IRAs, 401(k)s and Roth Optimization

“In this world, nothing can be said to be certain, except death and taxes.” Benjamin Franklin

In an article I wrote recently titled How Safe Is Your Money?, I discussed the rumors that the government was looking to seize citizen’s IRAs and 401(k)s. I opined that I don’t think it is plausible that a bill, in which gives the government the right to come seize our assets without any legal reasons (garnish wages, unpaid debts like child supports, etc.) would not only pass both the senate and house of representatives but also be found legal by a conservative weighted Supreme Court.

Thanks to some very smart people though, taxing citizen’s IRAs and 401(k)s differently in the future versus the laws today is definitely a possibility. Recently, the founder of PayPal, Peter Theil made headlines after it became public that he pulled off a major tax coup. First a couple of high-level facts:

• IRAs and 401(k)s (from here on out just IRAs), provide a tax break in the year you contribute to them, grow tax deferred, then are taxed as ordinary income when you take distributions.
• There are caps on how much you can place in an IRA each year.
• Roth IRAs provide no upfront tax savings but they grow tax free in the future.
• In 2021, if a couple earned over $208,000 (or $140,000 if you are a single filer) you cannot contribute to a Roth IRA. However, this applies to contributions only and not conversions.
• The max someone can contribute to a Roth if they earn less than those limits is $6,000.
• Regardless of earnings and with no caps, you can convert money from an IRA to a Roth IRA, which is moving money from an account that grows tax deferred to one that grows tax free. You must pay taxes on the conversion in the year you convert.

Mr. Theil placed pre-IPO stock into his IRA. He was able to contribute many shares because the value of that stock was very low at the time. He then did a Roth conversion, which means he moved those shares to a Roth IRA. He had to pay taxes on the move, but recall the shares were priced very low at the time. Those shares are now held in a Roth IRA, which grew tax free and is currently valued at over $5 billion.*

This is called a backdoor Roth IRA, which allows someone who earns more than the income limitation to get money into a Roth even though they make too much to ordinarily contribute. If you believe tax rates are going to increase, then a Roth IRA might be better for you. However, and this is very important, there are two parts to that equation regarding increased taxes. You must compare your current average tax rate to the average tax rate you expect to be in when you distribute the money. For example, if a couple’s taxable income is $300,000 with no additional credits, their average tax rate would be approximately 20%. What if you expect to earn much less in retirement?  Based on distributions, pensions, and all other taxable income, you only expect it to be at $100,000? If you had $100,000 of taxable income today, your average tax rate is 14%.

For it to be a prudent move, based purely on taxes and not estate planning goals, the tax rate for $100,000 of earned income must rise above 20%. One main issue in this math question is there are so many unknown variables that cause most of us have the following look when trying to solve the equation.

There are more benefits of Roth IRAs, including but not limited to how they are handled at death and they currently do not have required minimum distributions. For those two reasons alone, Roth IRAs are very popular for wealthy couples/individuals.

Then there are Mega Back Door IRAs. Instead of using IRAs, this works with 401(k)s. A 401(k) has higher maximums than IRAs. Current tax laws allow a person to contribute $58,000 in after-tax dollars. You then can turn and convert that amount to a Roth IRA. Just another way for the optimize the amount they contribute to the vehicles of their choice.

This bothers some people, including politicians. To be fair, IRAs and 401(k)s were established to help middle- and lower-income people to save for retirement. It was never meant to be a method where people, the ultra-rich, could turn a Roth IRA into a $5 billion dollar windfall.

The manipulation of these laws could see tax reform on IRA and Roth maximum values, meaning the most you can have total in all your IRAs is some capped number. I want to be clear: I wrote in the article How Safe Is Your Money? that I do not believe for a second that the government is going to seize those assets but I could see those accounts being taxed differently.  We definitely could see limits put on how much you can have in an IRA, 401(k) or Roth IRA.  However, unless you have over $10 million in one, I wouldn’t worry about this either.

We shouldn’t over-complicate our lives with our wealth. In my opinion, right now it is way too premature to start asking how you plan on avoiding the cap, if there is even one passed.   The questions we should be addressing are: how should you optimize the use IRAs, 401Ks or Roth IRAs?  Do back door and mega back door strategies interest you?  How does all this fit into your estate plan?  These are the questions we can and want to address today. If you are interested in these strategies and maximizing the benefits of your retirement accounts, we’re here to help. Give our office a call at (817) 717-3812 to schedule a time to meet. Let the politicians worry about the tax laws and know that if or when any tax law changes are legitimately on the table, we will be here for you and ready to address those changes.

(*)  Per Barron’s Advisor, “Wealthy Clients Clamor for Backdoor Roth IRAs.  Advisors May Want to Keep That Door Shut, August 3, 2011

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal.