Financial Tip #2: Maximize use of after-tax Roth IRAs

Tip number 3:  Most households use traditional retirement accounts instead of Roth accounts.  The Tax Policy Center reports around 23% of taxpayers have a traditional IRA compared to around 12% of taxpayers with a Roth IRA.  According to CNBC, in 2016 around 70 percent of firms offered a Roth 401(k), but only 18% of workers used the Roth 401(k) option.  

More people should choose a Roth retirement plan over a traditional one.  People should use Roth accounts in the following circumstances.

  • Workers at firms not offering a retirement plan with a marginal tax rate less than 25% should use a Roth IRA instead of a deductible IRA.
  • Workers at firms offering both a traditional and Roth 401(k) should choose the Roth 401(k) if their marginal tax rate is less than 25%.
  • Workers with marginal tax rates less than 25% at firms with 401(k) plans without employee matching contributions should select a Roth IRA or Roth 401(k) over a traditional 401(k) plan.
  • Workers who maximize receipt of employer matching contributions should place additional contributions in a Roth IRA.
  • Spouses of workers with family AGI below the contribution limit for Roth contributions should contribute to a Roth IRA, if eligible.

Comments:

  • Gains from 401(k) contributions are relatively small when employers don’t provide a matching contribution and a worker’s marginal tax rate is low.  
  • Workers with Roth accounts are less likely to withdraw and spend all funds prior to retirement than workers with traditional accounts because they can access the amount contributed without penalty or tax prior to age 59 ½. 
  • The tax saving from Roth disbursements in retirement are high both because disbursements after age 59 ½ are not taxed and the Roth disbursement does not increase the amount of Social Security subject to tax.
  • Workers at a firm that do not match employee contributions, around 49 percent of employers, should contribute to a Roth IRA instead of a 401(k) plan unless the worker has a high marginal tax rate.
  • One effective contribution strategy is to take full advantage of the employer match and contribute all additional funds to a Roth IRA. Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary. 
  • Most new employees at firms with a vesting requirement, a rule delaying full ownership of 401(k) matches, should contribute to a Roth IRA instead of a 401(k) plan.
  • Stay-home spouses of workers with income should choose a Roth IRA over a traditional one if they are eligible. In 2021, a single filer with MAGI less than $140,000 and a married joint return filer with MAGI less than $206,000 cannot contribute to a Roth IRA.  Workers with income above these contribution limits should contribute to a Roth IRA.  Other workers should use a backdoor IRA.

Readers should remember to open their Roth IRA early in life as explained in financial tip number one.

Financial Tip #1: Open and fund a Roth IRA early in your career

Tip #1: Open and fund a Roth IRA and invest funds in a low-cost ETF when you get your first job in high school or college.

  • People who open a Roth IRA early in life have a long investment horizon.   The longer investment horizon allows individuals to invest in equities and accumulate substantial wealth.
  • A person who invests $1,000 in a Roth at age 17 will have $25,729 at age 65 if the average rate of return was 7.0% per year.   The total wealth at age 65 would be $62,585 when rate of return is 9.0% per year.  This Nerd Wallet article suggests the average rate of return on stocks is around 10 percent per year.
  • Firms like Fidelity, Schwab and Vanguard offer exchange traded funds with low fees and no minimum balance. A fund like VOO from Vanguard which covers the entire S&P 500 at low cost could easily earn 7% over long investment horizons.
  • The wealth estimates presented above assume the person does not tap funds in the Roth IRA prior to age 65.   This is not always possible.   The owner of the Roth IRA is allowed to disburse the after-tax contribution without penalty or tax at any time.   The Roth contributions can be used without penalty or tax for emergencies or to repay debt. The investment returns from inside a Roth are subject to penalty and tax if disbursed prior to age 59 ½.
  • All funds disbursed from traditional 401(k) plans and deductible IRAs are subject to penalty or tax if disbursed prior to age 59 ½. A young person embarking on her first job with a lifetime of obligations ahead of her should select the Roth over the traditional retirement plan, especially if there is no employer match, which is generally the case on a first job.

Concluding Thoughts:  Many employers automatically enroll new employees in a traditional 401(k) plan even though the worker would do much better in a Roth IRA.  Too many workers contributing to a traditional 401(k) plan, disburse funds prior to retirement and incur penalty and tax.  My view, expressed here and in several future posts, is that the Roth IRA should become the default option.

Potential Modifications to Student Loans

Introduction:

The current cohort of students is entering the workforce with substantially more debt than the previous cohorts of student and the growth of both the number of people with student debt and the average debt level have been consistently upwards. High student debt burdens are leading many student borrowers to forgo saving for retirement, delay starting a family, or put off purchasing a home.  

Some Democrats have urged President Biden to cancel up to $50,000 in student debt for all people with student loans.  Most economists believe that a widespread cancellation of student debt would be an inefficient and regressive subsidy.  Many student borrowers with debt could repay their loan without financial assistance and an indiscriminate loan relief program would allocate resources away from other pressing concerns. Most economic analysis supports the view that indiscriminate student debt cancellation programs would do very little to stimulate the economy.

Several papers including one by the New America Foundation one discussed in Inside Higher Education and my own work published by NASFAA have focused on reforming Income Driven Repayment Plans.  Current Income Driven Repayment (IDR) programs offering debt relief and linking debt payments to income have many problems.

  • The programs may incentivize some students to increase the amount they borrow.
  • Some students that commit themselves to an income linked loan may have been better off with a traditional loan.
  • Some student borrowers enrolled in IDR programs struggle to meet other financial priorities despite the benefits of the programs.
  • A large portion of applications for loan discharge have been rejected by the Department of Education as discussed in this CNBC article.

The memo presented here discusses ways to provide meaningful debt relief through modification of standard loan agreements instead of expansion of IDR loans or the creation of indiscriminate loan discharges.

A Proposal:

  • Discharge 40 percent of the initial loan balance after receipt of 60 monthly payments on 10-year loans and 72 monthly payments on 20-year loans.
  • Encourage partial interest payments for people in economic hardship rather than total payment forbearance.
  • Eliminate Interest charges on all loans on the scheduled loan maturity date.
  • Allow and facilitate collection of outstanding student loans after maturity of the loan by the IRs through federal tax returns.

Benefits of the Proposal:

The proposal presented here eliminates many of the uncertainties and problems associated with current programs offering student borrowers debt relief.    It offers students some assistance early in their careers allowing households to save for other priorities.   It does not create an incentive for students to increase the amount they borrow and contains incentives to facilitate quicker repayment of student debt.  The partial discharge of debt and the elimination of interest charges should reduce the number of people entering retirement with outstanding student debt.

  • The current system does not provide any loan forgiveness for 10 or 20 years.  The earlier debt relief in this proposal allows borrowers to pursue other financial objectives and may facilitate refinancing to lower-interest rate loans.
  • Many borrowers are unaware of any problems with their loan for 10 or 20 years when they apply for loan forgiveness.  The revised program will uncover problems with loan forgiveness applications after 60 months of payments for 10-year loans and 72 months of payments for 20-year loans.
  • The current system incentivizes many borrowers to pick the IDR program as soon as they leave school even though this choice can lead to higher lifetime loan payments if circumstances change.   The revised program assists borrowers with standard loans reducing reliance on IDR loans.
  • IDR plans create an incentive for some people to borrow more than they otherwise would because they anticipate low life-time loan payments and complete loan forgiveness. The alternative loan forgiveness terms presented here will always result in higher repayments for people who borrow more.
  • The loan discharge offered in this program occurs earlier for people making all payments on time, creating an incentive for student borrowers to prioritize student loan payments early in their career.
  • The existence of financial assistance for student borrowers with 10-year loans will reduce an incentive for borrowers to take out long-term loans and will speed repayment to the Treasury.
  • One study found the number of American over 60 with outstanding student debt quadrupled between 2005 and 2015. The elimination of interest charges at loan maturity proposed here should reverse this trend.
  • The elimination of all interest at the loan maturity creates an incentive for borrowers to allocate payments to other debts charging interest.  This problem is mitigated by requiring a minimum payment on student debt outstanding after the loan matures collected by the IRS through the federal tax return.

Concluding Thoughts:

Student debt is creating financial hardships for many borrowers and existing IDR programs often fail to provide meaningful debt relief.  Problems associated with student debt will worsen because of the growth of debt.  Most student borrowers can repay and manage their student debt with limited financial assistance.  An indiscriminate large discharge of student debt would impose costs on taxpayers and divert funds from other pressing priorities.

The program outlined here provides limited quick and efficient debt relief to student borrowers without the distortions caused by existing programs or proposed large-scale debt discharge proposals.

A Modified Roth IRA

Introduction:

Many people, for a wide variety of reasons, are failing to save enough for retirement. The proposal presented and evaluated here seeks to expand retirement savings by replacing 401(k) plans with a modified Roth IRA.  

The modified Roth IRA maintains key features of current Roth IRAs but adds additional sources of contributions in the form of employer matching funds and contributions for low-income households from the government.  The modified Roth IRA creates incentives for young people and people with debt to start saving for retirement early in their career and prevents people from disbursing their entire retirement accounts prior to retirement.  The tax incentives for contributions to the modified Roth could increase workforce participation.  The introduction of the modified Roth is more equitable than the current system, which favors workers at firms with generous but expensive 401(k) plans.

Description of the modified Roth IRA:

  • The basic rules governing worker contributions to the modified Roth are identical to rules governing current Roth IRAs. Contributions are fully taxed during the year the contribution is made.  Contributions as with current Roth rules.  Contributions cannot exceed wage income of the household.  All employee contributions to the modified Roth IRAs can be withdrawn without tax or penalty at any time.  All disbursements from the modified Roth after age 59 ½ are untaxed.
  • The modified Roth allows for additional contributions from employers, from people hiring an independent contractor, and from the government.   The rule allowing non-taxed compensation to independent contractors will allow more people to work independently and save for retirement.  The government contributions are only available for workers from low-income households and will not exceed $10,000 over the lifetime of the workers.
  • Disbursements from investment returns, government contributions and employer contributions would not be allowed until age 59 ½.  
  • The maximum allowable employee contribution to the modified Roth account is $10,000 per year, indexed for inflation.

Advantages of the modified Roth account:

  • There are strong incentives for young people to open a Roth account and start saving as soon as they enter the workforce.   The modified Roth account expands gains from saving at a young age because matching contributions would compound for years.
  • People entering the workforce with student debt often delay or forego 401(k) contributions. There is less incentive to delay contributions to a Roth retirement account than a traditional one because contributions can be used for emergencies or for debt reduction without penalty or tax.  The modified Roth maintains this advantage and allows for additional matching contributions, which will compound over time.
  • Many young adults now routinely distribute a substantial portion of their 401(k) savings early in their career often when switching to a new position.   The rules of the modified Roth IRA guarantee that a portion of retirement savings, employer and government contributions cannot be withdrawn until age 59 ½.   This proposal substantially reduces shortfalls in retirement income caused by early distributions. 
  • Many employees work at firms that do not offer 401(k) plan or work at firms that do not match employee contributions.  The modified Roth IRA will provide for some matching funds for workers
  • Independent contractors do not have access to matching funds from people hiring them.  The modified Roth allows for matching contributions for people hired as independent contractors.  The matching contributions for contract employees would be the outcome of a negotiation between the firm and the independent contractor.   
  • Workers at firms without employer contributions could obtain matching contribution.
  • Some current 401(k) plans lock workers into a high-fee 401(k) plan, which leads to a substantial loss in retirement wealth.  The modified Roth account described here allows workers to choose a low-fee investment vehicle from a firm like Fidelity, Schwab, or Vanguard.
  • Unlike the child tax credit, the government contributions to the modified Roth are only available for households with wage income.  The combination of tax-free retirement savings and some matching contributions from employers or the government could induce some people to remain attached to the workforce.
  • Some people will choose to report income they otherwise might have reported because without reported income they will be ineligible to contribute to the modified Roth an ineligible for matching contributions. 

How to pay for the modified Roth IRA:

  • The selection of the modified Roth leads to lower use of 401(k) plans and lower loss of tax revenue from decreased 401(k) usage.
  • Additional tax revenue from the introduction of the modified Roth account could be obtained by reducing allowable contributions to 401(k) plans. 
  • A tax of 1 percent of Roth balance over $2,000,000 would recoup some revenues and would be more equitable than current required minimum distributions.
  • The increased retirement savings induced by the modified Roth IRA could lead to a phased change in the Social Security retirement age from 62 to 63 to reduce the long-term Social Security deficit.
  • Part of the cost the modified Roth could be offset by a reduction in the child tax credit.   The combination of a modified Roth and a smaller child tax credit would remain favorable to low-income households and would expand labor force participation relative to current subsidies.

Concluding Remarks:

Many policy proposals either improve equity and reduce economic growth or worsen equity and increase growth.  The additional subsidies created in the modified Roth proposal are both progressive and pro-growth.   The new subsidies stimulate savings by low-income households, workers without access to the most generous 401(k) plans and new entrants to the workforce with high levels of debt and low levels of liquid assets for emergencies.  The new subsidies, in sharp contrast to some existing subsidies like the child tax credit, stimulate workforce participation, which will lead to higher economic growth.

The case for greater use of Roth retirement accounts

  • Many workers should increase their utilization of Roth retirement accounts. 
  • Young workers should open a Roth account as soon as they enter the workforce.
  • There is very little downside for contributions to Roth accounts by low-income workers because the worker opening the Roth has immediate access to contributed funds without tax or penalty and the tax advantages from contributing to a tax-deductible account are small.
  • There is no reason to choose a traditional retirement account over a Roth if your marginal tax rate is zero and if the employer does not match contributions to a traditional retirement plan.
  • Roth contributions are likely to result in a better outcome than traditional contributions for most workers with a marginal tax rate less than or equal to 22 percent, especially when the employer does not match contributions.
  • Most workers at firms with matching contributions to a traditional plan should divert additional contributions to Roth accounts after maximizing the employer match. 
  • Roth accounts are usually superior to traditional accounts for workers without emergency funds or high debt levels who might tap retirement funds prior to retirement.
  • Households experiencing a decrease in income because they or their spouse temporarily leave the workforce should convert traditional retirement asset to Roth assets when their marginal tax rate is low.
  • People leaving a position can rollover 401(k) assets to an IRA and then convert the traditional IRA to a Roth IRA.
  • Some firms with Roth 401(k) plans allow for in-service rollovers.
  • Retired workers should spend from assets outside their retirement plan and convert traditional retirement assets to Roth assets prior to claiming Social Security and disbursing traditional retirement assets.

Introduction:

One of the most important decisions for workers preparing for retirement involves the choice between use of traditional and Roth retirement accounts.   

Contributions to the traditional retirement accounts are not taxed in the year the contribution is made. Contributions to the Roth IRA are fully taxed in the year of the contribution but are not taxed when disbursed prior to age 59 ½.   Moreover, Roth distributions are not included in AGI and do not increase the amount of Social Security subject to tax.

All funds (both initial contributions and investment returns) inside a deductible IRA or a traditional 401(k) that are withdrawn prior to age 59 ½ are fully taxed and subject to a 10 percent penalty.  By contrast, contributions to a Roth retirement account are fully taxed in the year they are made but disbursements of contributions from the account prior to age 59 ½ are not subject to a penalty or tax.  The tax penalty for early withdrawals from a Roth is only applied to returns on investment.

Many workers overutilize traditional retirement accounts and underutilize Roth accounts.  The tax savings from incremental contributions to a traditional retirement account are often small.  The cost of converting traditional retirement assets to Roth assets is often low. Retirees with a mixture of Roth and traditional retirement assets often have substantially higher after-tax income and are less likely to outlive their retirement assets than people with all retirement assets in a traditional retirement account.

A Roth retirement account should be a key feature of your financial plan. We discuss steps you should take to increase savings though Roth accounts:

Set up a Roth account as soon as you get your first job:

Any person with income reportable to the IRS regardless of age can set up a Roth account.   A teenager can and should establish a Roth. It is possible for a young person doing real work for a family business to establish a Roth, but this type of transaction could be audited by the IRS.

Most teenagers who work don’t think about setting up an IRA but there is basically no downside from Roth contributions by young workers.  The Roth contribution could be disbursed or spent if necessary and only investment income is subject to tax.  The gains if left in the account until age 59 ½ will compound for a long time and will never be taxed.  The mere existence of a Roth IRA in a student’s name does not reduce the ability of a student to qualify for financial assistance for college.   

A working teenage with modest income would never choose a deductible IRA over a Roth because there is no immediate tax savings for a taxpayer that earns less than the standard deduction, $12,400, and disbursements in future years could be subject to tax and penalty.  The teenager is entitled to a standard deduction of earned income plus $300 even if the parents claim the child as a dependent.

Most young adults entering the workforce should choose a Roth IRA over a traditional 401(k) plan or a deductible IRA when the firm does not offer a 401(k) plan with an employer match.

Around one-third of employees at private firms do not have access to a retirement plan and around 49 percent of employers with 401(k) plans do not match employee contributions.

The choice between a Roth retirement account and a traditional retirement account is straight forward when there is no matching contribution.  The after-tax contribution to a conventional IRA or traditional 401(k) plan is the pre-tax contribution minus the immediate tax savings. Workers should make contributions to Roth accounts when their marginal tax rates are low and make contributions to traditional deductible accounts when their marginal tax rate is higher. 

A person filing an individual return making $12,400 or a married couple filing a joint return making $24,800 in 2020 claiming the standard deduction would pay $0 in tax.  These taxpayers could also reduce tax on additional earning by contributing to a health savings account.

The savings from contributing to a deductible IRA would be $0 because the person does not pay any tax. It is basically irrational for this person to contribute to a deductible IRA instead of a Roth IRA because the tax preferences are larger from the Roth and there is no gain in working years from contributing to the deductible IRA.

Interestingly, it is also almost irrational for a person in the 0 percent tax bracket to fail to contribute to a Roth.   The worker has immediate access to his Roth contribution without penalty or tax and only pays penalty and tax on investment returns prior to age 59 ½. 

At higher tax rates the tax deduction from the traditional IRA becomes more valuable.  A taxpayer facing a 12 percent marginal tax rate for the last $6,000 in AGI would have identical working year spending by contributing $6,000 to a conventional IRA or $5,280 contribution to an after-tax Roth account.

When the last $6,000 is taxed at 22 percent the taxpayer can either contribute $6,000 to a pre-tax traditional plan and pay no additional tax or contribute $4,680 to a Roth and pay $1,320 in additional tax.

The potential tax savings from the use of Roth assets both to the taxpayer in retirement and the person who inherits the Roth account can be very large.  Most taxpayers are better off using a Roth instead of a traditional retirement plan if their marginal tax rate is less than 22 percent.

Consider selecting a Roth IRA over a 401(k) plan with matching contributions if you have high levels of debt and/or have not met 401(k) vesting requirements.

Many financial planners argue that all workers at firms with 401(k) plans that match employee contributions should maximize the employer match because the employer match is free money.  My view discussed here is that even when firms match employer contributions new workers with substantial debt should prioritize debt repayment over saving for retirement.

The failure to pay debt on time can lead to a bad credit rating and higher borrowing costs for an entire lifetime.  The contributions in a Roth can be used to avoid this outcome.

Many young adults entering the workforce with substantial debt in the form of student loans do not have funds for an emergency.   As a result, many young adults with traditional retirement plans disburse funds early and incur taxes and penalties.  A person with a Roth account could disburse Roth contributions without penalty and tax.  The retirement account would remain open and hopefully the worker would not touch capital gains.

Often new workers will not receive the employer matching contribution unless they stay at a firm long enough for the contributions to vest.   Many workers will be better off leaving for a better job instead of staying for the employer match. 

Workers who have not met the vesting requirement for employer matches and who are not likely to meet the vesting requirement should invest in a Roth IRA rather than a firm-sponsored retirement plan.

Contribute to a Roth IRA after taking full advantage of matching employer contributions to your 401(k) plan.

Many employers with 401(k) plans match employee contributions.  Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary.  

The employer matching contribution to 401(k) plans is an attractive benefit if you are not drowning in debt, have funds for basic emergencies and will not lose the matching funds or be unable to move to a better job due to a vesting requirement.

Workers can divert additional retirement plan contributions to a Roth IRA once they obtain the entire 401(K) match from their employer.   Direct contributions to Roth IRAs are not allowed for higher income workers, however, higher income workers can contribute to a Roth through a backdoor IRA. 

The strategy of contributing to a 401(k) plan to obtain the full employer match and then diverting additional contributions to a Roth IRA will leave the worker with a mix of traditional and Roth assets in retirement.

Consider contributing to a Roth 401(k) plan instead of a traditional 401(k) plan if one is offered at work.

Roth 401(k) plans became available January 1, 2006. Prior to that date, after-tax or Roth retirement options were only available through IRAs. Seven in ten firms now offer a Roth 401(k) option. However, only around 18 percent of workers contributed after-tax dollars to their 401(k) plan in 2016.

The Roth 401(k) plan has two advantages over a Roth IRA.  First, contribution limits are much higher for 401(k) plans than for IRAs.  Second, employers can match employee contributions to all 401(k) plan including Roth plans but cannot match contributions to IRAs. Note, employer contributions to Roth IRAs are placed into a traditional account and are fully taxed at retirement and are subject to tax and penalty if disbursed prior to age 59 ½.   Go here for a discussion of features and rules governing Roth 401(k) plans.

The decision rule for the choice between contributing to a traditional 401(k) plan or a Roth 401(k) plan depends primarily on the marginal tax rate of the worker, assuming the same level of matching contributions.  Workers should contribute to a Roth when marginal tax rates are low and contribute to a traditional plan when marginal tax rates are high.

The use of a Roth 401(k) plan will result in the worker retiring with a mix of traditional and Roth retirement assets, which substantially reduces taxes and improves financial outcomes in retirement.

Convert traditional retirement assets to Roth assets in years when household income is low:

Tax law allows people to convert traditional 401(k) plans and IRAs to Roth IRAs.  The conversion can occur at any age.  Most conversion of 401(k) assets occur after the employee departs from a firm and transfers 401(K) assets to an IRA.  However, some firms with Roth 401(k) plans allow for in-service conversions for older workers.

The amount converted is treated as ordinary income and the cost of the conversion is the additional tax paid due to the increase in reported income.   

The conversion of traditional retirement assets to Roth assets when the household has a marginal low marginal tax rate is profitable and can substantially reduce the likelihood of a person outliving her retirement resource.  The cost of conversion is zero if the taxpayer is in the 0 percent tax bracket or when the taxpayer earns less than total deductions.

The profitable conversion of traditional to Roth assets could occur when a person leaves the workforce for part of a year.  This commonly occurs when a person returns to school or when a spouse temporarily leaves the workforce.

Profitable Roth conversions can also be implemented early in retirement prior to the retiree disbursing funds from a traditional 401(k) plan or claiming Social Security benefits. The strategy of Roth conversions early in retirement described in this recent article requires the household  use assets outside of her retirement plan to fund current consumption.

Money converted from a traditional IRA or retirement account to a Roth is subject to the five-year rule.  Converted funds that are disbursed before five years from the end of the calendar year of the disbursement are subject to tax and a 10 percent penalty.

Contribute to a backdoor Roth IRA if you have excess cash at the end of a year.

Tax rules establishes limits on household income for allowable direct contributions to Roth IRAs.  Direct Roth IRA contributions are prohibited for single filers with income greater than $140,000 and married joint filers with income greater than $208,000.  (The phase out of direct Roth contributions occurs at $125,000 for single filers and $198,000 for married joint filers)

People with income above these limits can make indirect contributions to Roth IRAs by first contributing to a non-deductible traditional IRA and then immediately convert the funds in the non-deductible IRA to a Roth IRA.  This technique is called a backdoor IRA.

The contributions in the non-deductible IRA are not subject to tax at the time of the conversion because funds in the non-deductible IRA were taxed in the year the contribution was made.  The funds in the newly created Roth IRA are subject to tax and penalty if disbursed prior to five years from December 31 of the year of the conversion even after age 59 ½.   The goal of the five-year rule is to prevent immediate gains from the conversion. 

A reconciliation bill recently passed by the House would abolish backdoor IRAs. One rationale for abolishing the backdoor IRA is that it favors the rich.  However, many incomes do not have income levels persistently above the contribution thresholds and not all households making backdoor contributions are wealthy based on a lifetime income concept.  In my view, the proposal to abolish backdoor IRAs is misguided because tax law should encourage additional savings in good years.

 Concluding Thoughts:

People are becoming more aware of the advantages of Roth retirement accounts. Households retiring with a mix of both traditional and Roth assets are much better positioned than household that are dependent on traditional assets.  A recent CNBC article found that many millennials are now recognizing the value of Roth IRAs.  

However, the use of Roth accounts remains counterintuitive to many households. Contributions to Roth accounts and conversion of traditional retirement accounts are more profitable when household income and marginal tax rates are low when it is harder to save for retirement.  

401(K) Plan Features and Worker’s Investment Decisions

Firm-sponsored 401(k) plans differ in several important features and overall quality. Many workers could build a more secure retirement by diverting funds from 401(k) plans to an Individual Retirement Account (IRA), a Health Savings Account (HSA), tax-deferred EE-Bonds and I-Bonds issued by the U.S. Treasury, and in some cases an annuity.

Introduction:

The tax code provides generous tax savings and deferral of tax for workers who contribute to a 401(k) plan.  Virtually all financial advisors advocate extensive use of firm-sponsored 401(K) plans for retirement savings and much has been written on the amount of funds a worker needs to place in a 401(k) plan to retire comfortably.  A recent survey found that 68 percent of firms with a 401(k) automatically enroll new workers. 

However, 401(k) plans differ in several important respects with some plans offering more generous and useful options than other plans.  The features offered in a firm-sponsored retirement plan can have a large impact on returns and wealth realized from saving through a firm-sponsored retirement plan.  Workers at firms with less generous or low-quality 401(k) plans can often achieve better outcomes by using an IRA and through alternative investments outside of a retirement account.

Some of the features impacting outcomes from investing in a 401(k) plan include — (1) the existence of an employer matching contribution, (2) vesting requirements on employer contributions, (3) the allowable employee contribution, (4) fees, (5) the availability of a Roth option, (6) loan and early withdrawal features, (7) investment options, and (8) payout options.

Matching contributions from employers: 

The tax code allows both the employee and the firm to make contributions to a 401(k) plan.  However, firms are not required to make contributions on behalf of their workers and the level of employer contributions varies substantially.

Around 49 percent of employers with 401(k) plans do not match employee contributions.

Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary.  

The employer matching contribution to 401(k) plans is an attractive benefit.  Most financial planners advise their clients to always take full advantage of employer matching funds.   

I have argued that new entrants to the workforce with substantial debt can delay all retirement savings until their debt is reduced to a sustainable level.   

Some workers at firms that match employee contributions will set their contribution limit to the level that takes full advantage of the matching contribution but will divert any additional saving for retirement to an IRA.

Employees at firms at 401(k) plans that do not match employee contributions may be better off contributing to an IRA. The choice between using an IRA or a firm-sponsored plan depends on other characteristics of the firm-sponsored plan, including the level of 401(k) fees and whether the firm offers a Roth 401(k) option.

This study by EBRI reveals that many workers are now choosing to contribute to a health savings account instead of a 401(K) plan even when the firm matches contributions to the 401(k) plan.  People who cannot afford to contribute to both a 401(k) and a health savings account might in fact be better off by contributing to a health savings account even if the 401(k) includes an employer match because contributions to the health savings account are not taxed, the health savings account allows for tax and penalty-free distributions on qualified medical expenses prior to retirement, and some health savings accounts also include an employer match.

Vesting Requirements:

Most companies that match employee contributions to 401(k) plans require workers stay at a company for some time prior to receiving full ownership of the employer match. The length of time a worker must stay at a company to receive full ownership of employer matching contributions is called a vesting requirement.  Around 28 percent of companies have no vesting requirement.  Vesting requirements range from one to six years with around 13 percent of companies vesting at one year and 10 percent of companies vesting at six years.

Vesting requirements are irrelevant for workers who have stayed at the company longer than the vesting periods.  

A recent poll found that one in four workers is considering changing jobs in 2021 and the number of potential job changers is higher for younger adults.   Many people who will lose their employer matching contributions because they will not meet the vesting requirement might be better off contributing to an IRA instead of the firm-sponsored retirement plan.

New workers who have not reached the vesting period should consider the likelihood they will leave for a new job and not receive the employer match.  Many of these new workers may choose to contribute to an IRA instead of a 401(k) plan, depending on the vesting requirements, their long-term plans, their job satisfaction, and other features of the retirement plan.

Allowable contributions by employees:

The tax code allows for generous employee contributions to 401(k) plans. The maximum allowable employee contribution to 401(k) plans in 2021 is $19,500 or $26,000 for workers 50 and up. However, most companies limit the amount their employees can contribute to a 401(k) plan to a certain percent of salary because non-discrimination rules limit contributions to highly compensated employees.

Some higher-compensated employees at firms with a relatively low employee contribution limit may choose to use IRAs once the contribution limit is met.  This is a relatively nice problem to have.

Retirement Plan Fees: 

A report by the Center for American Progress revealed that annual 401(k) fees are a substantial drain on retirement income for many workers.  

The level and impact of fees documented in the report differed substantially across plans.

The average annual fee for all workers was 1.0 percent of assets.  The average fee at firms with fewer than 100 401(k) participants was 1.32 percent of assets.  A well-managed retirement account at a larger firm could have a fee as low as 0.25 percent of assets. 

The report calculates lifetime 401(k) fees for a median age worker at three different annual fee rates – 0.25%, 1.0%, and 1.3%.   The scenarios assumed the worker contributes 5% of salary and receives a 5% employer match. 

The lifetime 401(k) fees for a median-wage worker under these conditions are $42,000 at a 0.25% annual fee, $138,000 at a 1.0% annual fee, and $166,000 at 1.30% annual fee.  

Higher retirement fees were associated with a higher likelihood of ending up with insufficient retirement income.  An increase in retirement plan fees from 0.5% of assets to 1.0% of assets will reduce the likelihood a worker will have sufficient retirement income from 57% to 69%.

High retirement fees are an especially important issue when interest rates are low, as with the current macroeconomic environment.  The de-facto interest rate on investments in bonds inside high-fee 401(k) plans is currently negative.

Workers are often unaware of retirement plan fees and their impact because the fee is an indirect charge.  Workers need to be aware of the fees at their retirement plan and seek alternatives if their plan has high fees. 

Some investment managers argue for the use of high-fee actively managed funds.  However, Warren Buffet, arguably the best active stock picker of all time, argues sticking with the S&P 500 will lead to better returns than active management for most investors.

Workers at firms charging high 401(k) fees that do not match employee contributions could likely do better with a low-cost IRA, at a firm like Vanguard or Fidelity, than through a higher-cost retirement plan. 

Workers at firms matching employee contributions could participate in the firm-sponsored retirement plan, take full advantage of the 401(k) match, and immediately roll over funds to a low-cost IRA when switching employers.   Some firms allow in-service roll overs for older employees, another difference in 401(k) features.

Workers at firms with high-cost 401(k) plans could increase returns by shifting investments in bonds to Treasury Direct, where there are no transaction fees.   This approach would leave the 401(k) plan more fully invested in equities and subject to losses during market downturns.  However, the entire portfolio including both equity investments inside the 401(k) plan and bond investments through the Treasury would be in balance.

The main beneficiary of a system that provides matching funds to high-cost funds is Wall Street.  Congress should consider rules allowing employers to match employee contributions to IRAs combined with automatic enrollment in low-cost IRAs.

Such rules don’t exist.  401(k) fees can have a major impact on resources available during retirement.  It is up to the worker/investor to maximize the use of low-cost funds either by selecting a low-cost IRA over a high-cost 401(K) or by rolling over funds to a low-cost plan when switching positions.

Availability of a Roth 401(k) option:

Workers have a choice between contributing to a traditional pretax retirement plan or an after-tax retirement plan, also called a Roth account.   Roth 401(k) plans became available January 1, 2006. Prior to that date after-tax or Roth retirement options were only available through IRAs.

Seven in ten firms now offer a Roth 401(k) option. However, only around 18 percent of workers contributed after-tax dollars to their 401(k) plan in 2016.

Contributions to a traditional retirement plan are not taxed in the year they are made but are fully taxed when disbursed.  

By contrast, funds placed in a Roth retirement plan are fully taxed in the contribution year but are not taxed at disbursement after age 59 ½.  In addition, distributions from Roth accounts, unlike distributions from traditional retirement accounts, do not increase the amount of Social Security benefits subject to federal income tax.

Another advantage of the Roth account is that workers can disburse contributions from the account prior to age 59 ½ without penalty or tax.   However, funds disbursed from investment returns in the Roth disbursed prior to age 59 ½ are subject to penalty and are fully taxed.

In general, workers with a low marginal tax rate at a firm that does not match employee contributions to a 401(k) plan should use a Roth 401(k) or IRA instead of a traditional retirement vehicle.  This worker should use a Roth IRA when the firm does not offer a Roth 401(k) plan.

A worker that does contribute to the traditional 401(k) plan, perhaps because of the employer match, can in the future rollover the 401(k) assets to an IRA and convert the IRA to a Roth.   The conversion is economically desirable in a year the person has a low marginal tax rate.

Availability of hardship distributions and 401(k) loans:

The tax code allows but does not require 401(k) plans to take hardship withdrawals from a 401(k) plan or to borrow funds from their 401(k) plan.  Most firms with 401(k) plans do allow hardship distributions and 401(k) loans.  Also, the tax code allows all employees to distribute 401(k) funds early and pay both a 10 percent penalty and tax on the withdrawal. 

Research has shown that 401(k) savings is being used to finance current consumption. One recent paper has shown that leakages from 401(k) plans are primarily from highly leveraged households.  The early use of 401(k) funds may leave many households with insufficient income in retirement.

A person using retirement funds prior to retirement may be better off contributing to a Roth retirement account than a traditional retirement account because the amount contributed to a Roth IRA is not subject to tax or penalty at any time.  The funds from investment returns prior to age 59 ½ are subject to tax and penalty.

The use of the Roth can be done inside the firm’s plan if the firm has a Roth option or through an IRA if the firm plan does not have a Roth option.

Investment Options

Most 401(k) plans offer a range of stock and bond funds to invest in.  A core issue shaping 401(k) investments is the ratio of assets in stock funds to assets in bond funds.   Younger investors generally have most of their assets in stock funds while older investors move assets to bond funds as they near or enter retirement.  

The core fund is usually a broad low-cost passively invested stock fund, often covering the S&P 500, however, funds investing in stocks of small companies or international stocks are also usually offered. 

The bond funds hold either government bonds, corporate bonds, or a mix of both.

Target-date funds are a way to automatically move funds from stocks to bonds as a person nears retirement age.   Around 77 percent of 401(k) investors have at least some of their retirement savings in a target-date fund. 

There are some limitations with 401(k) options which can lead to adverse impacts for investors.

Some 401(k) plans might not offer a low-cost option.  As previously noted, the solution to this problem is to use IRAs instead of 401(k) plans when the employer does not match contributions and to eventually roll over the assets to a low-cost IRA.

Most 401(k) bonds do not offer bonds or bond funds that will rise in value with inflation.  This is a major potential risk for 401(k) investors in the current low interest rate macroeconomic environment.

A person looking for an inflation hedge should consider purchasing I-Bonds or EE-bonds directly through the Treasury.  There are no fees on purchases of bonds through Treasury Direct.    

The advantages associated with investments in I-Bonds are discussed here. The interest rate on EE-Bonds is currently very low but all EE-bonds double in value after 20 years.

Other ways to hedge against inflation risk and interest rate hikes is purchase Treasury inflation protection (TIPs) or to purchase funds specializing in TIPS like VTIP, STIP, or VIPSX.  These funds are generally not offered inside 401(k) plans.  Investors can purchase them inside an IRA or with funds outside of a retirement account.

In general, fund managers of 401(k) plans do not invest in individual stocks.  IRAs do offer this option.  Stock picking is challenging, and most investors should seek to achieve broad diversification through low-cost funds before attempting to create their own portfolio.

Use of Annuities:

During working years, the financial focus of 401(k) investors is on the accumulation of wealth.  After retirement, the focus turns to assuring that people have sufficient income going forward.

One way to lock in sufficient income in retirement is through the purchase of an annuity, an insurance contract that provides regular payments to investors some point in the future. 

Around, 10 percent of 401(k) plans offer an annuity inside their 401(k) plan. It is also possible to use funds in an IRA to purchase an annuity.

There are costs and risk associated with the use of annuities to fund consumption in retirement.

  • Annuities are not guaranteed by the FDIC.
  • A recent law, the Secure Act, reduced liability to plan sponsors if the insurance company offering the annuity were to fail.   This Act basically transfers risks from firms to workers.
  • The use of annuities often reduces inheritances from retirement wealth because with many annuities payments stop once the recipient dies.
  • Annuities can be expensive because people with long life expectancy are more likely to purchase an annuity than people with short life expectancy.

Annuities can reduce the risk of outliving retirement resources, but the products are expensive and difficult to evaluate.  One proposal designed to reduce the likelihood of a person outliving a retirement option, discussed here  involves automatic use of a portion of 401(k) funds for the purchase of an annuity.  This approach is not widely available, if at all, and most people entering retirement cannot easily convert their retirement wealth to a stable income stream.

Conclusion:

The focus of retirement planners is to automatically enroll workers in 401(k) plans and to maximize lifetime 401(k) contributions.  However, not all 401(k) plans have the same level of quality.  Many workers will be better off by diverting some investments inside their 401(k) plan to an IRA or other investment vehicle.

  • Workers at firms that do not match employee contributions are often better off in a low-cost IRA than a high-cost 401(k) plan. 
  • Workers that contribute to the high-cost plan because of the employer match can move funds to lower cost plans either through an in-service roll over or when switching positions.
  • Low-marginal tax rate workers at firms that do not offer a Roth 401(k) are often better off using a Roth IRA than the traditional firm-sponsored retirement plan.
  • Workers who are likely to disburse funds prior to retirement may be better off with a Roth IRA than a firm-sponsored plan.   
  • Most 401(k) plans do not offer adequate investment options that adequately insulate workers from an increase in inflation or interest rates.  These risks can be better addressed by investments outside of a 401(k) plan.

The analysis presented here suggests whether a worker is ready for a financially secure retirement cannot be summed up with a single number like the value of assets inside a 401(k) plan or even net worth. 

Childcare & Employment Outcomes


  • Recent research likely understates the impact of children and lack of childcare on the economic recovery.
  • Many people with children may be underemployed and hours worked should be a key economic variable in a study of the impact of children on employment outcomes.
  • The impact of children and childcare on employment outcomes is concentrated on the part of the workforce that is of child-rearing age.  An analysis including people who are older and retiring will understate the impact of childcare on employment outcomes.
  • Additional research should consider multivariate models based on repeated cross sections and on longitudinal datasets.  The research should consider multiple existence of children definitions and educational attainment groups.

In a recent article, Jason Furman and coauthors argue that lack of childcare had only a small impact on the U.S. jobs recovery at the end of the COVID pandemic.    

Furman’s focus is on the change in the employed to population ratio for people with children under 13 and for people with no children over 13.  He finds a small decrease in labor force participation for women without a bachelor’s degree but no impact for any other group.

The research paper is narrowly focused on labor force participation and on a single definition of households with children.   Several additional tests are needed.

  • Many people without childcare are employed part time and would like to work additional hours.  It would be useful to examine how the pandemic impacted hours worked and underemployment for people with and without small children. My hypothesis is the existence of children of certain ages has a larger impact on underemployment than on labor force participation or unemployment.
  • The article does not document a pre-pandemic baseline on the impact of children and childcare on employment patterns.  It is likely that in normal times many people with children were already out of or marginally attached to the workforce.
  • Furman and coauthors consider only one classification of people with children — at least one child under 13.  Other existence of children variables including a child not yet in school, a school-age child, and multiple children in certain age groups should be considered.     
  • Furman and coauthors consider the impact of two education groups – no bachelor’s degree and bachelors or above on the impact of childcare on labor market outcomes.  It would be useful to consider three groups – less than bachelor’s degree, bachelor’s degree, and above bachelor’s degree.   I suspect this partition will show a significant impact of children on labor force outcomes for the large cohort of people ending their educational career with a bachelor’s degree.  Additional education beyond a four-year degree may reduce the impact of children on labor force outcomes.
  • The bivariate results presented by Furman and coauthors can be misleading because of omitted variables.   The bivariate framework does not allow for consideration of multiple child-existence variables or multiple education groups.  (See two comments above.). The bivariate framework also does not account for the impact of age on workforce outcomes and the interaction of an age and children on work outcomes.  
  • An analysis of the population in peak working years age 26 to 50 is likely to show a larger impact than an analysis of the entire population.  Older workers who are retiring may be out of the workforce regardless of whether they have children.  Furman’s finding that the impact of children on employment outcomes is small may be the result of the existence of a large number of older workers who are leaving the workforce.  The pertinent population for this question is workers of child-rearing age only.
  • The speed of the recovery and the impact of childcare on the labor market is likely to differ across industries.  Labor shortages have been most pronounced in restaurant and hospitality industry.  It would be useful to determine if the impact of childcare on employment and the labor market recovery is larger in some industries than other industries, especially since certain industries have a more pronounced labor shortage and are more highly dependent on female workers with young children.
  • The CPS can be used to track individuals over a period of time.  It would be highly useful to use longitudinal CPS data to compare month to month changes in labor market outcomes – fully employed, unemployed, underemployed, non-participant, from month to month.

Concluding Thoughts:  The analysis by Furman and coauthors likely substantially understates the impact of childcare on the economic recovery.  Much more analysis on this topic is needed.

Jason Furman, Kearney, M., and Powell, W. How much have childcare challenges slowed the US jobs market recovery.

https://www.piie.com/blogs/realtime-economic-issues-watch/how-much-have-childcare-challenges-slowed-us-jobs-market

Julia A. Rivera Drew, Flood, S, and Warren J.R. Making Full Use of the Longitudinal Design of the Current Population Survey:  Methods for Linking Records Across 16 Months

https://www.ncbi.nlm.nih.gov/pmc/articles/PMC4477847/

IPUMS CPS https://cps.ipums.org/cps/

Conventional vs Roth Retirement Accounts

Some Tips on Saving and Distribution Strategies

  • Distributions from Roth retirement accounts are not subject to federal income tax, are often not subject to state income taxes and reduce the amount of Social Security benefits subject to tax.
  • People in low marginal tax brackets should choose to contribute to a Roth rather than a conventional plan and should covert conventional accounts to Roth accounts.
  • The conversion of conventional to Roth often requires workers roll over 401(k) plans to IRAs.
  • Non-deductible contributions to traditional IRAs can be converted to a Roth IRA without paying tax. 

Introduction:   Workers today have a choice between saving for retirement through a conventional or a Roth retirement. Both conventional and Roth retirement accounts allow investors to defer tax on gains from their account until funds are disbursed.   However, there are significant differences between the two types of retirement plans.

  • Contributions to most conventional retirement plans are made on a pre-tax basis and are not taxed during the year the contribution is made.  Contributions to Roth accounts are after-tax and fully taxed in the year the contribution is made.
  • Funds disbursed from the conventional account are fully taxed when disbursed. Funds disbursed from the Roth account are untaxed after age 59 ½.  
  • Funds distributed from a conventional retirement plan are part of adjusted gross income (AGI) and their inclusion in AGI can increase the portion of Social Security benefits subject to income tax.   Funds distributed from a Roth IRA are not included in AGI and do not result in an increase in Social Security benefits subject to income tax.
  • All funds disbursed from a conventional retirement account prior to age 59 ½ are subject both to income tax and a 10 percent penalty.   Withdrawals of contributions from a Roth account prior to age 59 ½ are not subject to penalty or tax because the funds were fully taxed at the time of the contribution.  Early withdrawals of investment income from the Roth account are subject to tax and penalty.

Most workers fund their retirement plan through a 401(k) or similar defined contribution plan at work.   Workers at firms that do not have access to a retirement plan through their employer may fund their retirement through an Individual Retirement Account (IRA).  Firms can offer either a conventional or Roth 401(K) plan and individuals can choose between a conventional or Roth IRA.  Some workers choose to invest in both their firm-sponsored retirement plan and an IRA. 

The conventional vs Roth choice for people who do not have access to an employer-sponsored plan depends primarily on potential tax and financial situations during working years compared to potential tax and financial situations in retirement.   

The conventional vs Roth choice for people with access to a firm-sponsored retirement plan is more complicated.    The choice depends on the characteristics (fees and employer match) of the firm-sponsored retirement plan and the availability of a Roth option.  In some cases, it makes sense for a worker to maximize the employer match available from the firm-sponsored retirement plan and invest additional funds through an IRA.

This memo provides several tips on how to save through retirement plans during working years and how to distribute funds from retirement plans during retirement.

Tips on the Conventional vs Roth Decision

Tip Number One – Tax avoidance during working years should not dictate the choice between conventional and Roth contributions. A smaller Roth contribution is comparable to a larger conventional contribution.  Whether a person with a smaller Roth balance is better or worse off than a person with a larger conventional balance depends on potential savings in retirement. 

Since contributions to conventional retirement accounts are pre-tax and contributions to Roth accounts are after-tax, people can afford to contribute more to conventional account than a Roth account.  

  • A person in the 10 percent tax bracket who contributes $4,000 to a conventional account would forego the same amount of current resources by contributing $3,600 to a Roth account and paying $400 in tax.
  • A person in the 32 percent tax bracket making a $4,000 contribution to a conventional retirement account would forego the same level of current resources by contributing $2,720 contribution to a Roth and paying $1,280 in tax.   

Naturally, a person who contributes pre-tax dollars into a conventional retirement account will have a larger balance than a person who contributes after-tax dollars to a Roth.  

Estimates of the differences in conventional retirement account balances were calculated assuming lifetime marginal tax rates of 10 percent and 32 percent.   The assumptions behind the estimates are equal after-tax conventional and Roth payments, a pre-tax conventional payment of $4,000, 30 years of work, 26 payments per year and a rate of return of 8 percent per year.  

  • At the 10 percent tax rate, the wealth at retirement is $499,132 for the conventional account and $449,219 for the Roth account.
  • At the 32 percent tax rate, the wealth at retirement is still $499,132 for the conventional account but is now $339,410 for the Roth account.

The larger magnitude of wealth in the conventional account does NOT mean people are better off with Roth accounts than conventional accounts because Roth disbursements are not subject to tax after age 59 ½ and their exclusion from AGI reduces Social Security benefits subject to income tax.

Tip Number Two: People in low marginal tax rates should choose a Roth account over a conventional account.

Most people start their career at a low marginal tax rate and move to a higher bracket when their career advances.  Note that at low-marginal tax rates the difference in contributions between conventional and Roth plans is relatively small.  People should contribute to a Roth rather than a conventional plan when their marginal tax rate is low and should contribute to a conventional plan rather than a Roth when their marginal tax rate is high.

The choice between conventional and Roth contributions may involve a reduction in the amount contributed.  As noted above, a $4,000 contribution to a conventional retirement plan is equivalent to a $3,600 contribution to a Roth account for a person in the 10 percent tax bracket.   

Tip Number Three:   Workers need to consider relative advantages of firm-sponsored retirement plans and individual retirement accounts.   In some cases, the choice of an individual retirement account leads to an increase in Roth investments.

Most people routinely enroll in the firm’s retirement plan.  Some firms do not offer a Roth 401(k) plan.  Workers at firms that do not have access to a Roth 401(k) plan may be able to contribute to a Roth IRA.

The ability to contribute to a Roth IRA is phased out for people with income of $125,000 for individual filers and income of $197,000 for married joint return filers.  Higher income filers are often unable to invest through a Roth IRA and must instead rely on the firm-sponsored plan.

All people can contribute to a traditional IRA as well as their employer-sponsored retirement, however, the tax deduction associated with the contribution to traditional IRAs is phased out for people at work.  The non-deductible IRA can be converted to a Roth IRA through a process called a backdoor IRA, discussed further in Tip Number Six below. 

Workers at firms that offer a 401(k) plan but impose high fees or do not match employee contributions might be better off with an IRA than the firm-sponsored plan. The most common rule is for employers to match 50 percent of contributions up to 6 percent of income.  A person at a firm with this matching benefit could contribute 6 percent of income to a 401(k) plan and then save additional funds in a Roth IRA if the person’s income is below the phase out limit. 

Tip Number Four:   Conversion of conventional retirement accounts to Roth IRAs can substantially increase after-tax retirement savings.  Tax considerations determine the best time to implement the IRA conversion.  It is possible for a person in retirement with a zero or low marginal tax rate because of Roth IRA disbursements to convert additional funds to Roth IRAs at little or no cost.

Some people with assets in a conventional retirement plan may be able to convert the assets to a Roth retirement plan.  The ability to make this transfer varies based on several circumstances described below.

  • Some, but not all, firms with both conventional and Roth 401(k) plans will allow employees to convert their conventional 401(k) plan to a Roth 401(k) plan.   
  • Employees who leave a firm can roll over their 401(k) assets to an IRA.   This action is highly desirable if the firm 401(k) plan has high fees or if the investment opportunities at the firm’s retirement plan are highly limited.  The conventional IRA can then be converted to a Roth IRA.
  • Some firms allow employees over the age of 55 to make an in-service rollover from the firm’s retirement to an IRA.   The conventional IRA can then be converted to a Roth IRA.
  • A person with a conventional IRA can convert to a Roth IRA at any time.  There are, however, limits on disbursements from the newly converted Roth IRA for five years after the conversion.

The cost of the conversion is the additional tax from the increase in adjusted gross income.   The payment for the conversion should come from funds outside the retirement plan to avoid a 10 percent penalty.  Some analysts argue the payment of taxes from sources outside the retirement plan is preferrable to allow greater tax deferral inside the retirement plan.  However, some investments outside retirement plans, like Treasury I-Bonds and EE-Bonds, also defer tax.   

The most desirable time to make a conversion from a conventional to Roth account is when the taxpayer is in a low marginal tax bracket.   This will occur when a worker becomes unemployed, takes a sabbatical, returns to school, has low taxes due to some other life event, or has low taxes in retirement.   

A person in retirement who is paying low or zero taxes because she is disbursing Roth assets can covert additional conventional assets at an extremely low cost.  

Tip Number Five:   Disbursements from Roth IRAs can substantially lower the amount of Social Security benefits subject to income tax.  People who delay claiming Social Security benefits should delay disbursements from Roth accounts and use funds from conventional accounts until they claim Social Security benefits.

Conventional 401(k) disbursements are included in Adjusted Gross Income (AGI).  Disbursements from Roth accounts are not included in AGI.  The portion of Social Security benefits subject to federal income tax is based on a concept called combined income, which is reduced by disbursements from Roth IRAs which are not include.

The reduction in AGI and potential taxes can be considerable.

  • A person with a $25,000 Social Security benefit and a $30,000 distribution from a conventional retirement account would, based on my back of the envelope calculation, have an AGI of $44,850.  (The conventional retirement account plan distribution is fully taxed along with $19,850 of Social Security benefits. 50 percent of benefits between $30,000 and $34,000 plus 85 percent s of the remaining $21,000.) A person filing an individual return, with a $25,000 Social Security benefit and a $30,000 Roth disbursement would have an AGI of $0.  (The Roth distribution is not taxed and all Social Security benefits below $25,000 are untaxed.)

The person in this example paying $0 in tax because of Roth will claim the standard deduction of $12,400.   If the person has no additional income, she could convert an additional $12,400 from a conventional to a Roth account and still pay $0 in tax.

Larger Roth disbursement lower the taxpayer’s marginal tax rate and lower the cost of additional conversions from conventional to Roth accounts.  A married couple disbursing $80,000 from a Roth instead of a conventional account, with no additional income would likely be in the 0% tax bracket and be able to convert $24,800 from a conventional to a Roth account at zero cost.

The total savings from the use of Roth is the sum of the direct savings from distributions from the Roth account not being taxed, the lower marginal tax rate from the exclusion of Roth distributions from AGI and the reduction in tax on Social Security benefits from the exclusion of Roth distributions from AGI.   The benefits from the use of Roth tend to be larger when the person is claiming Social Security benefits because of this third component.

Hence, a general rule of thumb is, distribute conventional assets when you are not claiming Social Security benefits and distribute assets from the Roth account when you are claiming Social Security benefits.

Tip Number Six:  Funds in a Non-Traditional IRA that were not deducted from income in the year the contribution was made can be converted to a Roth account without paying additional tax.

All people even those with high income or access to a firm-sponsored retirement plan can contribute to a non-deductible IRA.  Funds in the non-deductible IRA can be converted to a Roth with the investor only paying tax on investment returns because the investor has already paid tax on the contribution to the non-deductible IRA.   

The process of contributing to a non-deductible IRA and immediately converting all funds to a Roth account is called a backdoor IRA.   It basically allows higher-income people who are not eligible to directly contribute to a Roth account to circumvent the income limits on Roth accounts.   This useful tutorial shows how to establish a backdoor IRA.

Tip Number Seven:  People withdrawing funds from retirement accounts prior to age 59 ½ are likely to be better off with a Roth than a conventional plan.

Research indicates that distributions from 401(k) plans prior to retirement are widespread. One study by E-trade indicates that 60 percent of millennials have withdrawn funds from their 401(k) plan.   A study by the Boston Research Group found that 22 percent of people switching jobs routinely take funds out of their 401(k) plan and spend it.   My own recent research has indicated that people tapping 401(k) plans tend to have poor credit ratings and high levels of other consumer loans.  The use of Roth rather than conventional accounts may allow some people to avoid unanticipated taxes and penalties.

A person who is likely to withdraw funds prior to retirement will likely be better off having made contributions to a Roth account than a conventional account. Distributions from conventional accounts prior to retirement are fully taxed at ordinary income tax rates and are subject to a 10 percent penalty.   The initial contribution to a Roth account is not subject to tax or penalty.  

Tip Number Eight:  People who inherit a Roth IRA will be substantially better off than people who inherit a conventional IRA.

As explained in this CNBC article,  the 2019 Secure Act changed rules governing distributions from inherited IRAs and 401(k) plans.   The new rules require people, with the exception of spouses and minors, who inherit a 401(k) plan to take disbursements within a 10-year period. Funds not distributed by year 10 are subject to a 50 percent penalty.

Funds distributed from the Roth retirement account during the 10-year period are untaxed.  Funds distributed from a conventional account are taxed as ordinary income.   The additional tax for the person inheriting an IRA during peak working years can be considerable.

Tip Number Nine:  State tax considerations also impact investments in Roth IRAs.

The decision to use a Roth rather than a conventional retirement plan is more attractive in States with an income tax, especially if the state has a high marginal tax rate and states that tax Social Security benefits.

Thirteen states tax Social Security benefits.  Most states follow federal rules and do not tax Roth distributions and do not count Roth distributions towards the taxation of Social Security benefits.  However, it is permissible for states to differ from federal rules. 

The cost of the conversion from a conventional account to a Roth account is also impacted by state income taxes as discussed in this CNBC article.  People planning to move from a state with an income tax and a high marginal tax rate to a state with either no income tax or a low marginal tax rate should delay conversions until they move.   People moving in the opposite direction might convert prior to the move.

Concluding Remarks:   Financial planners often stress the need to accumulate large retirement plan balances.  Retirement plan balances are generally much larger for people who use conventional retirement accounts than Roth accounts.  However, people saving primarily through Roth accounts often pay very little tax during retirement and a person with a medium sized Roth account may be substantially better off than a person with a larger conventional account.

\

Some Comments on the 2021 Enhanced Child Tax Credit

Key features of the New Child Tax Credit:  The American Rescue Plan increases the child tax credit from $2,000 to $3,000 for dependent children age 5 to 17 and to $3,600 for children 5 and under.   

The extra $1,000 or $1,600 is phased out at AGI of $75,000 for single filers and $150,000 for married joint filers.  

Half of the tax credit will be paid in advance and half will be applied as a credit towards taxes paid on the 2021 tax return.   The Kiplinger report has a useful on-line tax calculator that provides an estimate of a taxpayer’s monthly stipend based on four variables – (1) filing status, (2) number of children age 5 or under, (3) number of children age 6 to 17, and (4) estimated AGI.   The AGI estimate is obtained from the 2020 tax return unless one is not available in which case AGI is obtained from the 2019 return.

The new child tax credit is only in existence for the 2021 tax year. The Biden Administration wants to make the tax credit permanent.

Some Comments on the New Child Tax Credit:

Comment One:   The rationale for the advanced monthly payment of the childcare tax credit is that the advanced payment will give taxpayers money in their pockets during the year.  Advanced payments are not needed to achieve this goal.   This goal could be achieved by allowing taxpayers who plan to claim the credit the right to reduce the amount of tax withheld from their paycheck.   Advanced payments for the tax credit covering health insurance premiums enacted in the ACA are needed because the person claiming the credit must pay insurance premiums and the credit is sent directly to the health insurance firm.  No such imperative exists for the child tax credit.

Comment Two:   The advanced monthly payments are based on an estimate of 2020 income or 2019 income if 2020 income was not available.  The taxpayer will receive advanced payments larger than she is entitled to if actual AGI exceeds estimated AGI, a situation that is likely given depressed income levels in 2020 and the current strong recovery.  Will many taxpayers owe the IRS money in this situation?  Why did Congress create an advanced tax credit that increases financial uncertainty when it would be less complex to simply have taxpayers adjust the amount of tax withheld.  Taxpayer estimates of the amount that should be withheld are almost certainly likely to be more reliable than estimates generated from past AGI.  Also, the amount withheld can be modified at any time in the tax year as income changes.

Comment Three:   The child tax credit will increase the number of taxpayers paying little or no tax.    The tax credit is refundable and does not alter the marginal tax rate applied to taxable income; hence, the tax credit does not appear to impact the difference in taxes paid from the choice between a conventional or Roth IRA.  However, the extra liquidity and lower tax obligation might make the choice of a Roth more attractive.  The potential tax savings from the use of Roth accounts in retirement are huge.  Consider a recent post on the advantages of Roth accounts.  Hope to share more on this topic soon.

Final Comments on the Biden Economic Approach:  I do believe the Biden team has their heart in the right place.   I would have prioritized permanent subsidies for health insurance premiums and additional subsidies for retirement savings over the expansion of the tax credit because such subsidies are more likely to remain in place over the long haul and these subsidies help fix other economic problems.

Many of the benefits enacted in the COVID relief bill including their child tax credit and some health care subsidies phase out quickly.    Phaseouts are sometimes necessary in order to meet budget blueprints and rules of the reconciliation process.   The case can be made that the reason for the short phaseout of some benefits in the COVID relief bill is political because Congress will have to vote on these popular benefits prior to elections.

The extra unemployment benefits in the COVID relief bill have been eliminated in many states.  In retrospect, funds allocated to programs like the enhanced unemployment benefit should have been allocated to a permanent enhanced childcare or health care tax subsidy.

Quick Tip: Invest in Roth Not Conventional Retirement Plans

  • Households paying little or no income tax in working years should select a Roth retirement account over a conventional one.  
  • The gain from the exemption on tax or deduction from a contribution to a conventional retirement account during working years is negligible for these taxpayers.
  • The potential reduction in tax during retirement from use of Roth is huge and from several sources.   The Roth distribution is not taxed.   Substantial Roth distributions lower marginal and average tax rates.   The Roth distribution reduces Social Security benefits subject to tax.  The Roth is not subject to a required minimum distribution, which improves tax planning.
  • The choice between Roth and conventional accounts can be a bit harder for higher income taxpayers.  These taxpayers may have access to Roth 401(k) plans at work that allocate contributions to a Roth account and employer matches to a conventional account.
  • The lack of tax on inherited Roth IRAs allows many beneficiaries to avoid large taxes during peak working years.
  • Roth accounts can be used as an emergency fund because contributions can be distributed without penalty or tax.

Over 40 percent of U.S. households pay zero or negative federal income tax.  A CNBC article finds this number will increase n 2021 due to the family tax credit.   Under the current tax code, there are also a lot of people in the 10 percent tax bracket.

People don’t like paying tax.   I certainly get that.  However, people who are already paying zero or negative tax due to tax credits should pursue other financial goals in addition to tax reduction.

Many of these people will be asked to choose between a traditional deductible retirement plan or a Roth retirement plan.    

People not covered with an employer-based retirement plan can usually choose between a Roth and conventional IRA, although, there is an income limit on eligibility for Roth IRAs.  Many firms now offer both conventional 401(k) plans and Roth 401(k) plans.

The traditional deductible IRA reduces income tax during the year the contribution is made while the Roth IRA reduces tax in retirement.

The tax reduction for many working-age people who contribute to a conventional retirement account is small, maybe even negligible.

People with negative income tax due to a refundable credit will get a slightly larger refund if they contribute to a conventional retirement plan.  People in the ten percent tax bracket could get a savings of 10 percent of the 401(k) contribution, likely a small number.

The existence of a Roth IRA during retirement will substantially reduce tax obligations in retirement through multiple channels.   

  • The distribution itself is not subject to tax.
  • A large Roth distribution could substantially reduce marginal and average tax rates relative to a large distribution from a conventional retirement account.
  • The distribution from a Roth rather than a conventional account often leads to a reduction and maybe even elimination of the taxation of Social Security benefits because Social Security benefits are only taxed above certain AGI thresholds.
  • People with Roth accounts are not required to take a required minim distribution (RMD) after age 72.   The lack of a RMD requirement extends retirement income and improves tax planning.

Working-age people can reduce their tax obligations many ways.  They can take the family tax credit if they have children, they can contribute to a health savings account, or they can buy a house and deduct mortgage interest.  Many of these measures are generally not used or not available for older households.    For example, people over age 65 are covered by Medicare and generally do not contribute to a health savings account.  Most people over 65 have paid off their mortgage and no longer deduct mortgage interest or other housing expenses.  Few people over 65 have minor dependent children and can claim the child tax credit.

The decision to take a Roth instead of a conventional account can be a bit harder if you are in the top tax bracket.  Many of these households will work at a firm that offers both Roth and conventional 401(k) plan.   These taxpayers can send their contribution to the Roth account.  Employer matching funds are placed into a conventional plan.

There are other advantages with Roth IRAs.

Roth IRAs can be used as an emergency fund.   The IRS allows contributions from Roth IRAs to be withdrawn without penalty or tax because they are fully taxed at the time of the contribution.  People should not rely on a Roth as the primary source of funds for an emergency. There is also a limited window to repay funds taken from a Roth prior to retirement.    This benefit from the use of Roth accounts is extremely important because as indicated by my paper many people taking distributions from conventional accounts prior to retirement are struggling.

The use of Roth accounts allows recipients of an inherited IRA or 401(k) to avoid a large tax bill.  Under current tax law, all IRA funds must be distributed over a 10-year period.  Conventional retirement accounts, inherited by someone other than a spouse, are taxed as ordinary income.  Roth accounts are untaxed.  A person that inherits a conventional retirement account during peak earning years could have larger than anticipated tax bills.

The main message here is don’t let immediate tax avoidance dominate your investment, savings and even tax planning goals.  Think long not short term.  The narrower message here is use Roth not conventional retirement plans.