Following the When Roth is Wrong post, readers responded with various questions and, sometimes, with a different form of the same question. I address several of those questions below since they’re good questions and may be helpful for other readers.
Q: If we end up leaving the retirement accounts to our children, doesn’t that make Roth 401k contributions more favorable relative to the pre-tax Traditional 401k contributions since the Roth account will be tax-free to my children? Also, doesn’t this help avoid required distributions and isn’t this somehow better for estate taxes?
A: Let’s tackle each of the concepts that underlie this “Roth is better for inheritance” thinking:
The kids will appreciate that we are leaving them with tax-free accounts rather than leaving them with accounts that will be burdened with an unpaid tax liability.
There is no debating that any beneficiary would rather get $100 in a Roth account vs. $100 in a pre-tax Traditional account. Unfortunately, this is not an apples to apples comparison since there is a tax cost to getting the funds into the Roth account.
Again, it boils down to tax rates now and in the future. Assume that mom and dad are financially successful and that any additional income they incur faces a 40% marginal tax rate. Further assume that the kids will likely face a 25% tax rate in the future, even after their inheritance. If mom and dad have to pay additional combined state and federal taxes of $40 to convert $100 into a Roth IRA, then the rest of the estate is $40 smaller than it otherwise would have been (plus the post-tax appreciation on this $40). If they had simply left the pre-tax IRA assets to their kids, the kids could convert the $100 for a cost of only $25. As a result, if the kids face lower marginal tax rates than mom and dad, it’s actually advantageous for the kids to inherit pre-tax assets and then pay the taxes on their own.
If we end up leaving these accounts to our children, the time period for tax-free growth will be really long and so the immediate cost of higher taxes will be offset by the lengthy period of tax-free growth.
The unfortunate truth is that the long time period for tax-free growth is only advantageous if the future tax rate for distributions is lower than the tax rate when Roth contributions occur. Otherwise, you’re just compounding the problem.
Additionally, it is likely that a bipartisan retirement bill which has already passed the House and Senate will become law in the coming months, thereby limiting the “stretch” period of inherited IRAs to no longer than 10 years.
Roth accounts do not have required minimum distributions (RMDs) like Traditional 401k accounts so the kids can “stretch” the tax benefits for a longer period.
A few things to clarify here. First, Roth 401k accounts face the exact same required minimum distributions (RMDs) beginning at age 70.5 as Traditional 401k accounts. The difference is that Roth IRAs are not presently forced to take RMDs starting at 70.5 so an individual can rollover a Roth 401k to a Roth IRA before the calendar year in which he/she turns 70.5 to avoid the required distributions.
The second item to note is that while Roth IRA accounts do not presently face required distributions, it seems likely that they will be brought to parity with all other such retirement accounts in the next few years.
Furthermore, inherited Roth accounts – whether Roth IRA or Roth 401k – both face required distributions provided that the beneficiary is not a surviving spouse. That means that regardless of what happens in Congress with possible changes to Roth IRA distribution requirements, non-spousal beneficiaries who inherit Roth IRA accounts will encounter the same required distribution rules as non-spousal beneficiaries who inherit Traditional IRA accounts.
Roth accounts have an estate tax advantage because the prepayment of income taxes reduces the size of the taxable estate.
While there can be an estate tax benefit to having funds held in a Roth account relative to a Traditional tax-deferred account, the expanded estate tax credits make it exceedingly unlikely that anyone reading this post will face any estate tax. The current credit, for example, results in an estate exemption of approximately $23 million for married couples in 2019. This means that unless a married couple intends to leave more than $23 million to heirs, there is no estate tax and the “estate tax advantage” is not really an advantage.¹
Q: I understand the logic regarding Roth accounts being ineffective for high income individuals but what about for my children who are early in their career? Should they still be contributing to Roth IRA accounts?
A: Absolutely. To be abundantly clear: Roth contributions are incredibly powerful and beneficial for most young professionals. Quoting the original post:
All else equal, what matters in the comparison of deferring to a Roth IRA/401k versus a Traditional IRA/401k is simply your marginal tax rate now versus your expected marginal tax rate when dollars are distributed.
The economics of a Roth account work best when you have one or both of two things: 1) a lower marginal tax rate now than your expected future rate; and 2) time. Young professionals tend to have both. They clearly have time until retirement for the tax-free compounding effects of the Roth to materialize. Additionally, many young professionals in the early part of their career find themselves with lower income and in a lower tax bracket relative to their expected future income and tax bracket. For these reasons, the economics tend to overwhelmingly support most young professionals in their 20’s and 30’s using the Roth 401(k) for all retirement deferrals.
Q: I am almost retired and do not have any tax-free Roth money. Shouldn’t I be saving to a Roth account in my final years of work, even if my income is high, just to create some flexibility in retirement?
It’s a good thought and definitely not one to quickly dismiss. Saving to a Roth account certainly helps create a tax hedge since you’re less exposed to future tax rates because of the tax-free Roth distributions. This is the “flexibility” of which you describe. And that flexibility has some value.
But a hedge doesn’t always make economic sense. Consider purchasing really expensive life insurance. Yes, it provides a hedge. But at what cost? If you’re paying a rich price for the hedge (i.e. insurance), then the expected value is deeply negative.² The same thing is true of buying protective put options during a market panic. Yes, they provide protection but there’s a cost at which the protection or hedge makes no economic sense.
This question is hard to answer in a vacuum because the answer is so specific to the situation. For example, the value of this “flexibility” depends on whether you have significant taxable assets, what your distribution rate in retirement is likely to be, whether you have real estate that is likely to be sold in retirement, and several other factors. But, if your current marginal tax rate is expected to be roughly the same as your future marginal tax rate and you have no tax-free Roth money at present, then it definitely can make sense to defer some funds to a Roth just to create better tax planning flexibility in retirement.
Have other questions about Roth accounts? Do not hesitate to leave them in the comments section below.
¹Even for the very rare estates that do face an estate tax, the oft-ignored IRD deduction alleviates some of the advantage for Roth accounts relative to Traditional accounts.
²It’s worth noting that insurance always has a negative expected economic value as there’s no free lunch. This is getting at the point that the expected economic value goes even further in the red when the cost of insurance is egregiously expensive.