The unintended consequences of a change in tax law and might inadvertently force people to do what they should have been doing anyway.
Congress Ended a Tax Break. How That May Help Higher Earners
This is a “gift” article courtesy of the WSJ, that is free to read without a subscription. Here are some snips, but I suggest taking a look at the full article.
Tax Change Background
Many retirement savers are furious about a law set to take effect in January, and at first glance it’s easy to see why.
The provision, enacted in late 2022, denies a key tax deduction to workers aged 50 and older who had $145,000 or more in wages the prior year. They’ll no longer be able to put “catch-up” contributions into traditional 401(k) or similar plans, which allow upfront deductions on dollars going in but impose income taxes on future withdrawals. Catch-up contributions, which help bump up workers’ savings late in their careers, currently add $7,500 to the $22,500 annual limit for many savers.
Instead, these savers can only put catch-ups into Roth 401(k) accounts—so they won’t be tax deductible, although future withdrawals can be tax-free. As many of these savers are in peak earning years, putting after-tax dollars into a Roth account when one’s tax rate is higher can reduce and even erase the benefit of later tax-free payouts.
So here’s a surprise: Affected savers shouldn’t be mad, says Betty Wang, a Denver-based financial adviser. “I tell them, ‘Congress is doing you a favor by forcing you to save in a Roth account. In the long run, you’ll likely come out ahead.’ ”
Congress didn’t enact the recent change to help higher earners. For lawmakers, a key lure of Roth accounts is that they provide tax revenue upfront within a 10-year budget window, while tax-deductible IRAs and 401(k)s lose it. This is one reason recent law changes have favored Roth accounts—and why it could be complicated for Congress to restrict them in major ways.
Roth Benefits as Noted by the WSJ
- Roth 401(k)s provide Roth access. Many savers can’t contribute to Roth IRAs because their income is too high or else don’t because “backdoor” Roth contributions would be complex and partly taxable. In addition, current Roth IRA contributions are limited to $6,500 per year, plus $1,000 more for savers age 50 and older. Savers with Roth 401(k)s can typically put in much more.
- Roth benefits can cascade. Tax-free Roth withdrawals don’t count as income, so they don’t leave taxpayers more susceptible to means-tested Medicare surcharges called IRMAA or the 3.8% net investment income tax.
- Roth contributions start the five-year clock. To withdraw tax-free Roth earnings without penalty, the saver must be at least 59 ½ and have held the account for five years in many cases. Even a small amount in a Roth account can start that five-year clock running.
- Roth accounts can be better than taxable investment accounts. Among the reasons: Payments of earnings in investment accounts (such as dividends or interest) are taxable, while they are tax-free in Roth accounts. If someone sells assets in an investment account before death, the net gain is taxable—unlike in Roths. Also, Roth IRA and 401(k) owners can pull out their own contributions tax-free without penalty even before five years, although with 401(k)s the employer also has to allow these payouts.
- Roth accounts are better for heirs. Many nonspouse heirs of IRAs and 401(k)s whose owners died after 2019 must drain the accounts within 10 years of the owner’s death. However, heirs of traditional IRAs or 401(k)s often must make taxable withdrawals for each of those 10 years. Heirs of Roth accounts can wait until the end to withdraw.
It’s not just the wealthy who can benefit from Roth IRAs.
But it greatly matters what you put into them. There was no discussion of this key point by the WSJ.
Suppose you have a strategy of stocks and bonds including some speculative stocks. Of that group, It’s the speculative assets that are most appropriate for a Roth.
If you hit a home run on a $50,000 investment that turns into $5,000,000, you only pay upfront taxes on that $50,000. Then, $5,000,000 is tax free at age 59 and a half. That same amount in an IRA is taxed as ordinary income when you withdraw the money.
If you have both taxable accounts and regular IRAs, also think about where you want the risk. This decision is more complicated because we do not know what capital gains laws will be in the future, or far that matter what the income tax rates will be. But we can say that home runs, although deferred in a regular IRA, will be taxed on the full amount, as income, not at long-term capital gains.
The point of this discussion is not to encourage speculation. Rather, it’s to suggest that if you have speculative assets, to consider putting those assets into a Roth if you can.
It’s not just wildly speculative assets either. If you are an active trader of anything, say energy, and are doing well with it, the cumulative gains of successful timing are likely much better off in a Roth.
Given the 5-year clock, its’ best to get that Roth funded with at least a minimal amount by the age of 54.
Finally, timing matters. For those converting from regular IRAs to Roth IRAs, it best to do so on major dips . So there is a lot to think about here.
Not Investment or Tax Advice
This is not investment advice or tax advice.
Instead, think of the WSJ article and my comments on the article as a starting point for discussion with your tax advisor.
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