Assume, for example, the couple is fortunate enough to be able to transfer $55,000 a year to a regular IRA for 25 years, starting at age 40, and begins taking RMD withdrawals at the new maximum age 72, when the account owner's taxable IRA account would have grown to almost $8 million (assuming the same 8% rate of return the author assumes). The RMD factor at age 72 is 27.3 (using the revised 2021 life expectancy tables), and the RMD for the year would be $293,000.
Remember, however, that $293,000 is the taxable RMD amount 32 years from now, and that tax brackets are adjusted for inflation. Assuming a 2% annual change in the “chained CPI” rate, $293,000, 32 years from now, is the equivalent of $155,475 today. Using 2020's tax tables, and assuming the standard deduction amount for a couple both over age 65 with no other sources of income, the federal tax on this amount is $19,757, which works out to an effective average tax rate of only 12.92%, not the 50% rate the author assumes in his comparative analysis. The author has thus overstated the couple’s age 72 federal income tax rate on the RMD by as much as 387%.
Of course, future tax rates will likely be higher than the 2020 rates (and probably sooner rather than later), and RMDs will become larger as the couple grows older. President-elect Joe Biden has not proposed increasing income tax rates on individuals making less than $400,000 (in today’s dollars) a year, however. Furthermore, even assuming the couple is age 85, the RMD under the revised tables would still only be the equivalent of 6.25%, and would likely even be lower than this, as life expectancy continues to increase over the next 45 years.
Assuming life expectancies do not increase over the 45-year period, and the value of the taxable IRA account (after all previous RMD withdrawals) remains at $8 million at the couple's age 85, the couple’s RMD at age 85 would be $500,000. On a present value basis, assuming a 2% average chained CPI growth rate over the 45-year period, today this number would be $205,098. Again utilizing 2020 tax tables for a couple over age 65 (i.e., because the couple would be making less than $400,000 a year, in today’s dollars), the federal tax liability on this amount would be $30,807 in today's dollars, for an average tax rate of 15.21%. The author has therefore overstated the couple’s age 85 federal income tax rate on the RMD by as much as 329%.
Now let's go back and add in the forgotten portion of the author's analysis described in the first section of this book review, i.e., the additional $27,500 in funds the couple will have available to invest each year under the regular IRA investment plan, beginning at age 40 and continuing through age 65 (i.e., on account of their not having to pay the Internal Revenue Service the full $55,000 in income taxes each year on a $55,000 Roth investment, assuming the same 50% marginal income tax rate the author assumes). As these funds are reinvested, we know the growth each year will not be taxed at a 50% rate. More likely, the effective tax rate on this reinvested account each year will be closer to the 10% rate assumed above, because the couple will only be taxed on the qualified dividends and harvested capital gains, and not on the tax-free investments, including cash value life insurance.
Of course, RMDs will continue to grow after the couple attains age 85 (although they are still only at 8.26% at the couple’s age 90, or only slightly above the author’s assumed 8% rate of return). But what nevertheless appears to be clear from the above analysis is that, especially in a world when the corporate pension plan is rapidly becoming a thing of the past—making scarce this previous source of outside income—and life expectancies are continuing to increase, making an assumption that all of the retired couple’s RMDs and growth in their outside account will be currently taxed at a 50% tax rate is probably going to be incorrect, most of the time. The initial hypothesis of this section should therefore be correct, and the $500,000 advantage which the regular IRA investment approach maintains over the Roth IRA investment approach, which was based on the author’s example and assumed 50% tax rate on all of the couple’s RMDs and growth in their outside accounts, should actually be a much greater advantage.
Most of the couple's potential taxable income, no matter how high, will either be inside of their regular IRA, and therefore not taxable to the couple until actually withdrawn by them (including via RMDs), or will be unrecognized capital gains inside of the couple’s taxable account and therefore not taxable to the couple until the investments are sold— or potentially never, to the extent the assets are held by the couple until death when they will receive a stepped-up income tax basis.
Are there any additional tax advantages to investing in regular IRAs over Roth IRAs, which the book does not reference?
The author makes a valid point that taxable RMDs could effect the amount of the retired couple’s Medicare premiums and/or taxable Social Security, assuming the couple’s other income has not already done so. However, the author fails to point out the potentially more significant effect that failing to take available tax deductions for regular IRA contributions can have on the couple’s current tax situation.
For example, to a large extent the new maximum 20% qualified business income deduction is dependent upon the taxpayer’s taxable income, ignoring the deduction. The greater the taxpayer’s taxable income, the greater the chance that all or a portion of the qualified business income deduction will be lost. Annually investing significant amounts in nondeductible Roth IRAs or 401Ks, versus the deductible IRA and 401K versions, can end up causing the waste of a significant taxpayer deduction.
Lowering the taxpayer’s taxable income, or “adjusted gross income,” can also help minimize or eliminate the 5% surtax on capital gains and qualified dividends, increase the potential of avoiding the 3.8% net investment income tax, increase the taxpayer’s itemized deductions such as the medical expense deduction, and enable the taxpayer to qualify for certain tax credits such as the child tax credit. Similar to the 20% qualified business income deduction, the value of these latter tax benefits, which are pegged to the taxpayer’s taxable income or “adjusted gross income” can be significant, and therefore electing to forego a deductible regular IRA or 401K contribution in favor of a nondeductible Roth IRA or 401K contribution can be very damaging in certain cases.
Finally, not to be overlooked is the potential impact of parents’ taxable income on qualifying their children for college financial aid, which of course has become a significant issue for many families, including families which may be “well off” financially, but who have multiple children. A financial advisor must be sensitive to this potential non-tax situation and to the various tax issues outlined above.
Summary
While there is no doubt the Roth IRA definitely has its place in financial planning, including when it comes to converting taxable IRAs to Roth IRAs, over time, after retirement, this book review has hopefully at least opened the reader’s eyes to the realization that investing in non-tax-deductible Roth IRAs will not always be preferable to investing in regular, tax-deductible IRAs. There are a host of factors to analyze before making this decision, most of which will be based on the facts and circumstances of the particular client.
James G. Blase, CPA, JD, LLM, is principal at Blase & Associates LLC in St. Louis. He is the author of "Estate Planning for IRAs and 401Ks: A Handbook for Individuals, Advisors and Attorneys."