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Key Factors in the IRA Debate

Christine Benz

Michael Kitces is a partner and the director of research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View. You can follow him on Twitter at @MichaelKitces or connect with him on Google+.

Christine Benz: Hi, I'm Christine Benz for It's IRA season, and one of the key decisions facing investors is whether to invest in a Roth or Traditional IRA. Joining me to discuss that topic is financial-planning expert Michael Kitces.

Michael, thank you so much for being here.

Michael Kitces: Great to be here, thanks.

Benz: Michael, you put out a piece on your blog where you were looking at the decision about whether to contribute to a Traditional IRA or to a Roth IRA. It's IRA season, so people are contemplating which is the right contribution type to make. You outlined four key factors that should go into that decision making. The biggest one in your view is current tax rate versus what you expect your tax rate to be in the future.

Kitces: We've seen all of these different kind of discussions and framings around what's better, Roth versus Traditional. We tried to do some research and pulled together all of the different arguments, all the different threads, and all the different things that people say. And we really found that it comes down to only four factors, and one of them is really the dominating one: tax rates. It's simply to recognize at the end of the day, if we've got this money that we've earned pretax and we're trying to figure out where to send it, should we send it to the IRA or the Roth side?

If we send to the [Traditional] IRA side, we get a deduction now, we pay the taxes later. If we send it to the Roth side, we pay the taxes now, and then we don't have to deal with them later. That fundamental split really actually just comes down to: If you are going to pay the taxes now or you are going to pay the taxes later, pay the taxes when the rate is lower, and then you finish with more money.

Benz: The amount that you expect to contribute also should be a factor in the decision-making. Let's talk about how that works and why that would matter?

Kitces: The amount matters, but often not in the way that people think of it. So, I've seen a lot of people say things like, "I'm contributing a big amount, so I really want to do it in a Roth so it can grow tax-free." Or "I'm really optimistic about this investment, so I want to put it in a Roth to get the bigger growth rates on the tax-free side."

As it turns out that alone doesn't necessarily drive the factor. If it's a really big contribution and your tax rate is really high right now, you should get the really big tax deduction of contributing it to the Traditional side and then still paying your taxes later when they are lower, or likewise if, you are going to get a great growth rate, but it turns out your taxes would have been lower in the future, you still should've done the Traditional. That just means you would have gotten the great growth rate and saved even more by not contributing to a Roth.

Benz: Let's talk about the role of required minimum distributions in this decision-making. Obviously, if you're investing in a Traditional IRA, you are subject to those RMDs; Roth assets are not. So how should investors think about this decision? Most affluent inventors want to avoid those RMDs.

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Kitces: Certainly we see this preference toward avoiding RMDs. Now, I joke a little with some of our clients. We have a few clients that are really upset about their RMDs, but the reality is they are actually using their retirement accounts to spend. It's kind like you were going to spend the money and have the tax bill anyway. We don't like what Uncle Sam tells us we have to do, but ironically for some people it's not actually even the [tax] impact that we worry about. If we're actually using that money, we were going to take it out anyways.

But certainly there is a subset of people that maybe don't need their IRA assets or don't need them yet. They want to use other dollars first. They want to let their dollars compound and grow a little more, and we lose that option when we have required minimum distributions from retirement accounts. Roths do become appealing in that manner. If I hold on to my money in a Roth, I avoid my required minimum distributions, so I keep the money in there longer, and that really is the value. I keep more money in the accounts with all of its tax preferences working for me. If I'm on the Traditional side, it starts forcing the money out.

Now there are two important caveats to that. The first, particularly for people who maybe are still in a contribution-accumulation phase, so this might not be a conversation for 20 or 30 or 40 years until they are going to be turning 70 1/2. Frankly, there is no assuredness that the lack of parity between these rules stays the way that it is. We actually saw a proposal just recently coming out of President Obama's budget that maybe we're going to lose this distinction and Roths someday may be subject to required minimum distributions. Technically, Roth 401(k)s and Roth 403(b)s are subject to required minimum distributions now. You could avoid that by going to a Roth IRA, but the days for that preference might actually be numbered, and frankly it wouldn't be surprising to me looking at what's going on just with retirement tax policy right now that that's a legitimate danger.

Now, at worst, it simply means the accounts are aligned and once again, we're back to things like current versus future tax rates. So, it doesn't make the Roth bad. It just means we may lose that as a preference.

The other thing worth noting, the reality is required minimum distributions in the early years are not huge. Just a couple percentage points of the account, and if it's money that ultimately you were going to spend anyway, so maybe you just spent it or withdrew it a few years earlier, frankly the actual wealth difference is not significant.

The other thing worth noting about just this idea and value of avoiding required minimum distributions, when we actually do some of the math and kind of run the projections, it matters a lot if you live into your 90s, when the required minimum distributions get really big and you've been doing them for 10 or 20 years. There's actually remarkably little benefit to avoiding required minimum distributions, maybe just through your 70s if it's money that eventually someone was going to spend anyways, you or your beneficiary. So, there is some value to avoiding RMDs by having Roths but, only if we keep the rules, which is not assured on that end and really only if you live well past age 70 1/2, so well into your 80s or into your 90s or beyond, then the value really starts to add up.

Benz: Let's discuss the role of estate tax in all of this. You say that the federal estate taxes actually don't matter a lot in this situation, and I'm hoping you can discuss why. But state estate taxes do matter. How should that factor into someone's decision-making on this front?

Kitces: Good question. We see this strategy kind of come up and get proposed a lot. This idea of let's say I've got a big IRA, I've got a lot of other assets, and I'm exposed to the estate taxes. The idea is if I convert my IRA now, and, if it's a big IRA, maybe I pay a couple of hundred thousand dollars in taxes, my whole asset base is now several hundred thousand dollars smaller, which means when Uncle Sam comes in to apply estate taxes, I just don't have as much money. I gave Uncle Sam my income tax bill upfront. So, now I have less to be subject to estate taxes.

The caveat at the federal level is we actually have this deduction. It's not very well-known. It's called the 691(c) deduction or the Income in Respect of a Decedent deduction, IRD. And what the IRD deduction says is, if you have a pretax asset like an IRA and you pay estate taxes on it, your beneficiaries in the future get an income tax deduction for any of the estate taxes that you paid. So, if your IRA caused an extra $400,000 of estate taxes--you had a $1 million IRA and the top rate is 40%--if you paid an extra $400,000 for estate taxes due to your IRA, when your beneficiaries spend the money, they will actually get a $400,000 income tax deduction and only pay taxes on the last $600,000. What that deduction does is it actually gets rid of all of the value of doing this conversion before you pass away.

You sort of get this circular process. I can pay my income taxes first and then have less of estate taxes, or I can pay my estate taxes and then get a deduction against my income taxes. They come out the same, and in fact the whole reason why the IRD deduction exists, its sole reason for being is to make sure that these come out the same, just so that people don't start distorting their investments and by holding an investment and asset decisions by trying to go through the strange tax dodge.

It doesn't actually help. In fact, ironically for a lot of situations, we've seen people do this, and it actually hurts them to convert to Roths and try to give Roths to their children. And the reason is if you have enough wealth to be subject to the estate tax in the first place, you're probably in a fairly high tax bracket. When you distribute that money out to kids where you may split it among multiple children they tend to be younger, they tend not to have a lot of other income already maybe because they're still getting their own careers going. The reality was, we've seen scenarios where mom and dad converted at 40% tax rates, they could have given it to kids who would have paid 25% tax rates, and they actually lost 15% of their wealth by converting at high rates instead of low rates.

It actually comes back to that same current versus future tax rate; the current rate is mom and dad's rate and the future rate is the kid's rate. And sometimes the kids' rates are actually lower, and you just want to leave them a good old Traditional IRA.

Now, while all of that is true with the federal tax system, there is a difference at the state level. If you were in one of the, I think there are still 21 states that have estate or inheritance tax. States do not have an IRD deduction. So, at the state level, if I do this conversion before I passed away, and I pay Uncle Sam and the state their share of income taxes, when the states come and look at this, they really do just see a smaller estate and charge less in estate taxes. And this idea of "At least if I pay the estate taxes, I get an income tax deduction later," that doesn't work at the state level. States don't have conformity on this.

If I have a state estate tax, if I'm in one of those states where that's an issue, there is a little bit more value to doing a Roth conversion before I pass away and giving Uncle Sam a share. Now, you still have to do a trade-off here. If I pay too much in extra income taxes, I'll pay more in income taxes than I was going to save in state estate taxes because the state rates are lower. But we have seen scenarios where it was appealing to do a Roth conversion to leave someone a Roth because they're trying to avoid state estate taxes. But it's really only an issue at the state level; it's not a federal issue.

Benz: Michael, it sounds like in listening to these factors and listening to your analysis around them, it sounds like a lot of the factors line up around Roth if you are a wealthier individual. Would you say that's generally correct?

Kitces: Yes or no. If you're wealthy, the factors line up to have a Roth; they don't necessarily line up to create a Roth. The problem is creating a Roth means paying a lot of taxes now, and if you're in a high tax bracket, that's actually not a good deal. Sort of the ideal scenario is, you're doing Roths when you're young and your income is low and you haven't created a lot of wealth yet, such that by the time you are wealthy--and now there is more assets and more income and higher tax rates--you're drawing on the wealth and the Roth tax-free.

If you're actually already in a situation where you're rather affluent, and you've already gone up the income tax bracket scale, we actually see problems often with doing Roths where we're just paying high tax rates today, and it turns out the best thing we could have done is put it into a Traditional account, get the tax deduction, let it accumulate for a long time, and give it to the next generation who are going to be in lower tax rates because they're probably younger and earlier in their careers, and we're going to split the assets among multiple people, which kind of brings each person's [tax load] down individually.

We actually still see a lot of scenarios where the best thing affluent folks can do is create a whole bunch of Traditional pretax accounts at their high rates and leave it to the next generation at low rates.

Benz: Michael, great insights. It's always great to hear from you.

Kitces: My pleasure.

Benz: Thanks for watching. I'm Christine Benz for