Change is in the air. And since the tax law is involved, you can be certain that “change” doesn’t mean the final version.
At the moment, no one knows for certain what will happen to taxes in the United States, but people do know rates are far more likely to increase than decrease. In the immortal words of Jimmy the Greek Snyder, a once-famous Las Vegas bookmaker: “The race is not always to the swift, nor the battle to the strong—but that is the way to bet.”
So let’s assume as a thought experiment that significant hikes are in the offing. The point of this article is to point out, and then parse out, the obvious: Tax-free investing can be attractive on any given day, but it will be especially remitting the day after a tax hike, and especially if you have already been invested since at least the day before the hike.
There are three investment structures that every U.S. taxpayer should carefully consider at this time as a hedge against higher tax rates:
1. Roth IRAs or Roth 401(k) plans;
2. Investments in qualified opportunity funds and related opportunity zones; and
3. Qualified small business stock.
Each of these is worthy of its own, separate article (which might be forthcoming if tax rates jump as expected).
What’s Right With Roths
The Roth IRA has been around for almost a quarter of a century, and its virtues are well understood by some people, but hardly at all by others.
A Roth IRA acts like a photographic negative of the regular IRA: It is funded with after-tax dollars instead of pretax dollars, and the distributions are tax-free when the money is distributed while regular IRAs are taxed when they pay out. Another important difference is that there are no minimum required distributions for a Roth IRA during the owner’s lifetime. Roth IRAs can be funded both by direct individual contributions and by converting regular IRAs.
How do the two investment strategies compare? A simple mathematical model explains the relationship—and the importance of anticipated tax rates in evaluating the vehicles.
Assume Taxpayer A is an individual who owns a regular IRA with $1 million in assets. Assume his effective tax rate is 40% and that he has an investment strategy that doubles his investment every 10 years.
After a decade, the regular IRA doubles in value to $2 million, and if Taxpayer A then distributes the $2 million out at a 40% tax rate, he will have $1.2 million after taxes ($2 million times 40% equaling a tax of $800,000 that’s carved out).
If instead Taxpayer A decides to convert his $1 million regular IRA into a Roth IRA, the $1 million is subject to tax, and at Taxpayer A’s current rate of 40%, the tax generated is $400,000. If he pays the tax using the funds in the IRA (we will discuss a better strategy in a moment) then he has $600,000 to invest in his Roth IRA. Assume that he then doubles his money over 10 years, so that he now holds $1.2 million in his Roth IRA account. This can be distributed tax-free at the end of the 10th year, leaving him with $1.2 million after tax.