Regular? or Roth!
by Richard
This is the decision we all face going into the final stretch of tax season. Today, I am driving my nephew to the nearest Schwab Branch to help him make this choice, as he funds his 2007 and 2008 IRA. My hope is that he will elect the Roth option, but the final decision is up to him.
It helps if you know what tax bracket you will be in when you retire. And for someone who is maybe 40 years shy of his retirement, like my nephew, this is simply an unknowable variable. But it’s worth taking a shot, so here we go…
The regular IRA gives you a deduction against your current marginal bracket, which is a known variable. What we also know is that we live in an era of relatively low tax brackets, for all except the very top income earners.
What will Social Security look like in the future?
A glimpse into the future, especially decades into the future, tells us that entitlement spending (Social Security, Medicare, Medicaid) will grow virtually uncontrollably. There is no effective constituency for reducing these benefits, only a massive interest group representing seniors who are in favor of expansion. Just look at these two camps and do the math, and you will understand how we got the Medicare prescription drug benefit enacted five years ago.
With constantly expanding benefits, there are only two policy options on the table that may help balance the books, and both of these were introduced during the last “lifetime” Social Security reform in the 1980s. The first of these was moving the goal line on the full retirement age from 65 to 67. This reflected both our increasing longevity and the necessity to somehow scale back on the benefit payout. I’m betting on 70 being the new 65. Do I hear 75?
The second was the introduction of taxation on Social Security income. This is truly the camel’s nose entering under the tent. This was followed just last year with the introduction of means testing on Medicare, which now has a variable fee schedule for the portion of Medicare paid by the recipient, i.e. part B, and now part D.
To understand how unfair this is, remember that payroll taxes for Social Security and Medicare are not deductible by the taxpayer when paid. The normal rule of taxation is very simple. If the taxpayer takes a deduction in the year paid, they are required to make it up when the payout comes at retirement. This is how a regular IRA is taxed. However, when there is no deduction taken when the contribution is made (the ROTH option) then the ultimate draw down is totally tax free.
For those in my nephew’s generation, my expectation is that…they can expect virtually all of their entitlement income to be taxed. Social Security. Medicare Benefits. The works. The only account exempted will their Roth retirement accounts, and, hopefully, their Health Savings Accounts when used for allowable medical expenses. For many if not most, they can anticipate a marginal tax rate as high as their regular working years tax rate, if not even higher yet.
Roth - Is the clock ticking?
I also predict that the ROTH option for IRAs and 401Ks will not be continued indefinitely. The upper income brackets are maxing out on these accounts, much more than the total number who are eligible. Anytime you have a tax subsidy skewed to upper income taxpayers, it is only a matter of time before the playing field gets leveled in the interests of social equity.
Then again, whenever the government phases out any tax benefit or retirement plan, it usually applies only to future years, and it normally grandfathers pre-existing plans which were funded in accordance with the prior tax laws. Those who were diligent in funding Roth IRAs and 401ks , when they were available, will be richly rewarded.
Here are your options:
- Fund your Roth IRA if you have current eligibility under the maximum income guidelines, which change annually. If you do not currently qualify, fund instead a non-deductible IRA each year through 2010. We have a big break in that year, when the income limits for ROTH IRAs are removed, and you have the option of converting your non-Roth into ROTH IRAs, and even spreading the conversion tax over two tax years.
- If you have the Roth 401k option at work, use it to the max. If you don’t have this option, let your 401k provider know you want the option. They can no longer say they do not want to make an option available if it is not permanent, because the 2006 Pension Reform act did in fact make the ROTH 401k option permanent. When you approach retirement, you simply roll over your ROTH 401 k into your Roth IRA. Note that the Roth option on your 401K applies to your salary deferral portion only, and not on your employers contribution, which must go into a regular taxable upon retirement 401k, so you will still have a mixture of both taxable and non-taxable retirement accounts.
We haven’t even gone into the legacy aspect of Roth IRAs, which can be inherited by your heirs, and paid out over their actuarial lifetime, rather than yours, all tax free. Personally, I have less enthusiasm for tax breaks that only kick in when you kick the bucket, but then again, you can’t ignore the inevitable. And you can’t take it with you. Really. Come on. Let’s face up to reality. When was the last time you saw a funeral
hearse with a luggage rack on the top?
