This article discusses three investments ranked in order of increasing tax efficiency: taxable assets, traditional 401(k)/IRAs (traditional accounts), and Roth 401(k)/IRAs (standalone Roth accounts). It is worth noting at the outset that retirement accounts are extraordinarily efficient for tax purposes. With any increase in personal income or capital gains tax rates, taxable assets become even less tax-efficient relative to both the “Roth” within the traditional account and the standalone Roth account.
The traditional account is in effect a joint venture between the employee/retiree and the government. When the employee initially invests, the government also can be thought of as putting up money—the otherwise-owed income tax on the earned income. It is as if the government collects that tax and then invests it in the joint venture.
At eventual partial liquidation (withdrawal), the so-called “income tax” collected by the government is really its ownership share created by that investment. At withdrawal, that ownership portion is determined by the tax rate at the time: the government’s ownership proportion could therefore be lower or higher than the government’s original percentage contribution. For simplicity, this article initially assumes that the ownership percentage (tax rate) is the same at contribution and withdrawal.
The part of the venture the employee/retiree owns is exempt from all income and capital gains tax and is in effect a “Roth” within the traditional account. In contrast, even with no realized capital gain, distributions on a capital asset might be taxable. For example, common stock dividends are subject to income tax—for individuals, generally as part of the net capital gains calculation at the adjusted net capital gains rate, which can be as low as zero depending on total income. Some tax on capital asset returns is more than zero tax on the “Roth” within the traditional account.
Like the “Roth” within the traditional account, the standalone Roth account is exempt from all income and capital gains tax.
Although the two are similar, the standalone Roth has some advantages, including the three discussed below (again initially assuming the government’s ownership percentage (tax rate) is the same at contribution and withdrawal). Nonetheless, in at least one situation the traditional account is superior.
First, the tax law imposes the same maximum annual contribution limit to standalone Roth accounts and traditional accounts. If an employer offers a standalone Roth account and the employee can spare the cash, the employee will get “more bang for the buck” by contributing the maximum to the standalone Roth instead of the traditional account. The following example illustrates why.
Suppose the annual maximum is $20,000.
With a $20,000 contribution to a traditional account, the employee will effectively only have ownership of a portion of the $20,000 (the employee’s “Roth” within the $20,000 traditional account). That is because, as noted, the traditional account can be looked at as though the government collects the tax due on a marginal $20,000 of earned income and invests it in the joint venture. Assume that the marginal tax is $6,000. Then, the balance of $14,000 is the amount in the employee’s “Roth” within the traditional account.
With a $20,000 contribution to a standalone Roth, the employee will have $20,000 in the Roth account. Note, however, that if the employee puts $20,000 in a standalone Roth, the employee must contribute from salary $20,000 after-tax and therefore must pay $6,000 of income tax from other funds.
Second, unlike the traditional account, the standalone Roth account (IRA and, starting next year, 401(k)/403(b)) is not subject to annual required minimum distributions (RMDs) when the holder reaches a certain age or retires after reaching a certain age. As mentioned earlier, in March 2023 President Biden proposed special distribution rules on certain “high income” taxpayers with “large” aggregate retirement accounts, including both traditional and standalone Roth accounts. If such rules were enacted, being able to avoid a RMD by having a standalone Roth account rather than a traditional account might enable the retiree to avoid falling within the “high income” category.
Finally, the standalone Roth account is advantageous when a person’s estate will pay no federal estate tax but the spouse’s estate will pay estate tax. The 40% estate tax applies not only to the employee/retiree’s share of the traditional account but also to the government’s ownership portion. If the employee/retiree’s estate pays federal estate tax on a traditional account, the “income with respect to decedent” (IRD) income tax deduction for the employee/retiree’s descendants will mitigate this unfairness. (IRD will not, however, eliminate the unfairness of any state inheritance or estate tax on the traditional account.)
The following example illustrates how these rules work.
Suppose the employee/retiree designates offspring as beneficiaries for a traditional account, but the employee/retiree’s estate pays no federal estate tax by using part of the employee/retiree’s lifetime estate/gift tax exemption. With no federal estate tax paid, the IRD deduction is not available to the account beneficiaries. The income tax on withdrawals thus significantly reduces the value of the inherited traditional account, although the full pre-tax value is applied against the federal lifetime estate/gift tax exemption.
Assume the employee/retiree’s spouse later also leaves assets to offspring and that the spouse ends up paying estate tax. The p/retiree’s giving the traditional account to descendants essentially wasted part of the employee/retiree’s spouse’s and employee/retiree’s joint lifetime estate/gift tax exemption on the government’s ownership share of the traditional account.
The standalone Roth account, in contrast, has no such wasted exemption because the employee/retiree owns the entire amount in the account (through either a 100% initial contribution or, at conversion, purchase of the government’s ownership interest).
Despite these standalone Roth account benefits, the traditional account is better than the standalone Roth account for bequests to charities (including a donor-advised fund). If an employee/retiree names a charity as the beneficiary of a traditional account, the donation at death is not only the employee/retiree’s share of the joint venture traditional account but also the government’s portion (as described above, generated through the government’s initial investment).
If, on the other hand, a traditional account has no charitable beneficiary, it would be worth gradually converting the traditional account to a standalone Roth account when possible to do so (assuming the government’s ownership percentage (tax rate) is the same at conversion and at withdrawal from the traditional account). The amount treated as the income tax on conversion is, under the analysis described here, not really a tax but the fair price of buying the government’s ownership share at current market value. By paying this so-called “tax” with outside money and increasing the employee/retiree’s ownership of the venture to 100%, the employee/retiree shifts dollars from a taxable vehicle to a tax-exempt one.
When a non-spousal beneficiary inherits a traditional account, that beneficiary generally must entirely liquidate the account by the end of ten years (and, in addition, may be subject to required annual minimum distributions). With a substantial traditional account, the distributions might thrust the non-spousal beneficiary into a high tax bracket. The government’s ownership percentage might therefore be higher at withdrawal than at contribution or conversion. With a standalone Roth account, on the other hand, the non-spousal beneficiary can wait until the end of ten years and terminate the account with no tax.
With the traditional account, if the tax bracket at withdrawal is higher than at conversion or initial contribution, the government increases its percentage ownership of the joint venture upon the partial liquidation. In contrast, if the tax bracket at withdrawal of a traditional account is lower than at conversion or initial contribution, the government decreases its percentage ownership of the joint venture upon the partial liquidation.
As a result, there is a crude “rule of thumb” regarding both the decision to convert or to contribute initially to a standalone Roth account rather than to a traditional account: convert or contribute to a standalone Roth account when the tax rate at would-be withdrawal from the traditional account is the same or higher than at conversion or contribution. In fact, even if the tax rate at would-be withdrawal is slightly lower than at conversion or initial standalone Roth contribution, the contribution/conversion is still beneficial.
What does “slightly” mean? By using outside money to pay the tax on the conversion or the tax due on the funds used to make a standalone Roth contribution, the employee/retiree shifts funds from a taxable vehicle into a tax-exempt one. That benefit of moving taxable assets to a standalone Roth account may exceed the traditional account’s advantage of the government’s “slightly” lower ownership percentage at would-be withdrawal. With any increase in personal income or capital gains tax rates, conversion or initial standalone Roth account contribution remains advantageous at a greater (but still small) decrease in the tax rate at withdrawal compared to that at conversion/contribution.
What if the potential money source for the tax on the conversion is an appreciated capital asset? An elderly employee/retiree might prefer to wait to allow for death’s stepped-up basis to eliminate any tax on immediate sale of the asset. Any congressional decision to repeal the stepped-up basis rule would, absent an exemption, increase the attraction of shifting funds from a taxable capital asset to a non-taxable account through selling the capital asset, paying the possibly inescapable capital gains tax, and using the net amount to finance conversion to a standalone Roth account.
