Question 1: True or False: The sole tax advantage of conventional IRAs is the tax deduction in the year the contribution is made, and the sole tax advantage of Roth IRAs is the tax savings in retirement.
FALSE: People can trade inside both a conventional and Roth IRA without paying any federal or state income tax on capital gains, interest, or dividends in the year the of the trade. The tax deferral provision inside retirement accounts allows investors to take profits and reallocate assets without paying tax.
Question 2: True or False: An extremely successful investor that earns spectacular returns on their investment should choose a Roth IRA over a conventional IRA.
True: There is no limit on the future balance of an IRA, hence successful investors should use a Roth account. Disbursements from a large conventional account will be fully taxed while disbursements from a Roth will not be taxed during the lifetime of the owner of the account and for the first 10 years of the inherited account. Investors receiving spectacular returns will be in a high tax bracket when they are forced to distribute funds. Peter Theil provides the prime example of why successful investors use Roth accounts.
Question 3: True or False: Municipal bonds are an excellent investment to hold inside an IRA.
False: Since the interest on municipal bonds is not taxed at the federal level and may not be taxed at the state level the yield on municipal bonds is less than the yield on federal or private securities of equivalent risk. (On January 5, 2024, the interest rate on three-month AAA municipal bonds was 3.67 percent while the interest rate on the three-month T-bill was 5.1 percent.). The IRA investor does not gain from the tax advantages of the municipal bond so the IRA investor should purchase the bond with the higher pre-tax yield.
Question 4: True or False: A middle-income married couple where both spouses work should plan on putting a higher percent of retirement wealth in a Roth than a married couple with identical income where one spouse does not have a career outside the home.
True: One of the tax advantages of Roth IRAs is that the distribution is not included in AGI and therefore does not impact the amount of Social Security benefits subject to federal or state income taxes. The savings from the use of Roth IRAs from this provision is larger for the married couple with two working spouses than for the married couple with one working spouse.
Question 5: True or False: Both IRAs and 401(k) plans allow account holders to invest directly in Treasury bonds, corporate bonds, CDs, or agency bonds.
FALSE: The investment options of 401(k) plans are determined by the plan sponsor and are usually if not always limited to a small number of equity and fixed income funds. By contrast, a worker or retiree can roll over a 401(k) plan to an IRA at a firm like Fidelity, Vanguard, or Schwab and directly purchase fixed-income securities. This is a huge advantage of IRAs because the lack of a maturity date on fixed-income funds will result in large losses during a period of rising interest rates. The bond investor can always hold the asset to its maturity. The fund investor does not have this option.
Question 6: True or False: Series I savings bonds and Series EE bonds can be purchased inside an IRA.
FALSE: I read an article saying this was possible, but the article appears wrong because IRA contributions involve cash followed by investments and firms sponsoring IRAs do not allow for purchases on Treasury Direct, the primary place where Series I and Series EE bonds are purchased.
Question 7: True or False: The optimal disbursement strategy between spending from assets in brokerage accounts, conventional retirement accounts and Roth retirement accounts remains constant after retirement.
The appropriate disbursement strategy depends on the age of the retiree, whether the retiree is claiming Social Security and whether the retiree is attempting to maximize the wealth of an heir.
- Early in retirement, prior to claiming Social Security, live on funds in brokerage accounts while converting traditional retirement assets to Roth assets.
- Delay claiming Social Security to age 70 if possible.
- After claiming Social Security distribute assets from the Roth account to both avoid tax on the distribution and reduce the amount of Social Security benefits subject to tax.
- Older taxpayers with heirs in a high tax bracket should spend from the conventional account to reduce tax burden on heirs.
This question pertains to Tip #7 here. Go here, for an interesting discussion of reasons to convert traditional assets to Roth assets early in retirement.
Question 8: True or False: A 62 year-old retiree with a very small amount of liquid assets outside of her retirement plan, around $1,000,000 of assets in a traditional retirement plan and no assets in a Roth account is well positioned to convert the traditional retirement assets to a Roth.
False: Since the retiree has little in the way of liquid non-retirement assets, she must distribute funds from the conventional asset to fund current consumption. Both the funds she uses for consumption and the funds that are converted to the Roth are fully tax as ordinary income. The incremental costs of the conversion are high because the person is in a relatively high tax bracket. By contrast, a person with liquid assets outside of her retirement account will only be taxed on the capital gain and the capital gains tax rate is lower than the tax rate on ordinary income.
The cost of converting traditional retirement assets to Roth assets is substantially higher for a person who must use traditional retirement assets to fund current consumption.
Question 9: True or False: A person who graduated college, works four years, puts $20,000 in her traditional 401(k) and leaves the workforce for two years for graduate school should convert her assets in her traditional retirement account to a Roth account while in school?
True: Converting traditional retirement assets to Roth assets is probably the last thing on the mind of person a person in their twenties returning to school but it is a great move.
Any conversion by a person with AGI less than the standard deduction is taxed at the 0 percent rate. Even conversions at a 10 percent rate (taxable income less than $11,000) or 12 percent (taxable income less than $44,725) will prove profitable.
Bottom line, as discussed here, is that costs of converting traditional IRAs to Roth IRAs are low when a person leaves the workforce.
Question 10: True or False: The total rate of return on a conversion of a traditional retirement asset to Roth by a 62-year person prior to claiming Social Security and who distributes funds in a Roth IRA after five years will be around 8.0 percent
False: The total return from this transaction, under reasonable assumptions, will be around 30 percent.
Key features of the transaction:
- Person relies on liquid savings and no Social Security benefits at age 62.
- Converts around $35,000 in traditional retirement assets to Roth and pays an additional $1,975 in tax.
- Assets in Roth earn 6.0 percent per year for five years.
- Roth assets grow to slightly over $46,000.
- Person lives off Social Security and Roth assets instead of conventional assets after five years.
- Tax savings from the use of Roth instead of conventional assets after five years is
- The use of Roth assets instead of traditional assets would reduce tax by $7,000 after five years and $700 after six years.
- The return on this investment calculated with XIRR is 30.7 percent.
A detailed discussion of this calculation and the regulations governing Roth conversions can be found in this Tax Notes article.
Question 11: True or False: A workers who resides in California one year and Florida the next year should wait until moving to Florida before converting conventional retirement assets to Roth assets.
True: The cost of conversion, the tax paid on the amount converted, depends on both federal and state income tax. California will tax the conversion to a Roth. Florida, which lacks an income tax will not.
Question 12: True or False: All else equal people who reside in California throughout their working and retired life should contribute to a conventional retirement account while people in Florida should always contribute to a Roth account.
False: Benefits of tax deduction from the contribution to the conventional retirement plan are higher in California, the state with a state income tax but benefits from distributions from the Roth account in retirement are also larger in the state with the income tax. All taxpayers should seek a mix of conventional and Roth assets regardless of the state where they are domiciled.
Question 13: True or False: The rules governing the tax and penalty on the distribution of funds contributed to a Roth IRA and funds from a conversion of traditional to Roth assets are identical.
False: All distributions from a converted IRA are subject to a penalty for five years from January 1 of the year of the conversion.
This penalty applies even if the taxpayer is over age 59 ½ at the time of the distribution.
A taxpayer who distributes funds on the converted Roth prior to five years from January 1 of the year of the distribution will pay both tax on the amount converted and a penalty.
There also exists a five-year rule on contributions to a conventional IRA but it appears to only restrict access to investment earnings on funds that have been in the account for less than five years.
Go here for a discussion of different aspects of the five-year rule.
Question 14: True or False: The Secure Act 2.0 requires the owners of all inherited IRAs to distribute all funds over a 10-year period after the death of the original owner.
FALSE: There are two exceptions.
- Non-spousal beneficiaries who inherited IRAS prior to 2020 can stretch payments over their expected lifetime.
- All spouse beneficiaries can spread payments out over their expected lifetime.
This article by TheStreet is a good resource.
Question 15: True or False: The increase in the age for required minimum distributions will substantially reduce the number of people who are likely to outlive their retirement savings.
FALSE: Most people who are in danger of outliving their retirement savings are distributing sums earlier than 73, the new age where RMDs start and are distributing sums greater than the minimum once distributions become mandatory. The RMD is only 3.8 percent of retirement assets at age 73. Go here for a useful RMD calculator.
Bottom line, the new RMD rules benefit the relatively affluent retirees and firms managing IRAs and 401(k) plans, not people struggling to survive in retirement.
Question 16: True or False: Some IRAs allow for alternative often non-liquid investments including real estate and private equity.
True: But they are complex and entail risk. Go to this nerdwallet article for some information.
Question 17: True or False: An IRA is an excellent vehicle for investment in a vacation home.
False: You can purchase real estate in a self-directed IRA, but it can’t be used as a vacation home, a second home or a place for your parents. The IRS is very strict about this. This Investopedia article is a good resource on this issue.
Question 18: True or False: The recently enacted Secure Act 2.0 substantially expands the ability of IRA and 401(k) owner to distribute funds prior to age 59 ½.
True: Although the increased access to funds prior to age 59 ½ is much larger for owners of conventional retirement plans than owners of Roth retirement plans because Roth accounts already allow for early disbursements of contributions.
The Secure Act 2.0 allows for additional penalty-free withdrawals including – (1) one withdrawal per year up to $1,000 for unforeseeable financial needs, (2) withdrawals for permanent disabilities, (3) victims of domestic abuse, (4) medical insurance when unemployed, (5) qualified education expenses, and first-time home purchases.
This Wall Street Journal article has a more complete list of expanded penalty-free disbursements.
My view is that these liberalized disbursement rules will result in an increased number of people retiring with insufficient retirement income. Go here for my empirical research on the issue of early disbursements from retirement plans.
Question 19. True/False: When tax rates are certain and identical in working years and in retirement a person will be indifferent between saving X dollars in a conventional deductible IRA and (1-t)*X dollars in a Roth where t is the tax rate that would have been applied to the funds placed in the deductible IRA.
True: The easiest way to check this is true is to plug in some numbers
- Tax rate 10 percent,
- $2,000 contributed to a conventional IRA,
- $1,800 contributed to a Roth IRA,
- 8.0 percent annual return for 30 years,
- Amount available for consumption in Roth after 30 years is $18,113
(1.0830 * 2000),
- Amount available for consumption in conventional account also $18,113.
0.90*(1.0830 * 2200),
Note the tax savings from Roth distributions instead of conventional distributions will be much larger than 10 percent for most workers who have some working-years in the 10 percent tax bracket because they will be in a higher marginal tax bracket based on lifetime earnings or high expenses and disbursements in a particular year and tax savings from the exclusion of Social Security benefits from AGI.
Question 20: True or False: A spouse who is not in the workforce cannot contribute to a retirement account.
False: A non-working spouse can create and contribute to a spousal IRA, if he or she files a joint return and satisfies the IRS contribution limits, income limits, and federal deduction limits. Even if the joint return has a high AGI the non-working spouse will be able to create and fund a non-deductible IRA, which is legally owned by the non-working spouse. Go here for more information.
Question 21: True or False. A person with adjusted gross income over the income limits for Roth IRAs cannot add to a Roth IRA
False: The income limits on Roth IRA contributions are easily circumvented through a procedure called a backdoor IRA. The steps used to create a backdoor IRA involve:
- Create and funds a non-deductible IRA.
- Immediately convert proceeds in the non-deductible IRA to a Roth account.
Since the funds in the non-deductible IRA were fully taxed you will not owe any tax on the amount converted. Conversions from a deductible IRA or a traditional 401(k) plan would be fully taxed, hence, people using the backdoor IRA should use funds from a non-deductible IRA to fund the conversions. Additional conversions from deductible IRAs and 401(k) plans could occur when household earning is low.
As noted in this Smart Asset article,
“If your income leaves you locked out of the Roth option, you can simply contribute to a non-deductible IRA and then convert that IRA to a Roth IRA. Voila! You’ve got a Roth.”