This tax season, several new clients came to me with unfortunate Roth IRA issues.
They were deceived into thinking that such an IRA was beneficial to their situation. They mistakenly contributed to a Roth after-tax plan and lost thousands of dollars, even 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 is only taxed on the actual retirement distribution, so if the money were lost due to poor investment decisions, there would be no tax. 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 other than more money now! Lots of things can happen between now and retirement that result in less taxes or no tax being paid at all!
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 tax rules could change, an emergency like Covid-19 could allow 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 person can create and fund a pre-tax MS plan 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 both individual and business contributions.
A Roth after-tax retirement plan does the opposite! Speed up otherwise unpaid taxable income until you distribute the funds after retirement! Ask the tax authorities to “Please tax me now!”
It is almost never wise to speed up taxes that would otherwise be due in the distant future!
So why the hell would someone choose an after-tax Roth retirement plan or a Roth conversion (of funds in a traditional pre-tax plan)?
Well, if you have a very bad year with no job and a lot of losses, due to Covid-19 or otherwise, your taxable income may 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 it and meet the December 31 deadline for a tax return. Roth conversion. By the time they reach my office it is already 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 are not allowed to deduct a contribution to a traditional plan might prefer to contribute to a plan on an after-tax basis if it is allowed, since there is no current deduction anyway.
And people within a year or two of retirement may prefer to contribute to a Roth plan that doesn’t have eventual required minimum distributions.
There are other subtle differences between a traditional plan and a Roth.
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 doing badly or closing deals, ask them if they have 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 you have a discussion with your tax professional to make sure it really works for you!