[This is a guest post from Bogleheads investment forum participant Bob’s not my name as a follow-up to his previous post How to Build a Time Machine With IRAs – Part 1.]
In Part 1 we discussed how your money can use a deductible traditional IRA to travel forward in time and to a different place to find more favorable tax treatment. In Part 2 we’re going to look at using a Roth IRA to travel backward in time.
Let’s consider a 30ish couple who are now in the 15% federal bracket with a 5% state tax, the full effect of which they feel because they don’t itemize. 20% total marginal rate.
Now grasp the bony hand of the Ghost of Taxes Future and fly with him to 20 years hence. The couple now have three kids aged 19, 18, and 13. They are making good money, but a lot of it is going into the insatiable maw of government. They’ve moved to an 8%-income-tax state. They itemize now so their state tax is deductible.
They might be in the American Opportunity Credit phaseout, which makes their marginal rate 56%. They might be in the Child Tax Credit phaseout, which makes their marginal rate 36%. They might be in the AMT and the American Opportunity Credit phaseout, which make their marginal rate 65.5%. (In our dismal tale federal income tax has not been revamped to make it less complicated, and all these stupid credits have been extended, so we’re assuming today’s rules are still in effect. If you think that requires too much suspension of disbelief, I would argue that these phaseouts and weird gotchas will only proliferate.)
It’s not just the government that wants their money. Their kids’ colleges want it, their mortgage lender wants it, and their 13-year-old wants it to buy ice cream. During these intense family years (which do pass) they can’t afford to contribute $22,500 to a 401k and $6,000 to a spousal traditional IRA, but at such high marginal tax rates they can’t really afford not to contribute, either.
Solution: they withdraw from their Roth IRA to make it possible to max their pre-tax retirement accounts. It’s effectively a Roth IRA conversion to a traditional 401k. You can withdraw Roth contributions (but not earnings) at any time without penalty.
Let’s do the math. Couple A contribute to Roth IRAs in their early years, leave it there, and fail to max out their traditional accounts later. Couple B contribute to Roth IRAs in their early years but raid them later to max out their traditional accounts in their high bracket years.
Let’s assume investments double in value every 20 years. Let’s assume a 20% marginal rate in their early years, a 40% marginal rate in their peak earning years, and a 30% marginal rate in retirement (because the baby boomers lobby hard for higher tax rates on themselves).
- $10,000 Roth IRA contribution
- Grows to $20,000
- Make no incremental 401k/spousal traditional IRA contribution
- At age 70: $40,000 Roth, $0 401k
- After tax value: $40,000
- $10,000 Roth IRA contribution
- Grows to $20,000
- Withdraw $10,000 contribution to make $16,667 401k/spousal traditional IRA contribution (saving $6667 in taxes, which is where the extra comes from)
- At age 70: $20,000 Roth, $33,334 401k
- After tax value: $20,000 + $23,334 = $43,334
This doesn’t change the foundation message that you should max out all your tax-advantaged options every year. But most people can’t afford to, especially in the high tax, high spending family years, and frankly don’t need to to enjoy a comfortable retirement. A working couple can contribute more than two million to tax-advantaged accounts over the course of their careers, and so can have many millions to retire on.
Caveat: if you are relying on your Roth contributions to cover an emergency that is not unemployment, disability, or death, you may not want to do this.
Thus you have completed your Time Machine. It has two levers. A traditional IRA allows you to travel forward in time clutching a bag of money, while an old Roth IRA contribution allows you to grab your bag of money and go back in time to the halcyon days of your youth when your bracket was low.
Reverse time travel is always more perplexing to the mind, but bear with me on the metaphor here. Essentially what you’re doing is wresting $10,000 of your current income from the clutches of the federal and state governments (who want 40% of it), hopping in your Time Machine, and traveling back to your low tax rate and low tax state of 20 years ago. When you arrive, you alight from your Time Machine and gladly pay the governments 20% instead of 40%.
Alas, hair does not regrow on your head nor big muscles on your arms, but, hey, this is a Time Machine for money. If there were a Time Machine for hair and muscle every barbershop and gym would have one.
Say No To Management Fees
If you are paying an advisor a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice.
My guess when you pre-announced this article was that it was going to be about the strategy to convert to multiple Roth IRAs, invest each one in a different, uncorrelated, high risk investment, and then recharacterize the one(s) that lost money. Is there a nickname for that strategy?
Nevertheless, this is an interesting tactic you have come up with, which I hope I never have to put into play (I hope to keep expenses low and pay high enough to contribute out of current income).
Bob's not my name says
A suitable nickname for that strategy might be “over-hyped”. It was discussed in some bogleheads threads back in 2009-2010. Here are some:
Roth conversions were new back then, so these threads do some meandering as the participants figure the issues out.