low, and your income and budget may have a little flexibility.
Of course, all of this depends on your situation and should not be undertaken without consulting your tax advisor. If you would like to discuss whether converting part or all of your traditional IRA to a Roth IRA is right for you, I would be happy to talk with you. You can make an appointment for a consultation here or reach out to me at russell.rivera@voicewealth.com.
Russell D. Rivera, CFA, CFP®, is the Founder and President of Voice Wealth Management (Voice) in New York, NY. He also likes to think of himself as a Personal CFO and Financial “Therapist” for entrepreneurs, young professionals, and their families. He helps clients make prudent financial decisions regarding spending, saving, investing, and planning while giving a voice to the individual client's financial priorities and experiences.
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