By William Green, CFP®
An individual retirement account (IRA) can help many individuals manage their retirement plan. One of the advantages of an IRA is that it allows for more investment options. And, when a person leaves a job with a 401(k), they can simply roll over money to an IRA to open up those choices.
However, traditional qualified plans in the U.S. have become the primary saving source for most Americans. This did not become a major phenomenon until around the 1950s when the majority of corporations began to eliminate pensions and promote 401(k)s and individual retirement plans. In effect, employers took the monkey off their back and passed the risk to their employees.
One of the common fallacies I see with IRAs is that people think they are saving money on taxes and receiving a compounding effect by putting money in their IRA. For instance, if an individual in a 30% tax bracket puts $1 in a traditional IRA, they automatically think they are getting the compounding effect on 100% of the money. However, if that $1 grows to $1,000, then tax is due upon withdrawal on the whole amount. Therefore, they are just deferring the tax, since the tax is growing at the same rate as the investment. Assuming a 30% tax bracket, the individual will owe $300 in tax on that $1,000.
In our practice, we see that many of our clients are in higher tax brackets when they retire. They have paid off their mortgage. They no longer have deductions for their children. A significant risk is that taxes may be higher in the future primarily because we have a Social Security budget problem and increasing expense on Medicare. These social benefit systems increase and cause more of a cost burden on future tax rates. It is possible that withdrawals from the IRAs could create higher tax consequences due to changing tax brackets as well as the fact that most retirees no longer qualify for itemized deductions.
I have seen cases in estate planning where an individual passes away with a substantial amount of money still in their IRAs. What happens then is their estate tax value is grossed up by the total amount of assets. Some individuals can lose up to 70% of their IRA because they had an estate tax due on their wealth. In addition, they also have to claim 100% income from their IRA to their heirs, which would put the heirs in the maximum tax bracket. It is worth noting that there are a few exceptions to this such as inherited IRAs and pushing the tax down the road a few years. In my practice, I have seen very little to no tax savings effectively in a traditional retirement plan considering the client’s overall macro-economic picture.
Another concern is that some individuals have massive amounts of wealth tied up in these plans that cannot be touched without a 10% penalty until age 59½. In fact, an IRA cannot even be leveraged or borrowed against as a financial instrument. To avoid these taxes, individuals take little to nothing out of their IRA until they find themselves dealing with a required minimum distribution (RMD), which kicks in at age 72. At this point, the client has to take distributions from these IRAs or suffer a 50% penalty if they don't meet the minimum.
A Roth IRA differs from a traditional IRA in that the former requires taxes to be paid now while the earnings are tax free. In a constant world where tax brackets are the same, there is little difference in the net result of a Roth versus a traditional IRA. In the case of the Roth IRA, investing a $1 now, assuming a 30% tax bracket, means that an individual starts with only .70. Since earnings in the Roth IRA are tax free, if that money grows to $700, then the individual can make a tax-free withdrawal in retirement. Essentially, this is the same financial result as the traditional IRA example where the taxes are paid upon withdrawal.
The Roth IRA advantage is that all the compounding can effectively be tax free and the client is no longer faced with a minimum distribution at age 72. It is important for individuals to speak with their financial advisor to determine if a Roth IRA or converting a traditional IRA to a Roth makes sense for their particular situation.
While it may take a few years to make financial sense, Roth IRAs often provide more flexibility. After five years, the Roth owner can withdraw their contributions to a Roth without penalty. Under current tax rules, Roth IRAs are not subject to the uncertainty of future tax increases or RMD rules and individuals can also leave this asset tax free to their heirs.
Bottom line: the biggest problem that I see with traditional IRAs is effectively clients are no longer in a lower tax bracket. In fact, they've lost their deductions and their effective tax could be higher upon distribution. Meanwhile, they have been locked out of using this wealth to create other assets such as purchasing a second home or starting businesses because of prepayment penalty concerns. Individuals need to start the retirement planning process with their financial advisor early to create a strategy that will optimize their financial security throughout retirement.
About the author: William Green, CFP®
William Green is a Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is a wholly owned subsidiary of Guardian. MillCreek Financial Consultants is not an affiliate or subsidiary of PAS or Guardian.