Roth IRAs and tax deferral

Posted by on February 16, 2011 @ 3:05 pm in Retirement

With a new year well underway, at Vanguard our attention is turning to IRAs, 401(k)s, and tax planning. This year, I, like a lot of others, seem to have Roth IRAs on the brain.

As you may know, as of 2010 income limitations were lifted on Roth conversions, allowing many more folks to think about converting their traditional balances to a Roth. And assuming you have adequate earned income and your taxable income in 2011 is less than $107,000 (or $169,000 for joint filers), you’re eligible to make a full $5,000 contribution ($6,000 if over 50) to a Roth IRA in 2011.

Choosing between making Roth or regular pre-tax/“deductible” IRA/401(k) contributions if you are eligible (or electing to convert pre-tax traditional balances to a Roth) can raise a variety of tricky issues around whether future tax rates will be higher relative to current rates. Vanguard discussed these issues in the 401(k) context in a 2005 research paper. While this paper admittedly needs some updates in terms of specifics, the basic ideas here are still relevant for thinking about whether a “deductible” pre-tax IRA, a Roth IRA, or a little of both might be most appropriate for your situation. There really isn’t a quick answer that applies to everyone when thinking about a deductible IRA versus a Roth.

But when it comes to what to do with any after-tax dollars that you have the option to save either in (1) a taxable account, (2) a nondeductible IRA, or (3) a Roth, there are generally clearer answers. There is a broad consensus that the Roth is (pretty obviously) the best option in these circumstances. But what I don’t think many people have a good sense of is how much better it is—particularly relative to a tax-efficient after-tax portfolio—and I want to share some basic math on this.

To do so, we need assumptions. Here are mine:

1. Tax rates: A marginal income tax rate of 28% (for 2011, that’s married filing jointly with adjusted gross income of $139,350 to $212,300), qualified dividends taxed at 15%, and long-term capital gains taxed at 15%.

2. A desire to hold a balanced portfolio, say a 60/40 stock bond mix, achieved tax-efficiently when held in the after-tax portfolio. Specifically:

•  In the IRA, a 60/40 mix of a stock index fund or ETF and broad-based bond index fund or ETF.

•  In the after-tax account, a 60/40 mix of a broad-based stock index fund or ETF with a broad-based municipal bond fund or ETF. (And yes, despite concerns that have been getting a lot of play in the press recently, my view is that a very broad-based muni bond fund continues to be a tax-efficient, reasonable way to get fixed income exposure in a taxable portfolio for many investors).

3. Investment returns:

•  Bonds: Assume long-term pre-tax broad bond market returns of 4.5%. And—present circumstances notwithstanding—assume that over the long term, tax-exempt bonds will return 1 percentage point less than taxable bonds, but involve no tax liability.

•  Equity: Assume the taxable yield will come in the form of qualified dividends, which might amount to 2% of the assumed total return. Assume the long-term total return is 8.5%.

4. Equal investing costs/expense ratios for all IRAs or taxable investors of 0.25%.

5. IRA distributions are not subject to the tax penalties for early withdrawals.

For the after-tax portfolio we have total expected returns of approximately 6.25%, with roughly 1.2 percentage points of each year’s return coming in the form of qualified-dividend income, taxed at 15% each year, 1.4% in the form of nontaxable muni-bond income, and the rest in the form of unrealized long-term gains. And for the 60/40 portfolio in the IRA accounts, we have total returns of 6.65%, with all investment returns untaxed until withdrawn, then hit at the income tax rate when taken from the nondeductible IRA, and never taxed when taken out of the Roth.

The chart below shows the difference in liquidated (and fully taxed) account values at the end of each year for 20 years based on these assumptions, for the two types of IRA relative to the taxable portfolio. The implications are pretty striking: the Roth shows dramatic advantages, while a nondeductible IRA actually subtracts value. For example, if the investment were liquidated after 10 years, the Roth IRA investor could have 10.3% more wealth relative to the taxable investor, while the nondeductible IRA investor could have 4.4% less wealth. While I don’t show this on the chart, the nondeductible IRA investor does not break even with a taxable investor until after year 30. This is because while taxes are deferred in a nondeductible IRA, when they are finally levied at liquidation, they involve significantly higher tax rates than in the case of the wealth accumulating without deferral in the tax-efficient, taxable portfolio.

How much higher are projected balances relative to an after-tax portfolio?

Projected balances over 20 years

This hypothetical illustration does not represent the return on any particular investment.

You might wonder about sensitivity of this example to the long list of assumptions. That can be analyzed till the cows come home. But one example in particular: Suppose qualified-dividend income treatment didn’t exist, so dividends are treated as taxable income (taxed at 28% in this example), and long-term cap gains rates go to 20%.

How would things change?

The chart below gives the answer. The Roth becomes an even more attractive option relative to the taxable portfolio, while the nondeductible IRA becomes a somewhat less worse option (now the nondeductible IRA investor breaks even with the after-tax investor after 14 years).

What if qualified dividends are treated as income and long-term capital gains are taxed at 20%?

Projected balances over 20 years

This hypothetical illustration does not represent the return on any particular investment.

This story is a pretty definitive illustration of why the Roth IRA is such a valuable tool for those eligible to use it. And it’s why those who aren’t eligible—and who have very little in pre-tax IRA balances—might want to consider the “backdoor Roth” strategy of contributing to a nondeductible IRA, then converting it in short order to a Roth. Just be careful if you have large pre-tax IRA balances: Remember you can’t convert only nondeductible IRA balances, you have to convert the same proportion of all your outstanding IRA balances.

Lastly, this analysis suggests that while after-tax annuities may offer some insurance features that certain investors may value, they may offer limited tax benefits relative to a tax-efficient portfolio, unless horizons are incredibly long-term. When expenses are taken into account (annuities typically cost far more than the 25 basis points assumed throughout here), annuities could get even less attractive.

Notes:

•  All investments are subject to risk. Investments in bond funds are subject to interest rate, credit, and inflation risk. Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

•  We recommend that you consult a tax or financial advisor about your individual situation.

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