The May 2017 issue of Financial Advisor Magazine has an article by William Reichenstein and William Meyer entitled “Beating Conventional Wisdom Using Roth IRAs” and subtitled “The best withdrawal outcomes require sophisticated analysis.” The article concludes:
The good news is that financial advisors can use financial software to help add substantial value to their clients’ accounts. The bad news is that, because of the complexities of the tax code and the need to take these complexities into account, we believe proper analysis requires specialized and detailed software if we are to find the best withdrawal strategy. In other words, it is far too difficult for you to determine the best withdrawal strategy by yourself or with existing software packages that only consider a few rules of thumb. Instead, we believe you will need to rely on software to help with your analysis to develop a good strategy.
It is clear that you can add a lot of value to baby boomers by helping them coordinate their Social Security claiming strategy and their withdrawal strategy in retirement. But a conventional wisdom withdrawal strategy will almost always leave a lot of money on the table.
Our own experience has found that advisors and CPAs alike tend to rely on simplistic rules and conventional wisdom which fails to optimize the after tax value to the client.
Tax planning is very different than tax return preparation. And those who engage primarily in tax preparation seek the short term goal of minimizing the tax paid this year. “Why pay tax early?” they argue, “And you especially should not pay it early if you can pay the same rate later!”
Unfortunately this conventional wisdom can leave hundreds of thousands of dollars, sometimes even millions of dollars on the table.
Investments growing in a taxable account are subject to taxation on interest, dividends, and capital gain. Assuming a simple 7% return and a qualified rate of 20.75% (15% federal and 5.75% Virginia state) results in a 1.4525% drag on your portfolio.
If you have $100,000 growing at 7% in a such a tax environment for 30 years it will be burdened with paying $256,054 in taxes and result in a portfolio just 66.36% of what it could have been in a Roth account.
Waiting until age 70 means your required minimum distributions must be put into your taxable account and be forever subject to the burden of taxation. Don’t delay.
Resenting paying the tax early misunderstands the sophisticated analysis. If you can convert $100,000 for $30,000 additional tax, then your Traditional IRA balance is better thought of as 70% yours and 30% the governments. Future growth will make both your shares bigger, but by converting and paying the tax now you can buy out the government’s larger future share.
You do not “have to” pay the tax early; you “get to” pay the tax early. You get to reduce your taxable account, which is subject to the burden of taxation, confiscate the government’s portfolio of your IRA, and put it in your Roth account where it will never be taxed again. This is like making a Roth contribution with whatever tax you pay.
Even these attempts to explain the savings of Roth conversions are simplifications of our sophisticated customized Roth conversion strategies.
The conventional wisdom regarding Roth IRAs leaves a great deal of after-tax money on the table. If $100,000 could earn $256,054 over 30 years it is easy to extrapolate that traditional IRA accounts with millions of dollars provide significant ways to maximize your after tax net worth.
Photo by Calum Lewis on Unsplash