One common piece of investment advice is to defer investment related income taxes whenever possible, especially through the use of 401(k) and Traditional IRA accounts. The underlying concepts are (1) your tax-deferred account will grow faster than otherwise because investment related income taxes are deferred until withdrawal and (2) you will receive current income tax deductions for your contributions, which you can invest in addition to your tax-deferred account. Some financial advisors take this concept even further and recommend that investors also use variable annuities after maximizing contributions to 401(k)s and IRAs to defer additional investment related income taxes.
I believe that maximizing “tax-deferred” investment accounts is not the best advice for many if not most people. It is true that 401(k) and Traditional IRA accounts grow tax-deferred, but your eventual income tax liability also grows. For example, let’s say that you contribute $1,000 into a Traditional IRA at age 35 and that it grows at 5% a year for the next 30 years. Then, by age 65, your $1,000 contribution will be worth $4,322. If you withdraw this entire amount at age 65, you will have to pay ordinary income taxes on $4,322 of income. This tax liability may not be too burdensome if you took your income tax savings from your $1,000 contribution and invested it consistently for 30 years. I wonder, however, how many of us really think, “I saved $300 in income taxes on my $1,000 IRA contribution so I had better invest that $300 carefully and consistently until retirement.” I believe that most of us do not bother to calculate our income tax savings on 401(k) or IRA contributions much less actually invest it.
The other issue with tax-deferred investment accounts is that it converts long-term capital gains into ordinary income for income tax purposes. Some of your investment return is from capital appreciation. If you have long-term (i.e., longer than one year) capital gains within a taxable account, it is taxed at favorable long-term capital gains tax rates under current law. If you have long-term capital gains within a tax-deferred account, it is taxed at less favorable (for most people) ordinary income tax rates at withdrawal.
I am not suggesting that 401(k)s and Traditional IRAs are all bad. If your employer’s 401(k) plan offers employer matching contributions, you should try to contribute at least enough to receive the maximum employer matching. This is what is called “free money.” Beyond that, however, I believe that most people should maximize contributions into a Roth IRA or Roth 401(k) account before making further contributions to a tax-deferred account. With a Roth account, you do not receive an income tax deduction at contribution, but the account grows tax-free (not just tax-deferred) as long as you wait until age 59½ before making withdrawals and meet certain other requirements (e.g., the five-year rule). So, if you were to contribute $1,000 to a Roth account at age 35 and it grows to $4,322 by age 65, you can withdraw the entire $4,322 at age 65 without paying any income taxes on the withdrawal.
There are several ways to get money into a Roth account:
- Roth IRA Contributions. You can contribute to a Roth IRA if you have taxable earned compensation (e.g., W-2 income or self-employment income) and your Modified Adjusted Gross Income is under certain limits. The maximum that you can contribute to a Roth IRA is $5,000 per year ($6,000 if you are age 50 or older). Being an active participant of an employer retirement plan does not affect your ability to contribute to a Roth IRA.
- Roth 401(k) Contributions. The IRS allows, but does not require, 401(k) plans to allow employees to designate their elective deferrals as Roth contributions. Many 401(k) plans now allow designated Roth contributions; so, check with your employer’s benefits department. Only employee elective deferrals (up to $17,000 a year or $22,500 if age 50 or older) can be designated as Roth. Employer matching contributions must be pre-tax (i.e., non-Roth).
- Roth IRA Conversion. If you have money in a Traditional IRA, you can convert some or all of the account into a Roth IRA. You will have to pay ordinary income taxes on the conversion amount in the year of conversion.
- 401(k) In-Plan Roth Conversion. The IRS allows, but does not require, 401(k) plans to allow employees to convert pre-tax amounts in their 401(k) account into a designated Roth 401(k) account in the same plan. The IRS has restrictions on the types of contributions that can be converted into Roth; so, check these rules carefully. As with a Roth IRA conversion, you will have to pay ordinary income taxes on the conversion amount in the year of conversion.