"Republicans are ready to take on tax reform. And to make the numbers work, they may radically change the way your retirement savings are taxed." http://theweek.com/articles/720131/gop-destroy-401k"As part of their tax reform package, House Republicans may tinker with the hugely popular 401(k) retirement benefit, a report says.According to Politico, one proposal under consideration would be taxing the money that workers place into their 401(k) savings plans up front instead of imposing the tax when they take the money out in retirement — 20, 30 or 40 years hence."http://www.chicagotribune.com/business/ct-gop-tax-cuts-401k-analysis-20170831-story.htmlCouple thoughts:
(1) This would likely reduce the participation rate. I believe it's the potential to "goose" one's retirement savings dollars early on beyond what "after tax" contributions would allow that spurs many to begin contributing at an early age. At least, in my own case, that was a real selling point.
(2) Even if participation held steady, this would be bad for the fund industry, since, after first paying taxes on the money, younger workers would have smaller dollar amounts left over to invest.
So, as much as I appreciate the advantages of a Roth under some circumstances, I don't think this change under consideration is in the best interest of younger workers.
Comments
Is 6 what you're talking about?
https://www.irahelp.com/slottreport/president-obamas-2016-budget-takes-aim-your-retirement
While all the writing seems to be reading "after tax" contributions as "Roth", that's not the only way after tax contributions can be handled in a 401(k). In some plans, you can make after tax contributions that don't go into the Roth side. They're like nondeductible IRA contributions - their earnings are still taxed.
FWIW, the various reports seem to ultimately reference a single source, a Politico story:
http://www.politico.com/story/2017/08/22/trumps-team-and-lawmakers-making-strides-on-tax-reform-plan-241873
That story makes reference to the 2014 Camp proposal. In that proposal the after tax contributions were indeed supposed to be funneled into a Roth 401(k).
I agree with Hank that this would definitely affect funds' AUM, and would likely affect participation, since people are more inclined to contribute if they see more going in, even if the after-tax value is the same.
There's another effect. Middle class employees may come out behind, because their tax brackets in retirement are expected to be lower than their tax brackets while working. So a deduction now (at a higher tax rate) is worth more than the tax paid on the back end (at a lower rate).
But high/wealthy earners could still be in high tax brackets in retirement. So forcing them to shift from pre-tax to post-tax would be closer to a wash.
Many young employees with currently low wages should already be contributing post-tax, in anticipation that their earnings will increase, and in retirement they will be in higher tax brackets than they are now. So for them, this should have no effect.
The worst of both worlds would be if they started taxing the money before it's invested and than changed the rules of the game in 25 years and started taxing withdrawals as well. (Sort of a Heads I win, tails you loose scenario.) There has of course been "talk" (both sides of the aisle I think) about taxing Roth withdrawals - but it hasn't gone anywhere yet. I'm not encouraged by the many different ongoing trends (both economic and political) which appear to disadvantage those who are already disadvantaged.
Brings to mind something I quoted in another post recently: Both the rich and the poor get their ice. The difference is the rich get theirs in the summer and the poor receive theirs in the winter.
If and when the government tries to tax before And after, there has been a grandfather clause for those Roth IRAs that exist before changes being made. IRAS that exist before will follow the old rules and new Roth that come later will be double taxed. My guess is that will be very unpopular and the will grave consequences to the politicians who try to enact on it.
Also there was discussion to do away with mortgage and property tax exemption. Next is charitable giving.
Huh? I'm sure the 403(b) preceded the IRA (both traditional and Roth) by many years - likely
by over a decade (Had one). Not as certain about the 401K but believe they also preceded IRAs.
http://www.fundinguniverse.com/company-histories/teachers-insurance-and-annuity-association-college-retirement-equities-fund-history/
https://www.newretirement.com/retirement/what-is-a-403b/
So the formalization of 403(b) plans came about nearly two decades before IRAs.
IRAs were added to the tax code in 1974, effective 1975. Initially, the contribution was set at the lesser of $1,500 or 15% of compensation. What people think of as the original limits ($2,000 or 100% of compensation) was the result of the Economic Recovery Tax Act of 1981 (ERTA).
ICI (2005), T h e I n d i v i d u a l R e t i r e m e n t A c c o u n t a t A g e 3 0 : A R e t r o s p e c t i v e
Now not a lot of people have solo 401Ks like I do, but a lot do max out the 18K employee contribution, which if you're in a 25% marginal tax bracket (middle class, I'd say), plus maybe paying 5% state tax...
I doubt this goes anywhere.
All employees, including self-employed "employees" have a limit of $18K (plus possible catch up for age 50+). So all employees, not just self-employed contractors, might see as much as $18K become taxable.
With a solo 401k, you're allowed to contribute up to $54K, counting both employee contributions and employer contributions. If one is doing well as a contractor, one can shift some or all of the $18K employee contribution to the employer side (which would go in pre-tax) and still hit the $54K max.
If one is doing really well (netting $270K+ after subtracting employer-side self employment tax), then one can shift all of the contribution to the employer side. Not a dime would be affected by this proposed tax change since the "employee" would be contributing nothing. That's a big advantage over W2 employees.
Even if one is "only" netting $200K, one could contribute $17.5K on the employee side and $36.5K on the employer side. One still maxes out at $54K total, and still contributes less than $18K on the employee side.
(The arithmetic here:
employer profit = $200K
paid to employee = $17.5K
employer profit = $182.5K
20% profit to 401k = $36.5K)
Fidelity worksheet: https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/customer-service/401k-self-employed-owner-only-business.pdf
Say you're in the 25% bracket, and you've got $8K in earnings available for the 401k.
Put it in pre-tax, and you've got $8K in a traditional 401k.
Put it in post-tax, and after taking out $2K for taxes, you've got $6K in a Roth 401k.
If the market doubles:
you've got $16K in a traditional 401k, which is worth $12K after taxes on withdrawal, or
you've got $12K in a Roth 401k, which is worth $12K upon withdrawal.
If the market goes down 50%:
you've got $4K in a traditional 401k, which is worth $3K after taxes on withdrawal, or
you've got $3K in a Roth 401k, which is worth $3K upon withdrawal.
I'm sure something will happen to retirement accounts at some point. For politicians[1], despite the potential backlash, it's just too tempting not to touch that enticing pool of restricted money.
Sadly there's still no talk of INCREASING the amount one can contribute to an IRA or Roth IRA.
IMO the pathetically low annual contribution limits on these accounts are not enough vs the 18K on an employer's 40X plan, and likely will NOT serve as a significant amount of retirement income for people, even as a SS suppliment. Nor does the tax code recognise that someone who is disqualified from Roth contributions due to higher income might still want to be a responsible adult and contribute to it to make up for the times when they might not be able to make a contribution. But such forward thinking never makes it out of Congress and/or into law, as we all know.
Frankly given the insanely complicated tax laws and administrative rules governing retirement accounts, I am quite happy that the majority of my retirement funds are located in taxable accounts. My 403(b) at the university is 100% in a single LCV fund, and my Roth IRA .. which I contribute to mainly out of habit .. is split mainly between LCG and LCV depending on market conditions.
I am in no rush to load up on a SRA, 457, or another type of account w/goofy restrictions on what goes in and what can go out and when.
[1] Who can't spend our nation's money responsibly or stick to a budget anyway.
Not the first time msf's math acumen has driven me up a tree.
What puzzled me (looking at his calculations) was how I've managed to gain an edge by doing Roth conversions of specific pockets of money in a traditional IRA at selected times (when an asset appeared undervalued).
I guess the difference (and potential gain) results from the timing factor. In other words, betting that those invested assets are (1) temporarily underpriced at the time of conversion (resulting in an artificially low tax payment) and (2) that prices will have recovered to more normal valuations at the time of withdrawal. Additionally (3), one could watch for a substantial near-term bounce following the conversion and than shift those assets into more stable investments like bonds or cash.
Wondering if Lewis' projection would work better if one alternated between the two tax methods: Making pre-tax contributions when markets appear high and after-tax contributions when valuations appear low? But even if regularily occurring contributions are made without regard to market valuation, I think it's accurate to say that an individual plan participant's method of taxation will make some difference in the end, resulting from the fact that markets will likely have fluctuated widely over his/her investment time-frame between periods of overvaluation and undervaluation.
Let's again take $8K sitting inside a traditional IRA. We can convert now, or convert at the end of the year, when (let's assume) the investment has gone up 25% in value from now.
Where does the money to pay for the conversion come from? If it's from the IRA itself (we'll assume you're over 59.5 so that there's no early withdrawal penalty), then it doesn't make any difference whether you convert now or at the end of the year:
- Convert now: take $2K out of the IRA to pay for taxes, leaving $6K converted in new Roth. At the end of the year, this has grown 25% to $7.5K.
- Convert at end of year: The $8K has grown to $10K; take $2.5K out of the IRA to pay for taxes, leaving $7.5 converted in the new Roth.
No difference.
There's a subtlety here. Either way (with or without immediate conversion), you start off with $6K in after-tax value that's sheltered.
If you convert up front, then you're starting with $6K in a Roth, which is worth $6K after-tax. If you wait to convert, then you're starting with $8K of pre-tax money in the traditional IRA, which is also worth $6K after taxes.
---
Consider instead that you have $2K in a taxable account that you use to pay for the conversion up front. By paying for the conversion with outside money, you're increasing the after-tax value of the sheltered money. "All else" is not equal.
Before conversion, you had $2K taxable, $6K after-tax value in a sheltered account (i.e. $8K in pre-tax IRA).
After conversion, you have $0K taxable, $8K after-tax value in a sheltered account ($8K Roth).
By prepaying the taxes on the traditional IRA, you're moving $2K from taxable to sheltered. That's why the conversion comes out ahead (assuming the IRA investment goes up in value).
In 2 of the 3 conversions ('09 and '15) I paid the tax from non-retirement money (effectively from pension & SS income). That's pretty cut & dry - per your examples.
Where it gets a bit complicated is that for the 3rd conversion in '16 taxes were paid by withdrawing a relatively small sum from some highly appreciated assets inside the '09 Roth (while converting a depressed asset). In hindsight, I might have simply shifted the highly appreciated assets into a depressed area of the market. But than, my total Roth amount would have been a lot less. I guess I "leveraged" the tax amount in some way to increase the size of the Roth. Complicated. LOL
Still pondering your numbers. But somehow feel these conversions set me up better financially. If they didn't do that, at least there's an advantage in avoiding the RMD.
PS: Perhaps one could calculate a monetary value to not having to withdraw money at 70.5 ?
As you observed, the benefit from the third conversion came primarily from rebalancing (or more generally asset reallocation).
Regardless of reason, it sounds like you did come out better financially.
Yeah - When I retired in '98, 100% of retirement money was in pre-tax plans (403b/IRA). Today, around 60% is in non-taxable accounts. The sum has also grown (but don't care to start throwing performance numbers around). If nothing else, prepaying taxes may impose some additional financial discipline. Sure eases the pain on withdrawal.
Regards