William Reichenstein, Ph.D., CFA, is head of research at the software firms Social Security Solutions Inc. (ssanalyzer.com) and Retiree Inc. (incomesolver.com). He is professor emeritus at Baylor University, and is a frequent contributor to the Journal of Financial Planning and other leading professional journals. His latest book is Income Strategies: How to Create a Tax-Efficient Withdrawal Strategy to Generate Retirement Income.
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There is a strong possibility that tax rates will rise in the next few years by more than the tax rate increases that are already scheduled to occur in 2026 according to the Tax Cuts and Jobs Act (TCJA). And, due to the taxation of Social Security benefits and income-based Medicare premiums, many retirees will have substantially higher marginal tax rates in retirement than their then-current tax brackets. As a result, many investors can expect to have higher marginal tax rates in their retirement years than in their pre-retirement years.
This column recommends advice financial advisers can provide this year and perhaps the next few years to help clients—especially pre-retirement-age clients—take advantage of what my colleagues and I believe are today’s temporarily relatively low tax rates. In the next few years, while tax rates are relatively low, pre-retirement-age investors should consider: (1) saving in tax-exempt accounts like a Roth 401(k) instead of tax-deferred accounts like a 401(k); and (2) making Roth conversions to fill today’s relatively low tax brackets.
Background
The key factor when deciding whether to save this year for retirement in a tax-deferred account (TDA) such as a 401(k), 403(b), or traditional IRA, or an equivalent after-tax amount in a Roth account such as a Roth 401(k), Roth 403(b), or Roth IRA, is the comparison between this year’s marginal tax rate, t0, and the expected marginal tax rate when the funds will be withdrawn and spent in retirement, tn. The marginal tax rate is the tax rate on the next dollar of income. The key factor when deciding whether to make a Roth conversion this year is also the comparison between t0 and tn.
In other words, the key comparison is the relative sizes of these two marginal tax rates, not the relative sizes of the client’s tax brackets this year and in retirement. For most investors younger than retirement age, this year’s marginal tax rate is their highest tax bracket this year. As explained later, the marginal tax rate for many, if not most, retirees will substantially exceed their highest tax bracket that year.
For simplicity, but without loss of generality, assume Betty is deciding whether to save $1 of pretax funds this year in a TDA or $1(1 – t0) of after-tax funds in a Roth account. Her marginal tax rate this year, which is her tax bracket, is 24 percent. Thus, the comparison is between saving $1 in a TDA or $0.76 in a Roth account. The $1 contribution to the TDA reduces her taxable income by $1, which reduces her taxes by $0.24. So, this $1 contribution reduces her spending this year, which requires after-tax funds, by $0.76. Similarly, the $0.76 contribution of after-tax funds to her Roth account would reduce this year’s spending by $0.76. So, these are equivalent contributions, because each contribution would reduce her spending this year by $0.76.
To hold everything else constant, let’s assume the funds are invested in the same asset, which earns a geometric average annual pretax return of r percent per year before the funds are withdrawn and consumed in n years. In n years, the pretax value of the TDA is $1 (1+r)n. Its after-tax value in n years is $1 (1+r)n (1 – tn). The after-tax value of the Roth account in n years is $1 (1 – t0) (1+r)n. Comparing these two after-tax amounts shows that the key factor when deciding whether to contribute funds to a TDA or a Roth account is the relative sizes of t0 and tn. If t0 is less than tn, then the contribution should be made to the Roth account, and vice versa.
Now, let’s compare the after-tax values in n years of $1 held today in a TDA under two scenarios. In the first scenario, the funds are converted to a Roth account this year, while in the second scenario the funds are retained in the TDA. In both scenarios, the funds are withdrawn and spent n years hence. If converted to a Roth account this year, its after-tax value after conversion is $1 (1 – t0), while its after-tax value n years hence is $1 (1 – t0) (1+r)n. If retained in the TDA, its pretax value in n years is $1 (1+r)n, while its after-tax value n years hence is $1 (1+r)n (1 – tn). As before, the key factor when deciding whether to make a Roth conversion this year is the relative sizes of t0 and tn. If t0 is less than tn, then the Roth conversion this year makes sense, and vice versa.
What about the Benefits of Tax-Deferred Growth?
Financial professionals have told me that this analytic framework ignores the benefits of tax-deferred growth. While there are benefits of tax deferral when stocks are held in a taxable account and when bonds or stocks are held in a non-qualified annuity, there is not a tax-deferral advantage when considering the decision to contribute this year to a TDA or a Roth account or the decision to make a Roth conversion this year. For these decisions, the key factor is the relative sizes of t0 and tn, but they have nothing to do with the length of the investment horizon.
Suppose the TDA amount to be converted to a Roth account is $10,000. These pretax funds would keep the taxpayer in the 12 percent tax bracket, and the taxpayer is at least age 59.5 at the time of the withdrawal. In this case, she could move $8,800 into the Roth account and use the remaining TDA funds to pay the associated taxes. In contrast, if she is under age 59.5, the TDA funds withdrawn to pay the taxes would be subject to a 10 percent penalty tax, because these funds were not converted to a Roth account. As a result, she would owe $1,056, [12 percent of $8,800] on the funds converted to a Roth account, and $264, [22 percent of $1,200] on the funds that were withdrawn from the TDA before age 59.5 but not converted to a Roth account. The total taxes of $1,320 exceeds the $1,200 withdrawal from the TDA that was intended to pay the entire tax bill.
In such situations, when possible, the $10,000 of TDA funds should be converted to a Roth account, and the $1,200 in taxes should be paid from funds held in a taxable account. In most cases, taxpayers younger than age 59.5 can find funds to pay the taxes from other sources besides the TDA funds. Nevertheless, this example explains a potential problem that may make Roth conversions inappropriate for some taxpayers younger than 59.5.1
In summary, if this year’s marginal tax rate is lower, clients should save this year in the tax-exempt Roth account and they should make a Roth conversion this year.
Retirees’ Marginal Tax Rates Often Exceed Tax Brackets
For pre-retirement-age taxpayers, their marginal tax rate is usually their tax bracket. This statement is generally accurate for pre-retirement-age single taxpayers with incomes below $200,000, and pre-retirement-age married couples filing jointly with incomes below $250,000. If these taxpayers’ income exceeds these threshold levels, the net investment income tax and Medicare surtax may cause their marginal tax rates to be, respectfully, 3.8 percent and 0.9 percent higher than their tax bracket.
In contrast, many, if not most, retirees will have marginal tax rates that substantially exceed their tax brackets. The taxation of Social Security benefits causes most lower- and middle-income retirees’ marginal tax rates to be 150 percent or 185 percent of their tax bracket on a wide range of their income.2 Within this wide income range, each $1 withdrawn from a TDA causes either an extra $0.50 or $0.85 of Social Security benefits to be taxed. So, their taxable income rises by $1.50 or $1.85.
Furthermore, income-based Medicare premiums can cause huge spikes in household’s marginal tax rates.3 For example, a $1 increase in 2018 income could cause a single individual’s annual Medicare premium in 2020 to increase by more than $1,272. This is effectively an income tax, because the $1 increase in income increases the amount of money this individual owes to the federal government by more than $1,272. Similarly, a $1 increase in 2018 income could cause a married couple’s annual Medicare premium in 2020 to increase by more than $2,544.
I suspect most pre-retirement-age taxpayers are not aware that the taxation of Social Security benefits and income-based Medicare premiums can cause these spikes in retirees’ marginal tax rates. If they are aware, they may feel that they have nothing to do with them because they are years, if not decades, from retirement. These pre-retirees are wrong! They should consider steps they can take now to minimize the adverse effects of these retirement-age spikes in their marginal tax rates.
Unless Congress fundamentally changes the rules affecting the taxation of Social Security benefits or eliminates income-based increases in Medicare premiums, then pre-retirees should consider saving in Roth accounts and making Roth conversions before retirement.
Future Tax Rates Compared to Today’s Tax Rates
For single taxpayers, the 2020 tax rate will be 10 percent on taxable income up to $9,875; 12 percent on income between $9,875 and $40,125; 22 percent on income between $40,125 and $85,525; 24 percent on income between $85,525 and $163,300, and so on. Similarly, we know what the tax rates and tax brackets will be for other households. We also know that, as legislated in the TCJA, tax rates and tax brackets are scheduled to revert in 2026 to the higher tax rates and often less favorable tax brackets (after adjustments for inflation) that existed in 2017.
Not only are tax rates scheduled to rise to 10 percent, 15 percent, 25 percent, 28 percent, etc.; tax brackets are scheduled to be less favorable, too. For example, for married couples filing jointly, some of the income in the current 24 percent tax bracket is scheduled to be taxed at 28 percent, but most of this income is scheduled to be taxed at 33 percent. Prior to the coronavirus pandemic and its impact on the federal budget, some Republicans talked about extending these historically low tax rates and tax brackets beyond 2025. But my colleagues and I have not heard any such discussion since the pandemic hit the United States.
Furthermore, given the Congressional Budget Office’s projected deficit of $3.7 trillion for fiscal year 2020, which would push the national debt to 101 percent of gross domestic product,4 my colleagues and I believe tax rates may rise before 2026, and the increases could be substantially larger than scheduled in the TCJA.
We are confident that today’s relatively low tax rates will continue for 2020 and 2021 but, depending on the outcome of the 2020 elections, major tax legislation could be passed in 2021 that would raise taxes, potentially substantially, beginning in 2022. In short, taxpayers should consider the actions they can take in 2020, 2021, and perhaps the next few years before today’s relatively low tax rates rise, perhaps substantially. The implications of the scheduled hikes in tax rates and the possibility of additional tax hikes in the next few years have investment implications for investors of all ages.
Investment Advice for Pre-Retirement-Age Investors
Pre-retirement-age investors include virtually all investors age 61 or younger. Simply put, most 61-year-old investors do not have to worry about how their 2020 income will affect: (1) the taxation of their non-existent Social Security benefits in 2020; or (2) the level of their non-existent Medicare premiums two years hence. Similarly, a 30-year-old married couple does not have to worry about how their 2020 income will affect: (1) the taxation of their non-existent Social Security benefits in 2020; or (2) the level of their non-existent Medicare premiums two years hence. Furthermore, some investors older than age 61 in 2020 will not receive Social Security benefits this year and they will not be on Medicare two years hence. So the advice here also applies to them.
Suppose a pre-retiree has a marginal tax rate, which is also her tax bracket, of 22 percent. She can convert TDA funds to a Roth IRA at 22 percent this year. If retained in the TDA until retirement, these funds may eventually be taxed at marginal tax rate of 46.25 percent, [25 percent tax bracket as scheduled in TCJA x 1.85, where 1.85 is due to the taxation of Social Security benefits]. In this case, each dollar converted this year to a Roth IRA would be worth 45.1 percent more after taxes in retirement, [(1 – 0.22)/(1 – 0.4625) – 1] than if these funds were retained in the TDA until retirement. Similarly, each $0.78 of after-tax funds saved in a Roth account this year would be worth 45.1 percent more after taxes in retirement than each $1 of pretax funds saved in a TDA this year.
Suppose new legislation raises the retirement years’ tax bracket for this investor to 28 percent. In this case, the after-tax advantage of saving in a Roth account this year and making a Roth conversions this year could be 61.8 percent, [(1 – 0.22)/(1 – {0.28 x 1.85}) – 1].
Finally, consider a young single female. She can convert $1,000 to a Roth IRA this year at a 12 percent marginal tax rate, which is also her tax bracket. The $880 of after-tax funds grows to $4,400 at the time of withdrawal in retirement decades later. In contrast, if retained in a TDA and invested in the same underlying investments, its pretax value at the time of withdrawal will be $5,000. Suppose she is in the 25 percent tax bracket, but this $5,000 withdrawal causes her Medicare premiums two years later to rise by $3,750. In this case, the combination of $1,250 in income taxes plus the $3,750 in higher Medicare premiums would take 100 percent of her $5,000 withdrawal. Obviously, she would be much better off converting these funds to a Roth IRA this year.
As illustrated with these examples, financial advisers can add substantial value to clients’ accounts—and to their children’s accounts—by recommending that they take advantage of today’s relatively low tax rates. This advice applies to pre-retirement-age investors that may be years, if not decades, from retirement.
Endnotes
- In this example, if the taxes on the Roth conversion had to be paid from the TDA funds, the average marginal tax rate on her withdrawal would be 13.33 percent. She could convert $8,666.67 to a Roth account and pay a 12 percent tax rate on these conversions, and the remaining $1,333.33 would be taxed at 22 percent for a total tax bill of $1,333.33. In this example, the investor should view t0 as 13.33 percent. However, most investors can and should pay the taxes from funds held in their taxable account.
- For more on this, see Income Strategies (2019) by William Reichenstein. See also the following articles by William Reichenstein and William Meyer: “Using Roth Conversions to Add Value to Higher-Income Retirees’ Financial Portfolios,” February 2020 Journal of Financial Planning, and “Understanding the Tax Torpedo and Its Implications for Various Retirees,” July 2018 Journal of Financial Planning.
- See incomme Strategies and “Medicare and Tax-Planning for Higher-Income Households,” 2019 Journal of Wealth Management (volume 22, issue 3).
- See The Wall Street Journal article, “Debate Over Impact of Deficits Resurfaces,” by Kate Davidson and Richard Rubin, May 5, 2020.