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To Roth or Not to Roth, That Is The Question

Conventional wisdom would have us believe that after-tax Roth IRA contributions only make sense if we expect higher taxable income and higher income tax rates in retirement than now. Is conventional wisdom wrong? Not completely but it is woefully simplistic in a complex financial world. Especially for client-facing advisors, the client implications of the Roth decision are profound. After-tax contributions to a Roth IRA or Designated Roth Account in a 401(k), 403(b), or 457(b) plan are impacted by more than just income tax rates. The savvy financial advisor should know that the Roth decision may also be influenced by major considerations such as:

  • Uncertainty of Future Income Tax Rates
    • “No man’s [or woman’s] life, liberty and property [money] is safe when Congress is in session” according to noted attorney, newspaper editor, and politician Gideon John Tucker in 1866.
    • Who can guarantee that income tax rates won’t rise in retirement?  While future income tax reductions are also possible, many pundits believe that current rates are less likely to fall in the wake of the seismic tax reductions from the Tax Cuts and Jobs Act.
    • Here’s the Takeaway – if expected income tax rates in retirement are only slightly lower or about the same as current income tax rates, a Roth contribution may insulate your client from financially painful income tax rate hikes when he or she can afford it the least: in retirement.
  • The Qualified Business Income (QBI) deduction
    • For owners of small businesses, the QBI deduction is generally calculated as 20% of the lesser of a taxpayer’s taxable income or QBI.
    • If the deduction is limited by QBI instead of personal taxable income, a Roth after-tax contribution instead of a pre-tax contribution could make sense.
      1. For example, assume the personal taxable income of a couple filing as married filing jointly is $250,000 and QBI is $231,000. The $231,000 is QBI after deducting a $19,000 pre-tax contribution to a qualified retirement plan.
      2. Their QBI deduction is limited to $46,200 (20% of the lower of QBI or personal taxable income). Why? Because QBI ($231,000) is lower than personal taxable income ($250,000).
      3. But watch this – An after-tax contribution to a Designated Roth Account instead of a pre-tax contribution to a non-Roth account increases QBI to $250,000.
      4. Consequently,  the QBI deduction rises to $50,000 (20% of the lower of QBI or personal taxable income).
    • Bottom Line – the higher QBI deduction effectively reduces the tax cost of the Designated Roth Account contribution.
  • Reduce Taxes on Social Security benefits
    • As little as 0% or as much as 85% of Social Security benefits can be included in a taxpayer’s total income, based upon a Social Security formula.
    • Unlike taxable distributions from Traditional IRAs or qualified retirement plans, qualified distributions from Roth IRAs or Designated Roth Accounts are excluded from total income.
    • Key Point – A lower total income could mean, under the Social Security formula, a reduction in taxable Social Security benefits.
  • Eligibility For Tax Credits
    • Although not all tax credits apply to some retired taxpayers, grandparents supporting a grandchild or funding a grandchild’s education may be entitled to tax credits such as the Child Credit, Family Credit, American Opportunity Credit or Lifetime Learning Credit.
    • Unfortunately, higher income taxpayers may not qualify – these credits are phased out at higher adjusted gross income levels.
    • Here’s the Takeaway – Taxpayers may qualify for more tax credits if Roth distributions are taken instead of taxable distributions.
  • Lower Long-Term Capital Gain taxes
    • These rates range from 0% to 20% and are based upon a taxpayer’s taxable income.
    • Distributions from pre-tax retirement accounts generally increase a taxpayer’s taxable income while qualified Roth distributions do NOT increase taxable income
    • Bottom Line – A lower taxable income may mean a lower capital gains tax rate.
  • Reduced Medicare premiums
    • Medicare Part B (medical services cost) and Part D (prescription drug costs) premiums are means-tested – the more you make the more you may pay in premiums. Individuals with higher adjusted gross incomes may pay significantly more in premiums than those with lower incomes.
    • Key Point – Those lovely tax-free qualified Roth distributions may avoid Social Security premium increases because they do not increase adjusted gross income as would taxable distributions from retirement accounts.

These 6 major considerations are not the only factors to consider. For example, property taxes are means-tested in some states while other states levy taxes on taxable distributions from IRAs an qualified retirement plans.

What does all of this really mean for a Financial Advisor? The next time a competing financial advisor tells a prospect that it’s ONLY about tax rates now vs. tax rates in retirement, you can make your client aware that there may be more, much more, involved in making the critical “Roth or Not to Roth” decision.