Understanding the use of Roth IRAs

This tax season, several new clients came to me with unfortunate Roth IRA issues.

They were misled into thinking that such an IRA was beneficial to their situation. They mistakenly contributed to an after-tax Roth plan and lost thousands of dollars, even tens of thousands of dollars in potential tax deductions.

A traditional pre-tax retirement plan allows most taxpayers to deduct their contribution to the plan. This delays taxes until retirement and the taxpayer only pays taxes on the actual retirement distribution, so if money were to be lost due to poor investment decisions, there would be no taxes. This traditional pre-tax plan is what most taxpayers want. It is ideal for most W2 earners.

Delaying taxes with a traditional pre-tax plan has advantages in addition to more money now! There are many things that can happen between now and retirement that result in less or no taxes being paid!

If the taxpayer ever has a low-income year, they can do a Roth conversion with little or no tax. The investment can be lost, in which case there are no taxes. The taxpayer could die, in which case he did not have to pay taxes during his lifetime. And fiscal rules could change, in an emergency like Covid-19 it could allow early withdrawal of retirement funds.

The amounts involved can be large. If the employer offers a traditional 401k before taxes, the contribution limits are even higher than with an IRA. A self-employed person can create and fund a pre-tax SEP plan with even higher contribution limits. And if the only employees are the owner and spouse, a Pre-tax Solo 401k allows for much higher contribution limits with contributions from both the individual and the business.

An after-tax Roth retirement plan does the opposite! Accelerates taxable income that would not otherwise be paid until funds are distributed after retirement. Ask the tax authorities to “Please tax me now!”

It is almost never wise to speed up taxes that would otherwise be paid in the distant future!

So why the heck would anyone choose an after-tax Roth retirement plan or a Roth conversion (of funds in a traditional pre-tax plan)?

Well, if one has a very bad year without a job and a lot of losses, due to Covid-19 or otherwise, the taxable income can be low, zero or negative. In a situation like this, it makes sense to accelerate future income that would eventually be taxed at a higher rate in the current low income year when the tax bracket is low.

The problem in that situation is that the taxpayer often thinks “I did so badly that I don’t need to file taxes” and they never bother to meet with a tax planner to discuss this and meet the December 31 deadline for a Roth conversion. By the time they get to my office, it’s too late.

Some real estate investors show negative income due to depreciation or other tax shields, and they benefit by accelerating future income in years of current losses.

People who are not allowed to deduct a contribution to a traditional plan might prefer to contribute to an after-tax plan if allowed, as there is no current deduction anyway.

And people within a year or two of retirement may prefer to contribute to a Roth plan that does not have eventual required minimum distributions.

There are other subtle differences between a traditional plan and a Roth plan.

However, in my experience, less than 1% of my clients would benefit from a Roth. The much more common mistake is choosing a Roth plan without fully understanding the tax costs.

So consider meeting with a tax professional before the end of the year, particularly during bad years when collecting tax from losses can help turn lemons into tax lemonade. If your friends or family are doing poorly or closing a business, ask them if they have met with a tax professional before the end of the year.

And don’t make the all-too-common mistake of choosing an after-tax Roth retirement plan before having a conversation with your tax professional to make sure it really benefits your situation!