This tax season, several new clients came to me with unfortunate Roth IRA problems.
They were misled into thinking that such an IRA was beneficial to their situation. They mistakenly contributed to an after-tax Roth plan and lost thousands of dollars, including tens of thousands of dollars, in potential tax deductions.
A traditional pre-tax retirement plan allows most taxpayers to deduct their contribution to the plan. This delays taxes until retirement and the taxpayer only pays taxes on the actual retirement distribution, so if the money were lost due to poor investment decisions, there would be no taxes. This traditional pre-tax plan is what most taxpayers want. It is ideal for most W2 earners.
Delaying taxes with a traditional pre-tax plan has advantages in addition to more money now! A lot can happen between now and retirement that results in lower or no taxes!
If the taxpayer ever has a low income year, they can do a Roth conversion with little or no tax. The investment may be lost, in which case there is no tax. The taxpayer could die, in which case he would not have to pay taxes during his lifetime. And the fiscal rules could change, an emergency like Covid-19 could allow the early withdrawal of retirement funds.
The amounts involved can be large. If the employer offers a traditional 401k on a pre-tax basis, the contribution limits are even higher than with an IRA. A self-employed individual can create and fund an MS plan on a pre-tax basis with even higher contribution limits. And if the only employees are the owner and his spouse, then a pre-tax Solo 401k allows for much higher contribution limits with contributions from both the individual and the business.
An after-tax Roth retirement plan does the opposite! Accelerates taxable income that would not otherwise be paid until funds are distributed after retirement! Ask the tax authorities to “Please record me now!”
It is almost never wise to accelerate taxes that would otherwise be due in the distant future!
So why the hell would anyone choose a Roth after-tax retirement plan or a Roth conversion (of funds in a traditional pre-tax plan)?
Well, if one has a very bad year without a job and a lot of losses, due to Covid-19 or otherwise, the taxable income can be low, zero or negative. In a situation like this, it makes sense to accelerate future income that would eventually be taxed at a higher rate in the current low-income year when the tax bracket is low.
The problem in that situation is that the taxpayer often thinks “I did so badly I don’t need to file taxes” and never bother to meet with a tax planner to talk about this and meet the December 31 deadline for a tax return. Roth conversion. By the time they arrive at my office it is too late.
Some real estate investors show negative income due to depreciation tax shelters or otherwise, and benefit by accelerating future income in current loss years.
People who aren’t allowed to deduct a contribution to a traditional plan might prefer to contribute to an after-tax plan if it’s allowed, since there’s no current deduction anyway.
And people within a year or two of retirement may prefer to contribute to a Roth plan that has no eventual required minimum distributions.
There are other subtle differences between a traditional and a Roth plan.
However, in my experience, less than 1% of my clients would actually benefit from a Roth. The far more common mistake is choosing a Roth plan without fully understanding the tax costs.
So consider meeting with a tax professional before the end of the year, particularly during bad years when tax collection of losses can help turn lemons into tax lemonade. If your friends or family are having a hard time or are going out of business, ask them if they’ve met with a tax professional before the end of the year.
And don’t make the all-too-common mistake of choosing an after-tax Roth retirement plan before having a discussion with your tax professional to make sure it really benefits your situation!