Barbell the Roths: How and When to Utilize Roth IRAs

History of the Roth IRA

Bob Packwood and William Roth are some of my favorite politicians for one reason, and one reason only; in 1989 they proposed what was originally called the “IRA Plus.” It took 8 years from the proposal but eventually was established with the passing of the Taxpayer Relief Act in 1997 with the new name of “Roth IRA.”

Since then, most Americans have had the opportunity to put money into retirement programs that can grow tax-deferred and eventually be distributed tax-free. These offerings have continued to expand beyond the Roth IRA and into 401(k), 403(b), and 457(b) programs.

Windows of Opportunity

For those at the beginning of their careers, a Roth can be a great savings tool while income and tax rates are low relative to expected future income and marginal tax rates. Then, as their annual income (and tax liability) grows with their career, it typically makes more sense to move those savings into vehicles that provide a current tax deduction (e.g. traditional IRA). Roth IRAs also make sense at the other end of the career spectrum. With required minimum distributions pushed back to age 72 and Social Security benefits growing until the age of 70, for many investors, the window between retirement and these programs kicking in can be a very attractive opportunity to get more dollars into Roth accounts.

In this case, rather than making contributions through a paycheck or from a taxable account, these transfers can be accomplished by utilizing Roth conversions during low income and/or retirement years.

For individuals retiring at 65, there may be a 5-7-year window in which their only income is coming from their taxable accounts. This means that a married couple in today’s tax regime can make ~$25K in interest, dividends, and capital gains and owe ~$0 taxes given the current standard deduction. This is a unique period of low taxes in contrast to the higher tax rates of their high-income professional and RMD years. And taking advantage of a Roth conversion in this window can be a fantastic opportunity to “smooth out” tax bills in retirement years.

With these windows of opportunity in mind, younger investors should consider planning for a “barbell approach.” This approach consists of seeking large contributions to Roth accounts at the beginning of life and then later utilizing their retirement window to perform Roth conversions.

There are two main windows of opportunity: (1) early in your career and (2) the period between retirement and RMDs/Social Security benefits. These windows commonly see the investor with less income, presenting the opportunity to make a contribution or conversion with lower taxes.

The Value of Dollar Diversification

Relative to historical rates, we are in a very kind tax regime. And although we don’t know where tax rates will be in the future, we do think it is prudent to consider diversifying your dollars according to tax treatment.

We find that having different types of dollars (taxable, tax-deferred, and tax-free) provides more flexibility in the future for effective tax planning, serving as a hedge against future tax rates (higher or lower). It can also be helpful as you consider risk location within your holistic portfolio across different account types.

Relative to regular IRAs, Roths are friendlier to leave to your heirs as distributions are not taxed. And with recent provisions for regular IRAs requiring quicker distributions of funds (2019 SECURE ACT), this can result in a heavy tax burden depending on the size of the account. In addition, many inheritors receive these accounts toward the end of their careers when their taxable income has reached their peak, along with their marginal tax rates.

Why Not Go All Roth?

Roth accounts are very attractive but be careful not to pay too much in taxes now using conversions. Typically, the goal is to smooth out future taxes rather than getting rid of them altogether, as this can come at a steep price if you are pushing yourself into higher marginal tax brackets. Although valuable, the Roth becomes less so as your future tax rate decreases; ergo if all your money is in Roth accounts, those dollars are less valuable because your current tax rate is effectively 0%. This also points back to the value of dollar diversification. Future tax rates could remain low or drop further, and if they do, then converting all dollars to Roths would result in lost value.

In addition, if you are charitably inclined, leaving money in tax-deferred accounts for RMD years can be a very effective strategy. Currently qualified charitable distributions (QCDs) allow you to take $100,000 (or less) out of your tax-deferred IRAs and deduct that full amount on your tax return if it is sent directly to a charitable organization. So, if you’re planning on giving that money away, there is no need to pay the taxes by moving it into a Roth.

End of Year Planning in 2020

Roth conversions are just one reason that retirement and tax planning should really be done throughout someone’s life. It should never end, and decisions should be made on a year-by-year basis. It is an annual process as tax and estate laws and account types/offerings are constantly changing.With this year-end, perhaps you should be strategically thinking through your Roth account options. If you think some assistance would be helpful as you do your planning, please reach out to any one of our team members at Kings Path. We would be happy to help.