What is Tax Diversification?
Tax Diversification refers to strategies that allow different tax outcomes from your investments. In this article, I am going to address the tax diversification of retirement accounts.
Why is it Important?
Have you ever heard of the story of tech mogul Peter Thiel? In 1999, he had a Roth IRA account with $2000 in it. At the end of 2019, it had $5 billion in it! And guess what, all of it is 100% tax free as long as he withdraws the money after 59 and ½ years of his age. Peter Thiel was born in 1967. In 1999, he was 32 years old and in 2019 he was 52 years old. In about 6 years, he will be able to tap into all of his Roth IRA without paying any taxes!!! This story can teach all of us that using the right amount of pre tax IRA vs post tax IRA can save you a lot in taxes.
Tax Diversification in Retirement Plans
Most of us are aware of 401Ks, Traditional IRA and Roth IRAs. For now, you can divide these into two groups – Pre Tax contribution vs post tax contribution. 401K and traditional IRAs are classified as pre tax contributions because the amount contributed to 401K or Traditional IRA is exempted from paying tax in most of the cases upto a certain amount of contribution. Thus if you contribute 19,000 to your 401K, you can reduce your taxable income by 19,000 there by saving $4750 worth tax assuming you pay tax at 25%.
Roth IRAs are classified and post tax contributions. This means when you contribute to a Roth IRA, you don’t save on taxes now. No matter how much you contribute to a Roth IRA, it will not reduce your taxable income. In fact in some cases, you will have to pay additional taxes when you contribute to Roth IRA especially when you do backdoor Roth conversion.
But there is an important difference between Traditional IRA and Roth IRA. While Traditional IRA saves on taxes now, when you withdraw the amount, you must pay taxes on the amount withdrawn. While Roth IRA allows you to have completely tax free growth. As long as you withdraw the money after the age of 59 and ½ you don’t pay any taxes at all.
Why is it important to have a Roth IRA?
Most people think that because they are going to have less income or may have no active income in their retirement, it’s okay to have only the traditional IRA or 401K. But there are some important things the Roth IRA offers that are different from the traditional IRA.
- Withdrawing Contribution: Once contributed, you can withdraw your contributions any time tax free and penalty free! This means if I contributed $5000 to the Roth IRA, I can withdraw them now or later at any time, at any age, without paying any penalty and any tax. This is so because you have already paid taxes on it!
- Children’s Education: If you withdraw money from a Roth IRA for qualified education expenses, you will avoid the 10% penalty assuming you are withdrawing it before you are 59 and ½. In this scenario, you will have to pay the normal income tax if you are withdrawing your earnings. Yes, the earnings are not tax free if you are withdrawing them before 59 ½.
- Requirement Minimum Distributions: Traditional IRAs require you to start withdrawing money when you become 72. Yes, that’s required by the government. It’s basically the government forcing you to withdraw your money so that they can collect the taxes on it! But in the case of Roth IRAs, you can leave your money until you die! There is no rule to withdraw your money at a certain age!
There is one more consideration as well. We won’t know what the tax rates will be when you retire. The tax rates could be higher or they could be lower. If they are lower, you could benefit from the traditional IRAs, if they are higher, you could benefit from the Roth IRAs. Since we can’t predict the future, it’s best to play safe and have both kinds of retirement accounts – Traditional IRA and a Roth IRA. And that is why if you don’t already have a Roth IRA, I highly recommend you to open a Roth IRA.
Backdoor Roth Conversion
Let’s say you are convinced about having a Roth IRA and decide to open one. But if your modified adjusted gross income is above $208,000, then you simply can’t do it! You are not allowed to contribute anything to a Roth IRA!
This is where Backdoor Roth Conversion comes into play. You are allowed to transfer money from your traditional IRA to a Roth IRA, provided that you pay taxes on the transfer. The calculation of tax is a bit complicated, but for the sake of simplicity you can assume that you will pay tax on the full amount transferred using your normal income tax rate. But this gives you an option of choosing the tax diversification. It allows you to pay tax now and save on taxes later.
To illustrate my case, let’s say we have $100,000 in traditional IRA and we did a backdoor Roth conversion. We ended up paying tax at 30% – $30,000 to the IRS. We let the $100,000 sit in a Roth IRA for 20 years. With 7% of annual compounding, the money will grow to become $386,968 in 20 years. That’s $286,968 more! At 20% rate. we will save $51,394 in taxes! If we let the IRA sit for 30 years, with 7% annual compounding, the money will be $761,225 and the gain will be $661,225. In this scenario, at the rate of 20% tax, you will save $132,245 in taxes!
To be fair, the actual math of comparing traditional IRA v/s Roth is complicated and it’s harder to predict because of changes in tax laws. I do not recommend anyone to have only a Roth IRA, I think that would be a losing proposition. The case I am making is to have both – a traditional IRA as well as Roth IRA.
In my opinion, every investor should have both types of retirement accounts pre-tax (Traditional IRA) and post tax (Roth IRA) to achieve tax diversification. Having such a combination will protect their wealth from changing tax laws. I think even if you are at the age of 50, you should open a Roth IRA if you don’t have one. Given the fact that life expectancy is increasing, we are all likely to see our 90s. In that case, having a Roth IRA account is a must in my opinion
Warning: I am not a Certified Public Accountant and cannot advise you on tax matters. You should talk with a CPA or other qualified professional before making your investment decisions.