Retirement Savers Useful Information

Can Upper-Income Retirement Savers Have Too Much Tax Deferral?

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Most tax advisers have forever preached that paying taxes later rather than sooner is almost always a good idea. This advice to lean in favor of deferring income and the related taxes has served clients well for a generation, largely because individual federal income tax rates have trended downward, with a few upticks along the way just to keep things interesting. Therefore, the strategy of deferring taxes has often resulted in a double benefit from: (1) the pure time-value-of-money advantage gained by putting off tax payments plus (2) lower tax bills when taxes finally come due, because tax rates were going down. Sweet! That Was Then…

Sadly, the era of falling individual income tax rates may have reached an end, because the rates under the Tax Cuts and Jobs Act (TCJA) are probably the lowest we will ever see-especially for higher-income individuals. Exactly when higher rates might arrive is a matter of speculation, but the enormous national debt and ongoing huge projected federal budget deficits, both greatly exacerbated by the COVID-19 crisis, probably foreshadow higher rates sometime in the not-too-distant future. Factor in looming Social Security and Medicare budget shortfalls, and the possibility of huge amounts of interest being owed on huge amounts of federal debt (especially if interest rates go up) and you get the picture. It’s not pretty!

Information from the IRS About Form 8880, Credit for Qualified Retirement Savings Contributions

What Does It All Mean? Here are some thoughts.

Retirement-Age Tax Rates for Upper-Income Folks Might Be Higher. The conventional wisdom that individuals will pay significantly lower income tax rates during their retirement years may turn out to be wrong. Rates might be about the same, or they might be higher-especially for upper income clients. If higher rates become law, deferring taxable income into one’s retirement years will not turn out to be the no-brainer that was advertised.
Accessible Funds Are a Good Thing. But putting money into tax-deferred qualified retirement plans is usually much easier than getting it out before retirement age without suffering adverse tax and financial consequences. Think restrictions on company retirement plan withdrawals before separation from service, the 10% early withdrawal penalty tax that generally applies to withdrawals before age 59½, and high-taxed ordinary income treatment for retirement-age withdrawals. Since you never know when cash might suddenly be needed, clients should probably think harder about the advisability of maxing out on salary-deferral contributions to company qualified retirement plans. Likewise, self-employed individuals should think harder about maxing out on contributions to their own tax-favored plans. Perhaps the most notable exception to the preceding advice is when salary-deferral contributions to a qualified company plan trigger significant matching contributions by the employer.
Unfavorable Tax Treatment for Retirement Plan Withdrawals. Tax-deferred qualified retirement plans have the nasty habit of converting what would otherwise be lower-taxed capital gains (or qualified dividends) into higher-taxed ordinary income. Also, the Internal Revenue Code requires you to start draining your tax-deferred retirement account after you reach age 72 under the dreaded required minimum distribution (RMD) rules. These shortcomings don’t affect taxable investments, such as equities held in brokerage firm accounts and real estate. These shortcomings also don’t affect investments held in Roth IRAs, assuming clients meet the requirements for tax-free qualified withdrawals when they take money out of their Roth accounts.
Roth IRAs Are Secret Insurance Policies. In truth, Roth IRAs are insurance policies against some of the bad things that can easily happen with tax-deferred qualified retirement plan accounts. First, you have complete control over your money when it’s in a Roth account, which is not the case with funds in an employer plan. Second, you usually don’t need to worry about the dreaded 10% early withdrawal penalty tax, because it usually hits only early withdrawals of Roth account earnings. You can always withdraw up to the total amount of your annual Roth contributions tax-free and penalty-free and you can always withdraw conversion contributions tax-free (and usually penalty-free). Third, you don’t need to worry as much about higher future tax rates, because Roth withdrawals are federal-income-tax free as long as they are qualified withdrawals. In general, qualified withdrawals are allowed after the client has reached age 59½ and had at least one Roth IRA open for over five years. So, your Roth account earnings are exempt from future federal income tax rate increases (and future federal income taxes in general) when taken out as qualified withdrawals. Finally, you don’t need to worry about the dreaded required minimum distribution (RMD) rules, because Roth IRAs (other than inherited Roth accounts) are exempt. That’s a lot of insurance!
QBI Deduction Rules Can Dictate Against Making Deductible Retirement Plan Contributions. The TCJA’s qualified business income (OBI) deduction for 2018-2025 is limited to 20% of taxable income, so reducing taxable income by making deductible retirement plan contributions can have the adverse side effect of reducing your allowable QBI deduction. On the other hand, not making deductible contributions can have the beneficial side effect of increasing the allowable QBI deduction.

Run the Numbers to Draw Valid Conclusions

Although the points mentioned above seem to dictate against maxing out on contributions to tax deferred qualified retirement plans, let’s run the numbers for six different scenarios, and see what they tell us. In these scenarios, let’s stipulate that the upper-income client is evaluating whether to contribute the same amount of after-tax dollars into either:

Option 1: a tax-deferred qualified retirement plan account or IRA (we assume no employer matching), or
Option 2: a taxable brokerage firm account, or
Option 3: a Roth IRA.

In all six scenarios, we assume the upper-income client’s combined marginal federal and state income tax rate is 33.33% for the contribution year.

Scenario 1: Invest for 20 Years at 7%; Lower Tax Rate at the End.

Option 1 (Retirement Plan): Contribute $10,000 to a tax-deferred qualified retirement plan account; invest the money for 20 years at a 7% annual rate of return; then pay a 28% tax rate (federal and state combined) when the account is drained at the end.

Result= $27,862: After paying the tax bill, the client has $27,862 in the bag.

Option 2 (Taxable Account): Contribute $6,667 to a taxable brokerage firm account (same after-tax outlay as contributing $10,000 via salary deferral to a qualified plan), and invest the money for 20 years at a 5.25% annual after-tax rate of return. This optimistically assumes a 25% combined federal and state tax rate on each year’s 7% return, (the entire return is stipulated to be from long-term capital gains from assets held for a year and a day; 7% x 75% = 5.25%).

Result= $18,551: After paying annual tax bills along the way, the client has only $18,551 in the bag. And that’s with the aforementioned optimistic assumption about taxes.

Option 3 (Roth IRA): Contribute $6,667 to a Roth IRA (same after-tax outlay as contributing $10,000 via salary deferral to a qualified plan); invest the money for 20 years at a 7% annual rate of return; then pay zero taxes when the account is drained at the end (assume the withdrawal counts as a qualified Roth distribution). We overcome the obvious objection that a client can’t contribute over $5,000 to a Roth IRA ($6,000 if he or she is age 50 or older) by conveniently assuming the client is married. Two spouses can together contribute up to $10,000, or up to $12,000 if they are both age 50 or older.

Result= $25,799: While this is not as much as with the qualified plan (Option 1), it’s close. And don’t forget all the insurance features you get with the Roth IRA (see Point No. 4).

Conclusion: In this scenario, which involves what you might call traditional expectations about the future, the tax-deferred qualified retirement plan account comes out ahead. Why? Because you start off with so much more money invested, and the taxes are deferred. Those two factors overwhelm the higher ordinary income tax rate paid when the account is drained at the end.

Scenario 2: Invest for 20 Years at 7%; Higher Tax Rate at the End.

Option 1 (Retirement Plan): Contribute $10,000 to a tax-deferred qualified retirement plan account; invest the money for 20 years at a 7% annual rate of return; then pay a 40% tax rate (federal and state combined) when the account is drained at the end.

Result= $23,218: Even after paying heavy taxes at the end, the client still has $23,218 in the bag.

Result= $18,551: Same as in Scenario 1. And this is after making the same optimistic assumption about

taxes.

Result= $25,799: Same as in Scenario 1. However, this time the Roth alternative comes out well ahead of the tax-deferred retirement plan alternative (Option 1) because we’ve assumed significantly higher taxes on retirement plan withdrawals at the end. Also, don’t forget the other insurance features you get with the Roth IRA (see Point No. 4).

Conclusion: In this scenario, which involves what you might call a pessimistic (some might say realistic) assumption about future taxes, the Roth IRA wins easily. The taxable account alternative (Option 2) still stinks badly compared to Option 1, which you may find surprising.

Scenario 3: Invest for Only 10 Years at 7%;

Higher Tax Rate at the End Plus Early Withdrawal Penalty Tax to Boot.

Option 1 (Retirement Plan): Contribute $10,000 to a tax-deferred qualified retirement plan account; invest the money for 10 years at a 7% annual rate of return; then pay a whopping 50% tax rate (40% combined federal and state rate+ 10% early withdrawal penalty tax) when the account is drained at the end.

Result= $9,836: Under these unfavorable assumptions, the result is predictably bad . You wind up with less than you started with.

Result= $11,121: In scenario, the taxable account comes out well ahead because the assumed tax results are so much better than for the other two options.

Option 3 (Roth IRA): Contribute $6,667 to a Roth IRA (same after-tax outlay as contributing $10,000 via salary deferral to a qualified plan); invest the money for 10 years at a 7% annual rate of return; then pay a 50% percent tax rate on the prematurely withdrawn earnings.

Result= $9,891: In this scenario, the Roth IRA’s earnings get hammered with taxes, which explains the yucky outcome.

Conclusion: You have to work pretty hard to make the taxable account alternative (Option 2) come out ahead, but it can be done. Note, however, that we’ve assumed a stable tax rate for the taxable account (on the theory that we are paying fixed long-term capital gains taxes on gains from assets that are always held for a year and a day). Unrealistically optimistic? Maybe.

Scenario 4: Invest for 20 Years at 3.5%; Lower Tax Rate at the End.

Option 1 (Retirement Plan): Contribute $10,000 to a tax-deferred qualified retirement plan account; invest the money for 20 years at a 3.5% annual rate of return; then pay a 28% tax rate (federal and state combined) when the account is drained at the end.

Result= $14,327: After paying the tax bill, the client has $14,327 in the bag.

Option 2 (Taxable Account): Contribute $6,667 to a taxable brokerage firm account (same after-tax outlay as contributing $10,000 via salary deferral to a qualified plan), and invest the money for 20 years at a 2.63% annual after-tax rate of return. This assumes an optimistic 25% combined federal and state tax rate on each year’s 3.5% return (3.5% x 75% = 2.63%).

Result= $11,205: After paying annual tax bills along the way, the client only has $11,205 in the bag. And that’s with the aforementioned optimistic assumption about taxes.

Option 3 (Roth IRA): Contribute $6,667 to a Roth IRA (same after-tax outlay as contributing $10,000 via salary deferral to a qualified plan); invest the money for 20 years at a 3.5% annual rate of return; then pay zero taxes when the account is drained at the end (assume the withdrawal counts as a qualified Roth distribution).

Result= $13,266: While this is not as much as with the qualified plan alternative (Option 1), it’s close.

And don’t forget all the insurance features you get with the Roth IRA (see Point No. 4).

Conclusion: In this scenario, which involves what you might call traditional expectations about future taxes combined with a dim view about the rate of return on investments, the tax-deferred qualified retirement plan account comes out ahead. Why? Because you start off with so much more money invested, and the taxes are deferred. Those two factors overwhelm the higher ordinary income tax rate paid when the account is drained at the end.

Scenario 5: Invest for 20 Years at 3.5%; Higher Tax Rate at the End.

Option 1 (Retirement Plan): Contribute $10,000 to a tax-deferred qualified retirement plan account; invest the money for 20 years at a 3.5% annual rate of return; then pay a 40% tax rate (federal and state combined) when the account is drained at the end.

Result= $11,939: After paying heavy taxes at the end, the client has only $11,939 in the bag.

Result= $11,205: Same as in Scenario 4. And this is after making the same optimistic assumption about

taxes.

Result= $13,266: Same as in Scenario 4. However, this time the Roth alternative comes out well ahead of the tax-deferred retirement plan alternative (Option 1) because we’ve assumed significantly higher taxes on retirement account withdrawals at the end. Also, don’t forget the other insurance features you get with the Roth IRA (see Point No. 4).

Conclusion: In this scenario, which combines what you might call a pessimistic (some might say realistic) assumption about future taxes with a pessimistic rate-of-return assumption, the Roth IRA wins easily.

The taxable account alternative (Option 2) still trails Option 1, which you may find surprising.

Scenario 6: Invest for Only 10 Years at 3.5%;

Higher Tax Rate at the End Plus Early Withdrawal Penalty Tax to Boot

Option 1 (Retirement Plan): Contribute $10,000 to a tax-deferred qualified retirement plan account; invest the money for 10 years at a 3.5% annual rate of return; then pay a 50% tax rate (40% combined federal and state rate + 10% early withdrawal penalty tax) when the account is drained at the end.

Result= $7,053: Under these horrific assumptions, the result is predictably horrific. You wind up with a lot less than you started with .

Result= $8,643: In scenario, the taxable account comes out ahead because the assumed tax results are so much better than for the other two options.

Option 3 (Roth IRA): Contribute $6,667 to a Roth IRA (same after-tax outlay as contributing $10,000 via salary deferral to a qualified plan); invest the money for 10 years at a 3.5% annual rate of return; then pay a 50% percent tax rate on the prematurely withdrawn earnings.

Result= $8,036: In this scenario, the Roth IRA’s earnings get hammered with taxes, which explains the bad outcome.

Conclusion: Once again, you have to work hard to make the taxable account alternative (Option 2) come out ahead, but it can be done. Note however that we’ve assumed a stable and relatively low tax rate for the taxable account. Unrealistically optimistic? Maybe.

Conclusions on the Too-Much-Tax-Deferral Issue

Of course, you recognize we can prove anything we want simply by manipulating the assumptions. If forced, we could conclusively prove that burying one’s retirement money in coffee cans in the backyard is by far the best course of action. So please take the preceding numbers for what they are worth. That said, we make the following observations.

Tax-Deferred Retirement Plans. The tax-deferred retirement plan alternative (Option 1) comes out ahead if you make rather traditional assumptions about the future (see Scenarios 1 and 4). That’s not surprising. Therefore, clients who are comfortable with rather traditional assumptions won’t have “too much” tax deferral if they continue contributing to the max to tax-deferred qualified retirement plans. Of course, their assumptions might turn out to be dead wrong with awful results (see Scenarios 3 and 6). Your job is to inform clients about what might happen under various assumptions and let them decide which assumptions they believe.

Taxable Accounts. The taxable account alternative (Option 2) only comes out ahead when you forecast rather dire circumstances (see Scenarios 3 and 6). That’s not surprising either. What is surprising is how downright lousy the taxable account alternative does in the other scenarios, where it comes in dead last by considerable margins. Even so, clients who are comfortable with rather dire assumptions about the future will have “too much” tax deferral if they continue contributing to the max to tax-deferred qualified retirement plans. Once again, their assumptions might turn out to be dead wrong with awful results (see Scenarios 1, 2, 4, and 5). Once again, your job is to inform clients about what might happen under various assumptions and let them decide which assumptions they believe.

Taking Money Out of Tax-Deferred Accounts. Some older clients might want to consider withdrawing some money from tax-advantaged retirement accounts sooner and faster than is necessary to comply with the RMD rules. That way, they can pay ta xes now at rates that may look quite low in a few years.

Clients can put the withdrawn money into investments expected to produce low-taxed long-term capital gains and qualified dividends (these types of income will probably continue to be taxed at preferential rates, especially long-term gains). This strategy will also result in lower RMDs in future years when much higher tax rates may apply. If the client is not yet receiving Social Security benefits, this scheme could also mean lower taxes on benefits when they are received, because the client will have less taxable income from RMDs. This idea probably makes the most sense if the marginal federal tax rate that would be paid on additional retirement account withdrawals would be only 10% or 12%. Those rates might prove awfully hard to get in the not-too-distant future.

Roth IRAs. The Roth IRA alternative (Option 3) comes out ahead if you assume higher future tax rates and no early withdrawals (see Scenarios 2 and 5). That’s not surprising. The Roth alternative also finishes a respectable second under most other assumptions (see Scenarios 1, 4, and 6). The Roth results are awful only if you assume a decent rate of return combined with an early withdrawal that results in the account’s earnings being ta xed at higher rates with the 10% penalty tax added on (see Scenario 3, which is not terribly likely). All things considered in the current environment, the more you think about Roth IRAs, the more you might like them. So maybe the best overall conclusion is that you can have too much tax deferral, or you can have not enough tax deferral, but you can almost never have too much outright tax avoidance. Roth IRAs make outright tax avoidance legal. That’s a good thing!

Not Tax Deferral: Roth IRA Contributions

Because qualified Roth IRA withdrawals are federal-income-tax-free, Roth accounts offer the opportunity for outright tax avoidance, as opposed to tax deferral. So, making annual contributions to a Roth IRA (if the client’s income permits) is an attractive alternative to “too much” tax deferral for clients who expect to pay higher tax rates during retirement. Similarly, converting a traditional IRA into a Roth account effectively allows the client to prepay the federal income tax bill on the current IRA account balance at today’s low rates instead of paying higher future rates on the current account balance and future account earnings.

Not Tax Deferral: Roth 401(k) Contributions

The Roth 401(k) is essentially a traditional 401(k) plan with a Roth account feature added. If the client’s employer offers a 401(k) plan with the Roth option, the client can contribute after-tax dollars (an elective deferral known as a designated Roth contribution) to a designated Roth account (ORA) set up under the plan. The ORA is a separate account from which the client can eventually take federal-income-tax-free qualified distributions. So, making ORA contributions is another attractive alternative to “too much” tax deferral for clients who expect to pay higher tax rates during retirement. Note that unlike annual Roth IRA contributions, the ability to make ORA contributions is not phased out at higher income levels.

Not Tax Deferral: HSA Contributions

Under the Affordable Care Act, health insurance plans are categorized as Bronze, Silver, Gold, or Platinum. Bronze plans have the highest deductibles and least-generous coverage and are therefore the most affordable. Platinum plans have no deductibles and cover much more, but they are also much more expensive. In many cases, the ACA has led to big premium increases even for those who prefer less-generous plans. However, having a not-very-generous plan might make your client eligible to open up and contribute to an HSA with the resulting tax advantages.

Because withdrawals HSAs are federal-income-tax-free when used to cover qualified medical expenses, HSAs offer the opportunity for outright tax avoidance, as opposed to tax deferral.

For the 2020 tax year, you can make a deductible HSA contribution of up to $3,450 if you have qualifying self-only coverage or up to $6,900 if you have qualifying family coverage (anything other than self-only coverage). An additional $1,000 can be contributed for those who are over age 55 and older.

You must have a qualifying high-deductible health insurance policy and no other general health coverage to be eligible for the HSA contribution privilege. For 2020, a high-deductible policy is defined as one with a deductible of at least $1,400 for self-only coverage or $2,800 for family coverage.

For 2020, qualifying policies can have out-of-pocket maximums of up to $6,900 for self-only coverage or $13,800 for family coverage.

If your client is eligible to make an HSA contribution for the tax year in question, the deadline is April 15 of the following year (adjusted for weekends and holidays) to open an account and make a deductible contribution for the earlier year. So there is still plenty of time for an eligible client to open an account and make a deductible contribution for 2020, because the deadline is 4/15/21.

Key Point: In response to the COVID-19 crisis, the IRS extended the deadline for making HSA contributions for the 2019 tax year to 7/15/20. Do not be shocked if there is a further extension.

The write-off for HSA contributions is an above-the-line deduction. That means you can take the write-off even if you don’t itemize. More good news: the HSA contribution privilege is not lost just because you happen to be a high earner. If you are covered by qualifying high-deductible health insurance, you can make deductible contributions and collect the resulting tax savings. Even billionaires can contribute if they have qualifying high-deductible health insurance coverage and meet the other HSA contribution eligibility requirements.

Overall Conclusions

Saving instead of spending is more important than the type of account used to save. That said, Roth IRAs, Coverdell Education Savings Accounts, Section 529 college savings accounts, and HSAs all have the attraction of offering federal-income-tax-free treatment for qualified withdrawals taken in future years. This is a very good thing if you believe tax rates are likely to go up-assuming you also believe that tax-free treatment will continue to be allowed for qualified withdrawals from these vehicles.

Roth IRA conversions may now make more sense than ever because the tax cost of converting is paid at today’s “low” rates. The benefit is avoiding future taxes at potentially higher rates (maybe much higher for upper-income folks).

Work with your higher-income clients to determine if they feel they have too much tax deferral, taking into account the TCJA and the distinct possibility of higher federal income tax rates in future years. Time may be of the essence here, because we cannot reasonably expect the current favorable federal rate structure for individuals to last for very long.

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