Joseph B . Darby III TAX ADVISOR
Joseph B . Darby III TAX ADVISOR
fore that age ( as of 2023 ) are subject to a 10 % penalty for early withdrawal ( in addition to income taxation of the distribution ). It ’ s worth noting that over time Congress realized the political expediency of giving taxpayers penalty-free early access to their funds and developed a variety of “ hardship ” exceptions to the early withdrawal penalty .
The math is relatively straightforward when you ’ re comparing a Roth IRA to a regular one . But your ultimate decision about which vehicle to choose will turn on your ability to predict your financial life path and your marginal income tax rates far into the future . In other words , it ’ s very challenging . Or nearly impossible .
The first insight is that if your income tax rates stay exactly the same over time , and if your investment return is the same in both vehicles , then the net after-tax result of investing in either the regular IRA or the Roth is exactly the same !
Let ’ s take Taxpayer X , who is trying to decide whether to contribute money for 2023 into a regular IRA or a Roth .
The math is relatively straightforward when you ’ re comparing a Roth IRA to a regular one . But your ultimate decision about which vehicle to choose will turn on your ability to predict your financial life path and your marginal income tax rates far into the future . It ’ s very challenging .
This individual expects to earn the exact same investment return over 10 years , anticipating that funds in both vehicles would double in value . We ’ re also assuming the income tax rate is exactly 40 % in 2023 ( using round numbers for simplicity ) and that it will remain at exactly 40 % through 2033 . So the taxpayer is trying to decide whether to contribute $ 1,666.67 into a regular IRA , or pay the 40 % tax on $ 1,666.67 and contribute the after-tax amount , or $ 1,000 , into a Roth IRA .
Fast-forward 10 years ; the accounts have doubled in value , giving the taxpayer $ 3,333.33 in the regular IRA and $ 2,000 in the Roth . If the taxpayer then distributes the funds from each IRA , paying 40 % tax on the $ 3,333.34 and no tax on the $ 2,000 , this means he or she has an after-tax return of $ 2,000 from the regular IRA and $ 2,000 from the Roth . The outcome is exactly the same !
This is not what people intuitively understand or expect . Yet our mathematical epiphany leads us to a couple of practical insights :
1 . If your income tax rate is higher today than you expect it to be when you ’ re mak- ing future distributions , then a regular IRA is the better alternative . This might occur , for example , because you expect your tax bracket in your retirement years to be materially lower than in your highest earning years .
2 . Conversely , if you think your marginal income tax rate today is lower now than it would be in the future when you ’ re making withdrawals , a Roth IRA is likely the better alternative . This might occur , for example , because you plan to work full time into your 70s and expect your income to stay high as federal and state income tax rates possibly increase .
Now let ’ s consider the other factors that can come into play .
Mandatory Distributions And Estate Planning Issues
With a few exceptions , IRAs are structured to penalize you if you make early distributions before age 59½ , but they also have back-end rules that start pushing money out of the account when the federal government decides it is time , and you must take required minimum amounts from your accounts each year after that . That was normally at age 72 , but it ’ s now age 73 if you reach age 72 after December 31 , 2022 . This applies to withdrawals from your regular IRA , SEP IRA and SIMPLE IRA plans .
The reason it ’ s now age 73 is likely because of the political pressure from elderly owners of large accounts , which increased the mandatory age for required distributions from 70½ . ( Stay tuned for further age increases as Congress seeks to ingratiate itself to this voting bloc .)
Now consider that Roth IRAs do not require these withdrawals until after the owner dies , an often overlooked benefit of this vehicle . Designated Roth accounts in 401 ( k ) and 403 ( b ) plans are subject to the required minimum distribution rules for 2022 and 2023 . But for 2024 and later years , RMDs are no longer required from designated Roth accounts . ( People must still take the distributions from designated Roth accounts for 2023 , including those with a required beginning date of April 1 , 2024 .)
24 | FINANCIAL ADVISOR MAGAZINE | SEPTEMBER 2023 WWW . FA-MAG . COM