This chapter focuses on retirement accounts. We begin with the decision on whether to invest in a Roth IRA or a traditional IRA.
Individual retirement accounts (IRAs) are tax-advantaged investments. The two different types of IRAs—traditional and Roth—have some similarities and some differences. The differences have implications for the development of an investment policy statement, the asset allocation decision, and the choice of the preferred vehicle.
Contributions to a Roth IRA are made on an after-tax basis and distributions are not subject to income tax. The traditional IRA is the mirror opposite. It allows contributions to be made on a pre-tax basis (on the tax return the adjusted gross income is reduced by the amount of the contribution), but all withdrawals are subject to taxation.
An example will illustrate both the differences and similarities of the two accounts. Consider two investors, John and Mary. Both are in the 25 percent tax bracket. Both expect to be in that same 25 percent bracket when they retire. They also have the same income and spending needs. They both invest on the same day in the same mutual fund. Each has just received a $1,000 bonus. We'll start with John.
John decides he will invest his bonus in a Roth IRA. Having to set aside 25 percent of his bonus to pay federal income taxes, John makes a $750 contribution to his Roth IRA, investing that amount in a mutual fund that invests in equities. John's investments increase in value by 33⅓ percent. He now has $1,000. Assuming no penalty for early withdrawal, John could withdraw $1,000 with no taxes owed. Now let's consider Mary.
Mary decides to use her bonus to contribute $1,000 to her traditional IRA. She can invest $250 more than John because she doesn't have to pay the current income tax on the $1,000 invested. Mary invests her $1,000 in the same mutual fund, earning the same 33⅓ percent return. She ends up with $1,333. When she withdraws the funds from her traditional IRA (still assuming no early-withdrawal penalty) she will pay a tax of 25 percent ($333). Like John, she ends up with exactly the same $1,000. That tax of $333 is equal to the original tax that was deferred ($250) plus $83—the 33⅓ percent gain on the $250. Mary was investing funds on behalf of the government, actually owning only 75 percent of her IRA. The government owned the other 25 percent. This example demonstrates five important facts.
A traditional IRA is identical to a Roth IRA if the tax rate at the time of contribution is the same as the tax rate on withdrawal. Our Mary/John example proves this: Both portfolios generated $1,000 net.
If the same investment in either a Roth or traditional IRA results in the same ending dollars after withdrawal, there is no tax on either. Many people have a hard time understanding this. The right way to think about it is that Mary never owned 100 percent of her $1,000 investment. She owned 75 percent of it; the government owned the other 25 percent. The government let Mary invest its share of the money until she withdrew her share. At that point the government claimed its 25 percent. Mary is in the identical situation as John. Just as there was no tax on John's earnings, there really was no tax on Mary's share of the earnings.
You may often have heard advice that you should not hold equities in a traditional IRA because doing so converts what would otherwise be capital gains into ordinary income. This is incorrect: As the example shows, there is no tax on the gain.
Taxes need to be integrated into investment policy. That Mary only actually owned 75 percent of her $1,000 investment has implications for investment policy and the asset allocation decision. Assume Mary and John each started with $1,000 of equity holdings in taxable accounts. John invests another $750 in his Roth, and Mary invests another $1,000 in her traditional IRA. This time they both put the money into bond funds. What are their respective asset allocations? The conventional analysis would be as follows:
John has $1,000 in stocks and $750 in bonds. His asset allocation is thus 57 percent stocks and 43 percent bonds.
Mary's allocation of $1,000 in stocks and $1,000 in bonds is 50/50.
But since the Roth and the traditional IRA are the same, Mary's allocation must actually be the same as John's, not 50/50. Her allocation is the same $1,000 in stocks and $1,000 × [1 minus the 25 percent tax rate], or $750, in bonds. This is the same 57/43 allocation. If Mary wanted to have an allocation of 50/50 her holdings should have been $875 of stocks and $125 of bonds in the taxable account and $1,000 of bonds in the traditional IRA.
The tax code impacts the asset allocation of taxable accounts as well as IRAs. For example, if John had a taxable account that owned an equity mutual fund with a cost basis of $1,000 and a present value of $11,000 (assuming a long-term federal and state capital gains tax of 20 percent and no step-up in basis expected), for the purposes of determining John's asset allocation we would conclude he owned just $9,000 of equities, not $11,000. The government "owns" 2,000 of the 11,000—20 percent of the $10,000 unrealized gain.
We now turn to the issue of what drives the decision of which IRA to purchase.
The decision of making a contribution to a traditional or Roth IRA should be based on whether the tax rate on withdrawal is expected be higher or lower than at the time of contribution. If lower, the preferred choice should be the traditional IRA: the government will own a lower percentage of the investment dollars. Here is an example.
John's tax rate is 25 percent on contribution. He expects it to be just 15 percent on withdrawal. In the original example, John invested $750 in the Roth IRA; given the 33⅓ percent return he would be able to withdraw $1,000. If instead he made the contribution to a traditional IRA, he could contribute $1,000, deferring the 25 percent income tax otherwise due. The $1,000 grows to $1,333. With John's income-tax rate just 15 percent at withdrawal, he can withdraw $1,133 ($1,333 × [1 minus 15 percent]). In terms of asset allocation, John owned 85 percent of the account, not 100 percent.
If the tax rate at withdrawal is expected to be higher than at contribution, the preferred choice should be the Roth: You pay the government its share when the tax rate is lower. Using John again as an example, assume he is in the 25 percent bracket at contribution but expects to be in the 33 percent bracket on withdrawal. If he invests in the Roth he can invest $750, and he will be able to withdraw $1,000. If he invests in a traditional IRA he can invest $1,000 and withdraw $1,333 before taxes. However, after taxes the net amount is just $893 ($1,333 × [1 minus the 33 percent tax rate]). Thus, when the tax rate is expected to be higher at withdrawal than at contribution the Roth is generally the preferred choice. But there is another consideration.
Maximizing the Benefits of the Tax Code. The maximum contributions to traditional and Roth IRAs are the same. For 2010, the maximum for those under age fifty was $5,000 and for those over 50 $6,000 (allowing for what is called a "catch up"). Assume Mary and John are both forty, each can contribute the $5,000 maximum and both have sufficient cash flow to make the contribution. Let's look at the implications of John's $5,000 investment in a Roth IRA versus Mary's $5,000 contribution to a traditional IRA.
Mary's $5,000 contribution allows her to save $1,250 of current income taxes. She has $1,250 to invest in a taxable account along with the $5,000 in her traditional IRA, for a total of $6,250. She does not own the full $5,000 of her traditional IRA, only $3,750 ($5,000 × [1 minus the tax rate of 25 percent]). The government owns the remaining $1,250. On her holdings, $3,750 will not be subject to any tax, and $1,250 (in the taxable account) will be subject to taxes on any gains. Her total holdings are $5,000, just like John. However, all of John's $5,000 is in a tax-free (Roth) account. If the tax rates at contribution and withdrawal are expected to be the same, the Roth account is the preferred choice for those that can make the maximum contribution. Doing so allows them to hold more funds in a tax-free environment.
The benefit of the lower tax rate on withdrawal has to be weighed against the benefit of being able to invest more dollars in the tax-free environment. The individual needs to decide which is more valuable: contributing a greater amount to a tax-advantaged account or having the government take a smaller share. Three issues warrant consideration. First, look at the difference in tax rates. The larger the difference, the more it favors the traditional IRA. The second issue is the length of the investment horizon. The longer the period, the more it favors the Roth. Issue three is the level of tax efficiency of your taxable investments. The more tax efficient, the less advantage the Roth provides.
Given that (1) tax rate differences can be large, (2) investors have access to highly tax-efficient investment vehicles (like tax-managed equity funds), and (3) the difference in the additional amount of investment dollars that can be placed in tax-advantaged accounts is relatively small, the traditional IRA would still be the choice if the tax rate is expected to be lower at withdrawal. Given the complexities of the issue, it would still be prudent to seek expert counsel.
The issues related to the ability to maximize contributions also relate to a Roth 401(k). The difference is that the Roth 401(k) is not constrained by the same income limitations or contribution rules constraining a Roth IRA. Employees can decide to contribute funds on a post-tax basis, in addition to or instead of pre-tax deferrals under their traditional 401(k) plans. An employee under the age of fifty could defer [whether to a traditional 401(k), a Roth 401(k), or to both] up to $16,500 for tax year 2010. If over age fifty, they could contribute an additional $5,500, for a total of $22,000. Note that employer contributions (employer match, profit sharing contribution) are always pre-tax; the Roth option is only available for employee contributions.
Since individuals should always try to maximize their contributions to tax-advantaged accounts, the Roth 401(k) is a valuable tool. The same issues apply to 403(b) accounts.
Pay Me Now or Pay Me Later. As seen from the examples above, it is just a case of when the government's "tax bell tolls." You control the timing. Your choice should be based on when you think the government's percentage ownership is likely to be lower. Since you don't know for certain what future tax rates will be, one strategy is to assume that your future marginal tax rate will be the same as it is today. Another strategy worth considering is diversifying the risk of changing tax rates, splitting contributions between a Roth and a traditional IRA. As your tax rate varies over time you will withdraw more from your Roth when your marginal rate is high and more from the traditional IRA when it is low.
While traditional IRAs require minimum withdrawals (RMDs), Roths do not: The government has already collected its toll (taxes on the income have already been paid). If an individual believes they will not need the RMD to pay for living expenses, choosing the Roth could be better even if the tax rate was expected to be slightly lower at withdrawal. Remember, too, that when estimating future tax rates you should consider the impact of an RMD on the marginal tax rate and on the taxability of Social Security benefits.
There are a few more considerations. If an individual has a traditional IRA but cannot make additional pre-tax contributions because his income exceeds the adjusted gross income (AGI) threshold, he can still make strategic decisions regarding the choice of IRA account. Since the government will take its toll at the time of conversion, you should convert if you expect the tax rate will be lower if you pay the tax now than when you would otherwise begin withdrawals.
One more point: Due to the specific formulas for the calculation of taxes for investors likely to be subject to estate tax, the dollars accumulated in Roth IRAs are, in effect, taxed less heavily than those in a traditional IRA. The formulas are complicated. Those likely to be subject to the estate tax should seek professional estate tax advice from their CPA.
Integrating tax consequences into investment plans can be complex, especially as tax rates and investment values change. There are two ways to address this problem. The first is to tax adjust your current holdings to account for the government's share. The other approach is to use a Monte Carlo simulation with tax codes built in to determine the odds of success of your investment plan. The simulation will account for the government's share and give you the estimated odds of your plan succeeding in achieving its goal. That goal can range from not outliving your assets to leaving an estate of $X million. The latter approach is recommended for its simplicity. Either will help you make the right decisions.
A final note: We urge caution in using software tools purporting to analyze the benefits of traditional IRA and Roth IRAs. The several we have looked at contain errors, missing some of the key points raised in this chapter.
The historical record provided by academic studies is clear: The prudent investment strategy is investing in low-cost mutual funds that are passively managed: index funds, ETFs, and passive asset class funds. Because of the expenses of providing and maintaining a plan, a conflict of interest can arise between what is best for the employer (least cost) and best for the employee (access to the best investment vehicles). This conflict is very often decided in favor of the employer.
The employer can save a lot of money by not having to pay for administration of the employee benefit. Management gets very interested when a fund family providing high cost, actively managed funds proposes to the employer that they will pick up all of the plan's administrative expenses if the employer makes their fund family the exclusive (or at least dominant) provider of investment alternatives. Because high-cost, active management is a loser's game, it is the employees who lose, accumulating fewer dollars in their retirement accounts.
It would be far better for both employers and employees to choose a plan with low-cost, passive investment vehicles. If the employer could not afford the administrative costs of such a plan, the costs could be unbundled and appropriately passed on to each employee. Employees may be concerned they would be charged for a service that in the past was "free." But through education they will learn they have been paying for administration services all along, just not being billed separately for them. The cost showed up in lower returns earned due to the higher internal expenses of the mutual funds in which they were investing. In the long term, charging employees directly for administration costs is significantly less expensive than paying both the expenses of high-cost mutual fund companies and the extra, and nonproductive, trading costs of active management.
If an employee does not have access to low-cost, passive investment choices the option becomes a choice between the "lesser among evils."
For three reasons, the best choice is to first use the retirement plan for fixed income assets. It is preferable from a tax-efficiency standpoint to hold the equities in taxable accounts and fixed-income assets in tax-advantaged accounts. Index or other passively managed funds should be used, but they are often not available. A second reason: Expense ratios and trading costs of actively managed fixed-income funds are generally lower than for actively managed equity funds. By choosing fixed-income funds, you can reduce total expenses and the drag on returns. Third, the dispersion of returns across bond funds is usually much lower than for stock funds. Actively managed stock funds are more likely to underperform by large amounts than even poor (or lucky) bond funds.
If the investor needs to hold equities in the tax-advantaged account the first choice should be to choose index or other passively managed funds. The preference should be for domestic funds, since the foreign tax credit is lost in tax-advantaged accounts. If passively managed funds are not available, style drift must be considered. Since controlling the risk of a portfolio is of paramount importance, investors should look for funds that "stick to their knitting." Investors should also look for funds having the lowest total expenses (operating expense ratios, other fees, and the lowest turnover): Expenses incurred in selecting securities and/or timing the market are highly likely to prove counterproductive. The bottom line is that investors should look for funds most closely resembling low-cost, passive funds. One example is Vanguard's Windsor Fund, a good choice for gaining exposure to the asset class of U.S. large value. It is low cost, low turnover and has shown no tendency to style drift.
It is important to build a portfolio that is globally diversified by asset class, thereby avoiding placing all your eggs in one asset class basket (U.S. large growth). However, if your only choices are active funds and one index fund (many plans include at least an S&P 500 Index or Total Stock Market fund), invest in the index fund and diversify your equity holdings outside the plan. If the costs of the active choices allowing you to diversify are high, forgo the diversification benefits in favor of the sure savings from lower expenses.
One more point to consider: If the only two index funds in the plan are an S&P 500 Index fund and a total stock market fund with similar expenses, choose the latter. It is more diversified.
Roth IRAs restrict contribution eligibility. For 2010, investors who were married filing jointly saw their contribution limits phase out once their MAGI exceeded $167,000, and they lost Roth IRA contribution eligibility with a MAGI above $177,000. For those with a filing status of single or head of household, the limits are $105,000 and $120,000, respectively. Qualifying investors can still own a Roth IRA by doing what is called a Roth conversion. This involves converting a traditional IRA into a Roth IRA. Determining if a conversion makes sense is where it gets more complicated.
Unless current tax laws change, income limits for converting traditional IRAs to Roth IRAs will no longer apply. In addition, those who convert in 2010 can stretch the tax liability over two years, with half the conversion amount included in taxable income in 2011 and the other half in 2012. Conversions occurring after 2010 will require the entire conversion amount to be included as income during the year of the conversion.
When considering a conversion, keep the following factors in mind:
Are sufficient funds available to pay the tax on the amount to be converted? (Remember, you are paying it at ordinary income tax rates.) The greatest potential for growth occurs when funds from taxable accounts are used to pay the taxes.
An IRA inherited from a person other than a spouse cannot be converted to a Roth IRA.
Assets must not be withdrawn from the Roth IRA within five years of the conversion. If you do, you will have to pay the 10 percent early distribution penalty, even if you are older than 59½. The five-year withdrawal limitation for IRA conversions begins January 1 of the calendar year the conversion takes place. So, if you convert to a Roth IRA in December 2010, the effective start date for the five years is January 1, 2010. That means you have only four years remaining until the withdrawal penalties disappear.
However, the conversion income could push you into a higher tax bracket, increasing your total tax liability and possibly disqualifying you from other tax benefits such as the dependent child care and college tuition tax credits. It may also push Social Security benefits into taxable income.
A Roth conversion may make sense if you answer "yes" to any of the following questions:
Do you have enough money outside your IRA to meet your needs? Unlike traditional IRAs, Roth IRAs do not have required minimum distributions at 70½. If you want to pass this account untouched to your heirs, conversions make sense.
Do you need to generate income to take advantage of tax credits or deductions? If you have charitable deductions, carry-forwards, or other tax-favored items, but not much income one year, conversions may make sense. Not only do you get the benefits of conversion, but by forcibly increasing your income (money moved counts as income), you can take advantage of all your qualified deductions and credits. A conversion can also be helpful for investors with high medical expenses; additional taxable income helps take advantage of the full deduction.
Do you believe your tax bracket is lower now than it will be in retirement? Conversions may be good for young investors with low income. The tax on the conversion should be low, and it is possible that when the money is withdrawn, a higher tax will later apply on taxable distributions. This would be especially true if the investors have high equity allocations in their Traditional IRA. Equities have high expected returns. The account could grow to sufficiently large levels, making the required minimum distributions large enough to cause their marginal tax rate to be at a high level. The longer the investment horizon, the more important this issue becomes.
Do you have enough money outside the IRA to pay the taxes on the conversion? Investors converting their IRAs should pay conversion taxes from taxable dollars. Doing so allows for greater growth potential.
If you answer "yes" to any of the following questions, a Roth conversion may not make sense:
Do you believe you are in a higher tax bracket now than you will be in retirement? The taxes paid to convert now may exceed the taxes paid later at the lower rate on IRA distributions, negating the benefits.
Are you interested in leaving your IRA to a charity? There are no advantages to rolling it into a Roth and paying taxes on it now, since it will be a tax-free event for the charity when received.
A partial conversion may make more sense in the following scenarios:
If you do not have money to comfortably pay the taxes, partial conversions over a set time period would soften the tax impact. As long as you meet the income and filing requirements you can continue to convert a portion every year.
When you convert money from traditional IRAs to Roth IRAs, it counts as income. If the amount of the conversion would increase taxable income enough to move you into a higher tax bracket, partial conversions may be more sensible. This can be difficult to estimate, so it is important to get your CPA involved.
What happens if you discover the Roth conversion cannot be made because your AGI unexpectedly (not unhappily) climbed over the allowable limit? Or suppose it would be in your best interest to reverse the conversion (perhaps because of a drop in the value of your investments), converting again at some future date and paying less tax? In either case you can "recharacterize" that conversion (and any earnings thereon) back to a traditional IRA. If you do so in a timely manner, you will not incur any taxes or penalties.
Recharacterizations must take place by the due date of your tax return, including extensions. You must move the Roth IRA funds (and applicable earnings) back to their traditional IRA prior to October 15 of the year following the conversion. If you wait until after the October 15 deadline, you will be required to close the account and pay taxes and penalties on any early distributions.
If you convert traditional IRAs to Roth IRAs and then recharacterize them back to traditional IRAs, you may not reconvert that amount back to Roth IRAs before the later of:
The first of the following year from when the amounts were originally converted to the Roth IRAs; or
The end of the 30-day period following the day on which the Roth IRAs were recharacterized back to traditional IRAs.
Any reconversion made before the later of these two dates would be deemed to have "failed."
Previously, Roth conversions could only be done from IRAs. There were no rules permitting the same type of conversion from employees' qualified retirement plans. However, effective for tax years after December 31, 2007, the Pension Protection Act of 2006 allows taxpayers to convert all or a portion of their eligible retirement plans to Roth IRAs.
The rules that apply to Roth IRA conversions from traditional IRAs will also apply to conversions from eligible retirement plans. Thus, married taxpayers filing separately will not qualify.
If you have only contributed to nondeductible IRAs and wish to convert, part of the conversion will be tax-free. Taxes are calculated only on the earnings from nondeductible contributions, not the nondeductible contributions themselves. However, if you own both deductible and nondeductible IRAs, the taxable portion of the IRA (or portion of the IRA you will convert) will be determined based on the proportion of taxable money in all the traditional and simple IRAs combined. If you have untaxed amounts in other IRAs, you may end up owing more in taxes on this conversion than expected. The IRS does not allow you to designate that your conversions are only from the nondeductible contributions.