Near the end of 2022, President Biden signed the Omnibus Appropriation Act of 2023. Included in this package was The Setting Every Community Up for Retirement Act of 2019, fondly referred to as the SECURE 2.0 Act of 2022 (because it’s shorter, easier to remember, and the second Act with the same name). One of the law’s goals is to increase employee and self-employed retirement savings. The act made some pretty exciting changes to the Internal Revenue Code and the Employee Retirement Income Security Act of 1974 that will benefit readers and clients.
We’ll review these changes in later articles. Today, I’d like to set the stage by reviewing the tax implications of three retirement-saving options: 1) Traditional IRAs and other tax-deferred retirement plans, 2) Skipping retirement plans and purchasing appreciating assets, and, finally, 3) ROTH IRAs and ROTH-like savings vehicles. The difference is significant, and you may be surprised by the results.
Option One: Traditional IRA & Tax-Deferred Retirement
Most of us are familiar with Traditional IRAs (Individual Retirement Accounts) and other tax-deferred retirement plans (SEP IRAs, SIMPLE IRAs, and 401K-like plans). IRA contributions get deducted as an adjustment on Form 1040 or a different return depending on the type of IRA and the owner’s business structure. SIMPLE IRAs, 401Ks, 403-Bs, and other tax-deferred retirement plan contributions are pretax deductions from your paycheck. These plans operate similarly – you put money into them, and the amount gets removed from taxable income. Plus, if your employer contributes on your behalf, it is tax-free to you, and they get a deduction.
[Note 1: If your employer contributes to your 401K, their contributions are 100% free money to you! If you have access to a 401k and want to minimize your tax liability, don’t ask your tax pro for tricks until you max it out – at least to the limit of your employer’s free-money match.]
So, with tax-deferred retirement, every $1,000 you contribute saves between $200 and $350 tax, depending on your state and federal tax rates. Plus, interest, dividends, and capital gains compound completely tax-free!
Does the government allowing income accumulation without taking a cut sound too good to be true? Yep – it is. Tax-deferred retirement has a catch:
When you finally retire, the whole kit and kaboodle get TAXED as ordinary income!
How much tax will you pay? Let’s use John as an example to analyze the taxation of tax-deferred retirement. We’ll then compare the cost of other retirement options.
John – The Hardworking Linesman: John’s a hardworking utility linesman. When he’s forty-two, he realizes he must start saving for retirement. John invests $1,000 in a traditional IRA and uses the money to buy some mutual funds inside the IRA. By doing so, he can deduct the $1,000 contribution on his tax return, saving John $220 because he’s in the 22% marginal federal tax bracket. Let’s assume John’s $1,000 investment grows at a 5% compounding rate for twenty years. So, when John’s ready to retire twenty years later, his $1,000 investment is worth $2,654!
Also, because John got his act together and effectively planned, his income did not drop much in retirement, and he’s in the 22% tax bracket.
[Note 2: The assumption that you will be in a lower tax bracket when you retire is often false.]
John withdraws the entire $2,654 from his IRA in the first year he retires, and the whole distribution gets taxed as ordinary income. John pays $584 in income tax. He is, essentially, paying back the $220 initially saved plus an additional $364 on the earnings!
Option Two: Non-Deferred - Investing in Appreciating Assets
A seminar instructor once said something quite profound about retirement plans, something I have never forgotten. He said, “What’s the big deal about putting all this money into tax-deferred retirement plans? People think they’re getting away with something, like beating the tax man. Do you know what’s really happening? They’re converting capital gains taxed at 15% into ordinary income taxed at a higher rate!”
With this in mind, let’s assume John skips tax-deferred retirement plans altogether. He surrenders the immediate tax deduction and invests his retirement funds in an appreciating asset, such as vacant land or growth stocks. How much tax would John pay when he retired? Let’s take a look.
John doesn’t invest the $1,000 in an IRA. Instead, he purchases some growth stock with after-tax money. John doesn’t get the $1,000 deduction and must pay the $220 on the $1,000 earned to invest. The stock pays no dividends, so he had no income to tax as the stock’s value grew at the same 5% annual rate. Twenty years later, the stock is worth the same $2,654 when John sells it. How much tax does he owe on the proceeds?
The stock is now worth $2,654. John paid $1,000 for it, generating a long-term capital gain of $1,654. Because it’s long-term, the tax rate is $15%, and John owes $248 on the profit.
What’s John’s total tax bill? He paid $220 on the $1,000 initially invested, then $248 on the increased value. That’s a total of $468.
Remember, John would have paid $584 when he took the same $2,654 as an IRA distribution because of his 22% marginal income tax bracket. So, he saved $116 because he didn’t use a tax-deferred account! That’s a tax savings of 19.8%, increasing John’s after-tax retirement income by almost 12 percent!
[Note 3: Other non-deferred investment options are rental real estate and collectibles such as precious metals, antiques, or art, which are taxed differently. Rental properties must be depreciated and may generate “recapture” when sold, generally taxed at 25%. Collectibles typically get taxed at 20%.]
Some may argue that John’s $220 in tax twenty years ago was worth far more than today. I agree, but so was the $1,000 he invested, which makes it a hair-splitting moot point. In fact, in 2003, John’s $1,000 had a purchasing power of over $1,600 today.
Luckily, there’s a way to avoid such time-value arguments altogether. What if I told you there’s a way save for retirement, allow the earning to accumulate and compound, then take distributions completely tax-free? Would you believe there’s a legitimate way to beat half of the proverb related to Death and Taxes? Before you stop reading in disbelief, allow me to introduce the ROTH IRA.
Option Three – The ROTH IRA
The ROTH IRA was birthed in the late 1990s by the Taxpayer Relief Act 1997. A few years later, the ROTH 401K arrived (which, for reasons I’ll discuss in a later article, is a bit of a hassle to manage).
Unlike the Traditional IRA, participants do not get a tax deduction when they invest in a ROTH, so – continuing with our example - John pays income tax on the $1,000 he earns to contribute. Like the traditional IRA, the ROTH earnings accumulate tax-free. But, unlike tax-deferred retirement (here’s THE MIND-BLOWING PART), when John retires, distributions from his ROTH are entirely tax-free! That’s correct. No Tax. Zero. Nada.
So, how does the ROTH tax bill compare to the other retirement options? Let’s take a look.
As you may recall, in option one, John’s tax-deferred Traditional IRA cost him $584 in the $2,654 distribution. When he bypassed tax-deferred plans in option two and invested directly into grown stocks, it cost him $468 in income tax on the income invested and the capital gain generated by the sale.
How about a ROTH IRA, option three? As the rules currently stand, John pays ZERO TAX on the $2,654 distribution! But he has to pay tax on the $1,000 he earned to invest. Because John was in the 22% tax bracket, that’s $220. Even though he’s in the same tax bracket when he takes the distribution, John pays NO TAX on the $2,654.
Here’s a comparative snapshot of taxes owed on the $2,654 under various arrangements:
- Traditional IRA: John pays $584 in income tax upon distribution and has $2,070 left to pay bills and travel.
- Appreciating Assets: $468 total tax - $220 on the income invested (twenty years prior) and $248 Capital Gain when sold, leaving John $2,406.
- ROTH: $220 income tax on earnings invested. Zero tax gets paid in the year distribution occurs. John keeps the entire $2,654. The US Treasury takes zero!
[Note 4: The fact remains that John pays $220 on the income earned to invest in both appreciating assets and the ROTH IRA, which is a factor to consider. However, my experience is that the $220 is - generally - an ancient sunk cost. Retirees, especially those who retain the same tax bracket, are more concerned with how much of their savings remain theirs, not the government’s. And ROTH retirement vehicles provide an answer most of us would like to hear.]
A ROTH Word of Caution
You may have noticed that I italicized the following statement regarding the ROTH taxation - “As the rules currently stand.” Why? Well, your econ-wonky author is concerned (to say the least) that the federal government’s penchant for deficit (debt-funded) spending will not cease anytime soon. Also, the fiscal motive of the SECURE Act 2.0’s ROTH is to reduce the amount of money going into tax-deferred plans. Why? To increase current tax revenue to pay for increased spending!
Eventually, if the current trajectory continues, a fiscal crisis will make continued borrowing impossible, and Congress will eye any viable source of tax revenue. The forbidden fruit sitting in ROTHs likely may prove irresistible. Remember – Social Security benefits payments began in 1940 and were tax-free until 1984. Now, most retirees pay income tax on 85% of benefits.
Take Away
Today, we reviewed the tax implications of three basic retirement options: Tax-deferred retirement plans, investing in appreciating assets, and ROTH retirement plans. The key point I hope to leave you with is that ROTH plans can substantially increase one’s after-tax income in retirement.
By utilizing a ROTH (assuming distributions remain completely tax-free), John ends up with 22% more after-tax income than a Traditional IRA (or other tax-deferred plans) and 15% more than investing in appreciating assets. For every $10,000 distributed, John would have $2,200 more disposable income with a ROTH than a Traditional IRA and $1,500 more than selling an appreciated asset
I wrote this article as both a primer on how retirement gets taxed and as an intro to discussing some significant retirement plan changes made by the SECURE Act, which we’ll discuss in an upcoming piece.