The Great Conundrum
Traditional Accounts allow you to save on taxes as the contributions are deposited prior to any deductions being taken from your paycheck. Pre-tax contributions reduce your taxable income by the amount you contribute, in example if you make 40k and contribute 19k to your pre-tax retirement account, your taxable about would be 21k (40k-19k). Taxes are then collected when you draw down or convert your account at some future date.
Contrarily, Roth type accounts allow you to pay taxes up front (on the seed) and no taxes on the growth. The key difference between the two is that taxes are taken up from on the Roth account, and taxes are taken on the backend on the traditional account.
There are some caveats between the traditional and Roth accounts for one all traditional accounts are subject to RMDs (Required Minimum distributions) upon approaching the seventh decade of life, yet Roth, specifically the Roth IRAs to do not require RMDs for the lifetime of the account.
The great conundrum is: Which of these accounts is the best choice as we approach middle age considering estimated future value of our traditional accounts?
The Dilemma:
Using pre-tax/traditional accounts has been great during our early wealth building stages. But as these accounts have grown, and began to hit the critical mass, I am strongly considering contributing to Roth accounts going forward. There are some key considerations for contributing to the Roth. My initial reasoning is that as we approach the threshold of early retirement, the more that I think that I never really going to truly stop working. Ultimately, my thoughts of what I will do after required paid work will most likely include some work. The caveat to the latter is that I will still earn an income, and most likely still accumulate more wealth in the pre-tax/traditional type accounts.
We have accumulated large balances in our tax deferred accounts, which at our average age of 38 could grow to over 3.2 million without contributing another dollar to our pre-tax accounts, assuming a 10% investment return at age 68. Conversely if we continue to max out our pre-tax/traditional accounts with a 7% match, these accounts are estimated to balloon to 5.8 million at age 68, if stopping contributions at age 50, (6.2 million if retired at age 68, not working this long). The caveat to keeping the majority of our savings in the tax deferred accounts is that they are subject to RMDs post age 70 which will force us to take distributions that may force us in to an unfavorable tax situation. Conversely, the Roth account (Roth IRAs) does not have any RMDs through the lifetime of the primary account holder or any income tax when qualified distributions are taken.
Additionally, we hold a separate deferred compensation account (non-qualified 409a) where we have deferred a significant amount of savings that will be treated as ordinary income upon distributions.
Our plan:
For 2022, we will forgo contributing to the traditional 401k, and begin to contribute to our Roth accounts up to the match along with our continued maximization of our Deferred compensation. The remainder that is typically invested in the 401k to the maximum will be invested into our taxable brokerage accounts. The reasoning for contributing to the taxable brokerage is to allow for us to have more liquidity as the taxable and Roth accounts are somewhat similar, especially if you don’t intend on ever selling your assets. For 2022, we intend to not perform any Roth conversions, because we would like to qualify for the additional child tax credit (if the Build Better Bill passes), which will provide us with a 12K dollar for dollar credit against our income as long as we can keep our adjusted gross income below the 150k thresholds. A large Roth Conversion (50k+ will surely phase out the credit in 2022 which is the reasoning for staring the Roth conversion in 2023.
We intend to perform our Roth conversions beginning in 2023, as the additional tax credit will most likely be phase out during post 2022. Our first conversion of 50K should generate a tax bill of approximately 10K (after Child Tax credit of 8k, we have 4 kids ☺). To pay for the tax bill we intend to lever a small portion on margin of the investments we hold in our taxable brokerage. We will be able to do so because we will be investing roughly 40k into the taxable brokerage in 2023 in addition to the prior year contributions of approximately 40k. The levered amount represents 10% of the overall contributions to the taxable accounts through 2023, which is a favorable levered position as 90% equity in the overall assets is maintained.
The plan is to perform the Roth conversion ladder until all pre-tax/traditional amounts have been migrated to the Roth accounts.
My Pros for the Roth Migration
• Getting closer to the 0% tax bracket – Having the majority of our tax advantaged accounts as Roth accounts, in combination with qualified dividends from assets held in the taxable accounts will allow for us to stay in the 0% tax bracket (as long as we stay within the 12% ordinary income bracket)
• Roth Accounts have no RMDs
• Assets that will be held in the Taxable accounts to offset taxes are subject to the step-up in basis upon death.
• Beneficiaries of the Roth account will not owe taxes
• Non-Qualified Tax Deferred payouts will count as ordinary income; which could drive up tax brackets on top of pre-tax/traditional account contributions.
My Cons for the Roth Migration
• Loss of the pre-tax treatment of contributions
• State and Federal income tax will have to be paid on the conversions
• No access to the converted funds until a 5-year period has lapsed from the initial conversion for each individual conversion.
• Losing the ability to fill in the progressive income tax brackets when income is lower.
• Loss of the ability to invest the tax amounts saved into the taxable accounts as a result contributing on a pre-tax/traditional basis
Choosing between Roth and Traditional:
The decision to go with Roth or Traditional route is personal, not to sound clichéd. Oftentimes within the early retirement community, we hear a lot of push for investing in traditional style accounts. The Traditional route is routinely pushed because the progressive tax buckets can be filled up as you pull down your distributions from your taxable accounts. When you save into the traditional account you save at the rate of your highest progressive tax bracket, and pay tax progressively on the withdrawals. This math works well when calculating static tax rates, but when you have 4 wonderful children that double as tax credits, the effective tax rate is a better consideration than your highest marginal tax bracket.
While I understand that for the vast majority of early retirees, the traditional route will be best. But if you have large tax credits now, and other deferred compensation benefits, it may make sense to begin to pay the tax now because you may be in the lowest marginal tax bracket that you will ever be in. No need save in pre-tax now, only to pay a higher effective tax rate in the future.
I highly recommend determining your effective tax rate versus simply relying on your marginal tax rates in your evaluation of Traditional versus Roth accounts dilemma.
