Roth IRAs: The Mathematics For High-Wealth Taxpayers

Benjamin Franklin famously observed, “The only two things you can count on in life are death and taxes.” To which an unknown wag offered the sardonic and almost equally famous rejoinder, “That may be true, but at least death doesn’t get worse every time Congress reconvenes.”

Let’s start by belaboring the obvious and note that high taxation makes it challenging to create and accumulate wealth. Sure, everyone should contribute a fair amount toward the functions of government, but even the most patriotic Americans could feel just as patriotic while paying a whole lot less. Unfortunately, it is generally difficult to escape the long reach of the (tax) law; fortunately, however, there is one specific tax-reduction tool widely available to all U.S. taxpayers—namely, the Roth IRA and its kissing cousin, the Roth 401(k).

The sales pitch for a Roth IRA is compelling: Money is contributed to the account on an after-tax basis, meaning that people do not get a current income-tax deduction for the contribution. But once the money is invested it can go into almost any investment activity you please (subject to the limitations imposed by the account custodian) and all income earned from those investment activities—whether it’s interest, dividends or capital gain—is excluded from current federal income tax (and typically state income tax) at both the IRA level and at the taxpayer level. Moreover, when it comes time to distribute funds from the Roth IRA in the future, these distributions are likewise fully exempt from federal (and usually state) income taxation. Thus, the Roth IRA allows taxpayers to enjoy a tax-free investment that earns a full market rate of return. All in all, a very sweet deal.

A Roth IRA (like the regular IRA) is generally limited to passive investments, and only a very limited amount of income each year can be derived from an activity characterized as trade or business (for example, the IRA must earn less than $1,000 per year of taxable income from public limited partnerships or other active businesses or else it must file a tax return and pay income tax). But this is an easy problem to avoid, and the opportunity to enjoy full market-rate tax-exempt investment returns is a major wealth-building opportunity.

The Math: Regular IRAs Vs. Roths
A Roth IRA is best understood by comparison to its older relative, the regular individual retirement account. The regular IRA was authorized in the early 1980s, and U.S. taxpayers were originally allowed to contribute $2,000 per year (which is tax-deductible) into the account (the contribution limit in 2023 is now up to $6,500 for younger taxpayers and $7,500 for taxpayers over 50). The IRA then allows the investment to compound tax-free, and it makes taxable distributions to the investors after they reach age 59½. Distributions before that age (as of 2023) are subject to a 10% penalty for early withdrawal (in addition to income taxation of the distribution). It’s worth noting that over time Congress realized the political expediency of giving taxpayers penalty-free early access to their funds and developed a variety of “hardship” exceptions to the early withdrawal penalty.

The math is relatively straightforward when you’re comparing a Roth IRA to a regular one. But your ultimate decision about which vehicle to choose will turn on your ability to predict your financial life path and your marginal income tax rates far into the future. In other words, it’s very challenging. Or nearly impossible.

The first insight is that if your income tax rates stay exactly the same over time, and if your investment return is the same in both vehicles, then the net after-tax result of investing in either the regular IRA or the Roth is exactly the same!

Let’s take Taxpayer X, who is trying to decide whether to contribute money for 2023 into a regular IRA or a Roth. This individual expects to earn the exact  same investment return over 10 years, anticipating that funds in both vehicles would double in value. We’re also assuming the income tax rate is exactly 40% in 2023 (using round numbers for simplicity) and that it will remain at exactly 40% through 2033. So the taxpayer is trying to decide whether to contribute $1,666.67 into a regular IRA, or pay the 40% tax on $1,666.67 and contribute the after-tax amount, or $1,000, into a Roth IRA.

Fast-forward 10 years; the accounts have doubled in value, giving the taxpayer $3,333.33 in the regular IRA and $2,000 in the Roth. If the taxpayer then distributes the funds from each IRA, paying 40% tax on the $3,333.34 and no tax on the $2,000, this means he or she has an after-tax return of $2,000 from the regular IRA and $2,000 from the Roth. The outcome is exactly the same!

This is not what people intuitively understand or expect. Yet our mathematical epiphany leads us to a couple of practical insights:

1. If your income tax rate is higher today than you expect it to be when you’re making future distributions, then a regular IRA is the better alternative. This might occur, for example, because you expect your tax bracket in your retirement years to be materially lower than in your highest earning years.

2. Conversely, if you think your marginal income tax rate today is lower now than it would be in the future when you’re making withdrawals, a Roth IRA is likely the better alternative. This might occur, for example, because you plan to work full time into your 70s and expect your income to stay high as federal and state income tax rates possibly increase.

Now let’s consider the other factors that can come into play.

Mandatory Distributions and Estate Planning Issues
With a few exceptions, IRAs are structured to penalize you if you make early distributions before age 59½, but they also have back-end rules that start pushing money out of the account when the federal government decides it is time, and you must take required minimum amounts from your accounts each year after that. That was normally at age 72, but it’s now age 73 if you reach age 72 after December 31, 2022. This applies to withdrawals from your regular IRA, SEP IRA and SIMPLE IRA plans.

The reason it’s now age 73 is likely because of the political pressure from elderly owners of large accounts, which increased the mandatory age for required distributions from 70½. (Stay tuned for further age increases as Congress seeks to ingratiate itself to this voting bloc.)

Now consider that Roth IRAs do not require these withdrawals until after the owner dies, an often overlooked benefit of this vehicle. Designated Roth accounts in 401(k) and 403(b) plans are subject to the required minimum distribution rules for 2022 and 2023. But for 2024 and later years, RMDs are no longer required from designated Roth accounts. (People must still take the distributions from designated Roth accounts for 2023, including those with a required beginning date of April 1, 2024.)

Roth IRAs also have advantages over regular IRAs when it comes to estate planning. For inherited regular IRAs, the future distributions are classified as “income in respect of a decedent” and are both 1) includable as a taxable asset at face value in the estate of the decedent and 2) considered taxable income when distributed to the beneficiary. Thanks to the 2020 legislation known as the Secure Act, regular IRAs left to a non-spouse—in other words, the account holder’s children—must now be distributed within 10 years of inheritance.

So if parents die in their 80s and leave regular IRAs to children in their 50s, this 10-year RMD regime coincides with the kids’ peak earning years (and peak tax brackets). In the worst-case scenario, the regular IRA triggers both an estate tax (with a paltry basis adjustment under Section 691 of the Internal Revenue Code) and the income tax (under the high brackets) on most of the distribution amounts. The combined tax cost of this “double tax” can be as high as 70%.

At estate tax seminars presented to knowledgeable estate planners, I generally recommend leaving regular IRAs to charity in order to avoid this hassle, and then (facetiously) comment, “You should only leave regular IRAs to your children as a prank.”

The 10-year distribution requirement also applies to inherited Roth IRAs, but if the decedent satisfied the five-year rule before they died then the withdrawals are tax-free. It makes a Roth IRA a better estate planning tool than the regular IRA, where taxes bunched into a 10-year post-death period can substantially erode the value.

Will Tax Rates Increase?
All this raises another question: What in the heck is going to happen in the future with federal and state income tax rates? The answer is, “God only knows, and even God is hedging the bets.”

On the one hand, it is easy to look aghast at federal government spending deficits, the endless growth of state and local government, and conclude that taxes must necessarily rise, and thus conclude that the Roth IRA is likely to produce a better end result over time.

But marginal income tax rates have a weird history. The maximum federal income tax rates at the end of World War II were as high as 90% (or more). They were still at 70% in the 1970s. These rates spawned a huge tax-avoidance industry, enabled by a compliant Congress that approved a plethora of tax shelters, and very few people paid the top rate. That rate dropped to 50% in 1981 and then down to just 28% (briefly) in 1986 under President Reagan. At the same time, the vast majority of tax shelters were eliminated, hurting formerly tax-favored industries like real estate and oil and gas.

The peak rate soon bumped back up to 31% under President George H.W. Bush in 1990, then to 39.6 % in the Clinton era, back down to 35% in the George W. Bush era, back up to 39.6% under Obama and down to 37% under Trump. Joe Biden tried, unsuccessfully, to raise tax rates back up to 39.6%. For more than 30 years, the top marginal rate has remained in a relatively narrow band between 35% and 40%.

Federal tax policy has been affected by the famous Laffer curve and similar theories suggesting that maximum income tax rates do not produce maximum revenues, and everyone pretty much accepts this observation. Even Sen. Bernie Sanders has said he would not raise rates to the 90% levels of the Eisenhower years. You might conclude, taking all this history into account, that people will resist federal income tax rates jumping much higher than 39.6%, and so there won’t likely be a quantum leap from the current rates. An interesting conclusion to reach, if you reach it.

Meanwhile, at the state level, competition among jurisdictions to slash rates has had a major impact, and some states, still flush with federal cash after the pandemic, now recognize that raising tax rates can lead to the flight of high-income individuals (and their businesses) and cause a net diminution in tax revenues. My home state, Massachusetts, raised the maximum tax rate on those making more than $1 million to 9% (and reclaimed its old nickname, “Taxachusetts,”) but almost every other state has either kept taxes the same or cut them—more than 20 states slashed taxes in the past three years.

Those in states with high income taxes can easily retire and move elsewhere, in the process slashing a New York state income tax of 12.4% or a California tax of 13.3% to zero. A call to the Mayflower moving company just before you turn 73 means that you could now fund the regular IRA without worries, since the tax math on the required distributions will see it as equal to a Roth at that point.

Converting In Down Years
Conventional wisdom and popular tax advice suggest that people should convert their regular IRAs or traditional 401(k)s into Roth investments in years when their income is down and their marginal tax rate lower. I have used this technique, but it has limitations and caveats.

Income tax brackets are staggered, and there is only so much income you can convert before you trigger taxes that throw you back into the maximum bracket. Remember, if your current bracket is low and your future bracket is high, a Roth IRA clearly comes out ahead. But if you can convert only $100,000 out of your $800,000 regular IRA before the tax brackets become indistinguishable, then the strategy has obvious ceilings and limits. It is probably worth doing if you are confident that the “down” year tax rate is likely to be materially lower than the one in your retirement year. That’s not always easy to judge. But you make the call.

Are Returns The Same For Both IRAs and Roths?
IRA accounts, whether they’re regular or Roth, ought to see the exact same investment returns over time. But in my experience, they do not.

That’s because a regular IRA openly invites investors to take disproportionate and even wildly improbable risks. After all, about 40% of the money belongs to the government, and who really cares if you lose what’s going to the feds? In gambler’s parlance, it is like playing with the house’s money. Go wild.

A Roth IRA, by contrast and by definition, is after-tax money, which means it is all your money. The income from the investment is yours, tax-free, forever. If you lose it—ouch! Because it’s yours, you might feel an irresistible impulse to invest in high-yielding investments that (falsely) suggest your principal is safe and that your interest/dividend return is huge. In fact, Roth IRA account holders are often drawn to invest in high-yield investments with as much risk as equity investments—but without the stratospheric upside.

When involved in investment decisions, I recommend that investors choose both Roth IRA and regular IRAs the way they would any other investment account: They should look for a good, conventional return and be satisfied.

Few people welcome that advice.

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