Episode 7: Tax Qualified Accounts – Let’s Talk Acronyms

Steven Jarvis:     Hello everyone, and welcome back to the Retirement Tax Podcast. As always, I am your co-host, Steven Jarvis, CPA, and my illustrious co-host with me, the one and only Benjamin Brandt. How are you?

Benjamin Brandt:         I’m so happy I can barely put it into words.

Steven Jarvis:     Well, we’ll spend the next 20 minutes trying to put it in words the best we can.

Benjamin Brandt:         Love it. What are we talking about today, Steven?

Steven Jarvis:     Today I thought we’d talk about acronyms, which is one of … oh, man, accountants love acronyms. We make them up for everything.

Benjamin Brandt:         Do you know the only group that loves acronyms more than accountants?

Steven Jarvis:     What’s that?

Benjamin Brandt:         People in the military.

Steven Jarvis:     Well, that’s fair. I won’t even try to argue that.

Benjamin Brandt:         So our powers combined, we’re acronym champions already.

Steven Jarvis:     Yeah, we could just spend the entire episode talking in acronyms and then no one would come back, so we better not do that.

Benjamin Brandt:         That’s true. All right, we won’t do that, we’ll do something else.

Steven Jarvis:     One of my favorite acronyms real quick before we get into taxes is TLA.

Benjamin Brandt:         TLA, that sounds like an airport in Colorado.

Steven Jarvis:     It’s not. TLA is the acronym for three-letter acronym.

Benjamin Brandt:         Oh my goodness, that is very meta. That’s very meta.

Steven Jarvis:     That’s how nerdy I am. We would haze new accountants, seeing how long it would take them to catch on to what the TLA was that we were talking about.

Benjamin Brandt:         Oh, that’s like hazing. That’s like telling somebody they need to change their blinker fluid.

Steven Jarvis:     Yeah. Yeah, or when you’re camping, you have somebody go find the smoke shifter. All right, we better get into taxes before we’ve lost everyone completely.

Benjamin Brandt:         I would have fallen for that one. I think I would’ve fallen for the smoke shifter.

Steven Jarvis:     Yeah, oh, I definitely did. That was one of those perpetuate the cycle kind of things. Since I fell for it, of course I had to do it to other people.

Benjamin Brandt:         Yeah, of course. Of course. Yes, well, let’s shift some smoke around some acronyms. How does that sound?

Steven Jarvis:     Yeah, we’ll get focused in a little bit more here. We’re going to talk about acronyms as it relates to tax qualified accounts, which we don’t have an acronym for. But a lot of these are things that for most of our listeners you probably hear headlines about, you probably participate in some of these, you probably have some base knowledge, but we still get questions all the time about how do we differentiate between these? How do we decide which ones to use? Can we use more than one at a time? Today is going to be a little more high-level about what these are and how they might be applicable to you, so you know which ones you should spend some time learning more about.

Benjamin Brandt:         So today we’re breaking it down to the absolute basics, so I think the best place to start, Steven, is what does IRA stand for?

Steven Jarvis:     Ben, it depends on who you ask, but I always go with individual retirement account.

Benjamin Brandt:         Okay, well, I’m glad you said that, because I have heard it called other things, individual retirement annuity. Every once in a while, I hear that. Which I’m not sure if we’re talking about something totally different, but individual retirement account is what’s in my head.

Steven Jarvis:     Yeah. Yeah, and so whether you can spell it out or not, when we’re talking about IRAs as it relates to taxes, we are talking about being able to contribute pre-tax money that’s going to grow tax deferred. That’s really the significance of an IRA.

Benjamin Brandt:         Okay, so that’s deduction now, pay taxes later.

Steven Jarvis:     Exactly. The IRS is generous enough to give us the opportunity to wait and see if they change their mind later about how much tax we should pay.

Benjamin Brandt:         Right. Well, and the government, they’re not dumb, right? They know that we’re going to invest this money wisely over time, and they’re going to get more money on the other end by letting us take a deduction on the seed. They’ll collect their taxes on the harvest.

Steven Jarvis:     Exactly. That’s a great analogy, because we got to remember that even though we get to put the money in pre-tax, get that deduction on our tax return now, and IRS is going to ask for their portion, both on what we put in and the growth over time.

Benjamin Brandt:         Okay, so that’s IRA. Tell me what is a Roth IRA?

Steven Jarvis:     Yeah, this is a great question. I’ll have people ask me sometimes what is the acronym Roth stand for? Because a lot of times you see it all in capital letters. Roth is not in fact an acronym, it’s named after a Congressman who helped get this created.

Benjamin Brandt:         Right. Someone’s actual name was Roth.

Steven Jarvis:     Was Roth. So Roth is not an acronym for anything, at least not for our purposes today. When we talk about a Roth IRA, the IRA piece is still the same, but this is a specific distinction of what type of account it is.

Benjamin Brandt:         Okay, so the Roth is modifying the IRA, it is a specific type of IRA. So, how does a Roth IRA differ from a IRA? Should we call it a traditional IRA? I’ve seen that term kind of pop up a little more recently, because we’re calling it a traditional IRA, because we’re often comparing it to a Roth IRA, giving it that additional modifier.

Steven Jarvis:     Yeah, a traditional IRA usually provides the most clarity in what we’re talking about, traditional versus Roth. So, the important distinction with a Roth IRA is that you’re putting in after tax money. So this means I earn money right now, I go ahead and pay my taxes and then put it in this account. The advantage of doing that is that since I’ve already paid the taxes, both the part I put in and any growth over time is tax free when I take it out.

Benjamin Brandt:         Okay, so regular IRA, traditional IRA, not named after someone named traditional, it’s just traditional IRA. Don’t confuse that with the Roth. Traditional IRA, tax deduction today, pay taxes down the road. Roth IRA, no deduction today, but you keep whatever’s left at the end. So $5,000 turns into $25,000, 25 years from now that $25,000 is yours to keep.

Steven Jarvis:     Yes. Now there’s a really important argument I’ve had with other accountants, really supposedly smart people on paper about the math over time on traditional versus Roth IRA. We’re not going to go through a whole bunch of situations, just trust me. I’ve run the numbers, I’ve got nerdy Excel spreadsheets, I’ve proven this over and over. The math of what you get to keep is not any different whether you contribute to traditional IRA or Roth IRA if tax rates don’t change.

Benjamin Brandt:         Okay, interesting. Say that again.

Steven Jarvis:     Yeah, really want to make sure that this point gets driven home. That if right now I contribute to either a traditional IRA, which is going to be pre-tax, so I can probably contribute a little bit more, or I contribute to a Roth IRA, which is after tax, so the IRS can take their portion now. Whichever type of contribution I make, if we go 10 years in the future and now they’ve both grown, and now at the end of that 10 years the IRS is going to take a bunch of money from my traditional, but if I had a Roth IRA, I could take it all. So in either situation, what I actually end up with in my bank account at the end of 10 years when I take this all home is going to be the exact same if tax rates don’t change.

Benjamin Brandt:         Interesting. So when we’re choosing between one or the other, is that the bet that we’re making is tax rates will change?

Steven Jarvis:     Essentially. Well, that’s one way to look at it. The other way I like to look at it is kind of like tax insurance. It’s not necessarily that I’m betting that absolutely it will change, I’m hedging against the risk that it might.

Benjamin Brandt:         It’s the devil you know.

Steven Jarvis:     Yep. Yep, and this is whether tax changes because my income goes up or because Congress decides to change the tax rules. Because Congress is who has power over this, and they prove quite often that tax laws are written in pencil and they can change them if they like.

Benjamin Brandt:         Absolutely. I won’t argue with your math about we’ll be in the same place, $100 contribution to either gets you to the same place 10 years from now. But one of the benefits I think of the Roth IRA in retirement is that you have essentially unlimited flexibility, in that we’ve got this pile of money, it’s probably our most aggressively invested pile of money, because you’ve already paid the tax tab on that, so might as well grow the fastest of any of our investments. That’s my personal opinion, do with that what you will, but we have that flexibility.

                           So if I need $50,000 as a gift or I’m going to buy something or pay off a bill for $50,000, if I take that out of my Roth, I already know where I stand, because I’ve already paid that bill. If I take that out of my traditional IRA or my 401(k), there are different variables that could affect it. It could mess up my health insurance, it could mess with other things, social security. So it’s a little bit more cumbersome, because there’s other things that are attached to that, because I have not yet paid taxes on that, have not earned that as income yet. So I see other than just the tax ramifications of it, I see flexibility and convenience as being something to be considered.

Steven Jarvis:     Another point related to flexibility is that Roth IRAs are not subject to required minimum distributions. So since the IRS has already taken their portion of your Roth IRA balance, they don’t care when you use it. Which is in contrast to traditional IRAs, which when you hit 72, the IRS is going to start demanding that you take a percentage of that every single year, because they are only going to wait so long for you to start paying what they think your share of taxes are.

Benjamin Brandt:         Well, interesting. Okay, so contrasting that, what happens to my traditional IRA versus my Roth when I die? It’s sort of the same thing as your RMDs, right?

Steven Jarvis:     Yeah, it’s the same general idea. The IRS already has taken their share of your Roth, whereas with … So, we want to look at this as what does it mean for the person who inherits it, right? So for the traditional IRA, the IRS has some pretty strict requirements on what you are allowed to do with that and how quickly you have to take that out.

Benjamin Brandt:         That’s a fairly recent change, right? The death of the stretch IRA.

Steven Jarvis:     Yeah. Yeah, so in most situations you’re going to have 10 years on the traditional IRA to take all of those distributions. Now there’s some nuance as far as who the beneficiary is, but in general, you’re going to have 10 years on an inherited IRA that you’re going to distribute all of that. Whereas-

Benjamin Brandt:         Right. So-

Steven Jarvis:     With the Roth, you’re back to having that flexibility, because you’ve already given the IRS their portion.

Benjamin Brandt:         So inheriting that traditional IRA, there are many cases where you probably would want to spread those payments out over 10 years, average that tax bill up. With the Roth IRA, you have that, again, flexibility where you could just take the money and run in year one, and that’s not going to change your tax situation.

Steven Jarvis:     Yeah, and so a lot of times people will ask for hard lines of, “Okay, at what tax bracket should I contribute to traditional versus Roth? At what income level?” Those kinds of questions. There isn’t one magic answer for everyone. I know that’s what you were hoping for, I don’t have magic answers like that. But in general how I frame this, both for myself and as I talk to clients, is, okay, if I look at my income now, when I look at where my tax rate is now, do I have any concern that it might go up in the future?

                           Whether that’s because I expect to make more money later or because when I get into retirement and have RMDs, I’m going to have higher income whether I want to or not, or if I expect that Congress might increase taxes. Then if I have any concern that taxes rates might go up in the future, it’s probably a good idea to look at your options for Roth.

Benjamin Brandt:         For me when I’m working with clients, sometimes I have to kind of quantify it, because I’m asked that question a lot. For me, I’m looking at about five years. Maybe it’s five years, because that’s close enough into the future that we can kind of make a guesstimate, or also because we’re investing that money and five years is sort of the difference between a savings goal and an investing goal.

                           But I would say for most people as they approach retirement, they’re in their peak earning years, and then their income will dip a little bit after retirement. Maybe they did the retirement plan five years from retirement, and they said, “I want to earn $100,000 a year in retirement, because that’s what I’m earning now and I want a similar lifestyle.” But then there’s five years of improving their skillset and getting raises or promotions, whatever. Now their income is 110, but they still planned at 100. They’re not paying payroll taxes anymore and they’re not saving for retirement, so you see that kind of come down a little bit.

                           So, I would say if you’re right on the cusp of retirement and you’re going to need a little bit less in retirement than you’re earning now, you should be in deduction mode, so you’re in the IRA world, HSA world, things like that. If you’re retired, now we can undo those. If your income truly has gone down, now we can undo some of those deductions with Roth IRA conversions, accelerating some income, things like that.

                           So if your income is going to go down, we want to be in full blown deduction mode. Once your income has come down, now we can undo some of those and recreate what would’ve been a Roth IRA contribution, we’re just going to do it as a conversion. So for me, kind of five years, where do you see yourself in five years? Is your income going to be higher or lower? And then act accordingly.

Steven Jarvis:     Yeah, that’s a great framework to put around it. So related to this conversation about traditional IRAs and Roth IRAs, we need to talk about traditional and Roth 401(k)s, because this also comes up with our lovely acronyms. The same general concept applies as far as the tax treatment of them. The contribution limits are different whether you have access to an employer sponsored plan or not, so there’s definitely some advantages in how much we can contribute if it’s a 401(k) versus a standalone traditional IRA or Roth IRA.

                           But one thing I really want to highlight that can come as a surprise to a lot of people when it comes to Roth 401(k)s, because this is a more recent opportunity, this hasn’t always been available to taxpayers. So when you make Roth IRA contributions and your employer matches them, that matching contribution is not Roth dollars, because your employer wants their tax deduction, so they are putting in pre-tax money.

                           So sometimes people get a little bit surprised when they go to start, whether it’s rolling those dollars into a separate account or start using those dollars, that wait a second, that piece that my employer was putting in all the time is actually pre-tax money that I’m still going to have to pay taxes on. So, that’s really important to keep in mind.

Benjamin Brandt:         That sort of makes sense when you explain it that way, right? Your employer’s putting money away on your behalf, they’re going to want that deduction, right? They’re going to want that tax deduction. They’re sort of existing in perpetuity, they’re not going to retire. This business, I’m thinking of a big telecommunications company or utility or something, they’re going to be around forever, so they’re going to want that deduction now. Whereas, you’re going to retire someday and live off of this money.

                           So that’s one thing that really stands out to me, traditional 401(k), Roth 401(k), versus the IRA version is that the Roth IRA, if you make too much money, they’re going to phase out and then cap what your contributions could be or you’ll phase out completely. With the Roth 401(k), you’ve got a lot more flexibility on that, because it’s an employer sponsored plan.

                           The other thing that’s interesting is the traditional 401(k) is essentially everywhere. Essentially every employer, unless they’re very small, has one. The Roth 401(k) feels like it’s just not as common having the Roth option in the 401(k). So if you don’t have a Roth option for your 401(k), contact HR and see if you could maybe go about doing that.

                           They’ve been around for long enough that I think most providers are going to be able to have access to those. But with one of the big custodians, Fidelity, Schwab, things like that, Vanguard, you will, but that’s something to look into. I’m always, less and less these days, but I’ve found myself surprised in the past when clients want the Roth option in their 401(k) and don’t have it.

Steven Jarvis:     It’s definitely becoming more common, but I think you’re right on, Ben, that if you’re in a situation where this isn’t available to you, ask, because it really probably just comes down that no one has asked yet. It’s probably available through the custodian that your employer’s already using.

Benjamin Brandt:         Yep, contact HR and start there and see where you might end up.

Steven Jarvis:     Yeah.

Benjamin Brandt:         So Steven, how’d you like to move on to some listener questions?

Steven Jarvis:     Yeah, let’s do it.

Benjamin Brandt:         All right, question number one. I understand the attraction of Roth conversions, but based on analysis my planner has done, our required minimum distributions will not be “excessive.” Do Roth conversions still make sense in this case?

Steven Jarvis:     Yeah, like we talked about before, the impact on required minimum distributions or RMDs is only one piece of the consideration, so I certainly wouldn’t stop my assessment just because of that one factor. I also always hesitate when people use vague words like excessive, because what does excessive mean? Maybe this listener just didn’t want to bore us with the details, but we want to make sure that that’s quantifiable. Especially if someone’s trying to make a decision on my behalf or trying to give me advice for my personal situation, I want to decide what excessive means, because we might have very different ideas of what those are. But the impacts on RMDs is only one of the considerations.

Benjamin Brandt:         Yeah, excessive is a bit of a loaded word, right? When I think of excessive, what I’m assuming the word excessive means here, which is already a little bit of a sticky wicket. When I think about situations where Roth conversions are much more needed is when we’re not already spending 4% or 5% per year of our IRA, and then when required minimum distributions kick in, we would have to take out more than we would have to take out otherwise to fund our lifestyle.

                           So the perfect RMD is, let’s say you’re taking out $50,000 per year to fund your lifestyle expenses. Based on your budget, based on what you’re trying to accomplish in the second half of your life, $50,000 out of your IRA is what’s going to do it. The perfect RMD is $49,000, $48,000. It happens behind the scenes, you are going to take that out anyway to fund your lifestyle and it sort of disappears into behind the scenes. Now that RMD goes up every year, but you’re probably taking out more every year for inflation, things like that.

                           What we want to avoid is I need $50,000 a year for my RMD, or I need $50,000 a year, excuse me, to fund my lifestyle, because I’ve been in deferral mode too long, my RMD is $75,000. I only need 50, but I have to take out 75. Well, in this case, your income is spiking and you are going to pay income taxes based on that spike that we could have otherwise avoided almost entirely by accelerating income before 72, either by withdrawing the money and giving it away or putting it in a different account. Or in this case, we’re talking about Roth IRA conversions, taking that extra money out, accelerating income, voluntarily paying more taxes in order to pay less taxes later.

                           So when I see the word excessive, that’s where my mind goes, in that they’re already spending let’s say 5% per year out of their IRA. Out of their IRA, meaning that required minimum distributions are going to start below that amount. When I see excessive, that’s where my mind goes, so maybe that’s what they’re talking about.

Steven Jarvis:     Yeah, that’s really a great to think about it. We want to be evaluating this compared to what that cashflow need is, and beyond that we want to maintain as much flexibility as we can, because we’re all going to come across a time where we probably need more than just our regular projected cashflow. Hopefully it’s for an exciting reason like buying an RV, it might be because of a necessary reason like replacing your roof, but the more we can maintain flexibility, the more empowered we’re going to be to really live that life that we want in retirement.

Benjamin Brandt:         Yeah, I think flexibility and certainty. So if we’re not going to be in any trouble with RMDs, what might be some reasons to do a Roth conversion? Flexibility and certainty. So flexibility, I think we talked about that either in this episode or maybe a previous episode, in that I sort of know where I stand, I’ve got this bucket of money that I have access to with a phone call or a mouse click, and I’ve already paid the tax bill on that. So I’ve got that flexibility, but also certainty. I locked in an effective tax rate of let’s say 15%. So now no matter what income taxes do, we’re in temporary income taxes now that are likely to sunset at some point in the future. I locked in that rate and I know exactly where I stand, I’ve got that certainty.

                           But even beyond that, if I am fairly certain that I’m not going to spend all of my IRA and I want it to go to my kids, well, I can do a little tax arbitrage. What’s my tax rate after my career? After my peak earning years, what’s my effective tax rate? How old will my kids be when I die? Well, based on my clients being in their 60s when their parents die, I can assume that’ll be the case for me, they’re in their peak earning years.

                           If I die at my normal mortality age of let’s say 85, and you had your kids at 25, well, they’re going to be in their peak earning years on the cusp of retirement. So, what if I were to sort of do this math that I’m not going to spend all this money in my IRA, why don’t I pay some of those income taxes at my lower rate and save them the taxes that they would pay? Because they only have 10 years to take the IRA out if the rules don’t change between now and then.

                           If they’ve got 10 years into retirement, peak earning years, what, we’ve just stepped right on a tax land mine right there, we could have avoided a lot of this. So nothing to do with your RMDs today, but if we do want to give this gift, if we’re not so sure that we’re going to spend it all or if it looks like we’re trending in that direction, it might make sense to do that Roth conversion anyway.

Steven Jarvis:     Yeah. Ben, that’s really great to highlight, that tax planning really should be considering the lifetime of our wealth. Not just this year, not just our lifetime, but it’s not just, well, how are we going to use it, but what legacy do you want to leave for our kids, for charity, whatever it might be? But the longer-term perspective we can take on taxes, the more we can do to sand off those rough edges of our tax bill.

Benjamin Brandt:         Like anything else with financial planning, the further we plan ahead, the better it’s going to be for us. So, I think that about does it for our time, Steven. Anything else to add?

Steven Jarvis:     Nope. Ben, this has been great. Thanks everybody for listening. Until next time, remember, don’t let the tax man hit you where the good Lord split you.

Benjamin Brandt:         We’ll see you next time.

Hi, everyone. Quick reminder before you go. While Ben and I feel very strongly about the information we’re sharing on this podcast, it is for educational purposes only and should not be taken as specific tax investment or legal advice. You need to make sure that you are working with a professional to evaluate how these concepts apply to your specific situation before you take action.