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All the talk about tax law changes, including changes to the Roth rules and then the prospect of higher tax rates for some, seems to be jacking interest in Roth IRAs and Roth 401(k)s.
Which is fine. Probably good.
Roth accounts let people time when they pay the tax on retirement savings. (The trick to making them work: Try to pay the taxes when your tax rate is lowest.)
But all this obsessing about Roth-style accounts sometimes obscures a tax reality: Some really good Roth alternatives exist.
For example, other ways exist to realize tax-free investment gains. Or nearly tax-free gains.
Other ways exist to extract income from a tax deferred account without paying taxes. Finally, for folks who see Roth accounts as a way to dial down required minimum distribution problems? Yup, even there, other non-R0th alternatives exist for addressing this predicament.
In this blog post, therefore, I list the ten best Roth alternatives.
Before I step through the list, however, let me review how Roth accounts save taxes. I promise. I’ll be quick.
How Roth Accounts Save Taxes: A Quick Review
Many folks don’t really understand how Roth accounts save taxes. But the mechanics work in a straight forward manner.
Say you have $10,000 of income from a job or a business.
You need to report the income on a tax return. And say you have two choices. You can report the $10,000 of income on this year’s tax return. Or you can report the $10,000 of income on a tax return you file in thirty years. So, say in 2051.
What you want to do is report the income on the tax return with the lower tax rate applied to the income.
For example, if you pay a 20% tax on this year’s tax return and a 30% tax on the return you file in 30 years, you want to report the income on this year’s tax return.
And the way you can do that? Use a Roth account. In other words, save $10,000 into a Roth-style 401(k) account or into Roth-IRA accounts. You will still pay a 20% income taxes on the $10,000 this year. But when you withdraw the $10,000 in 30 years, you avoid a 30% income tax.
By the way, if you pay a 30% tax on income this year and think you’ll pay a 20% in 30 years? You want to flip the timing. In this case, you want to report the income on the tax return you file 30 years from now.
And the way you can do that? Use a traditional IRA account. That traditional account means you pay taxes on the money in 30 years.
Finally, one other important point. Compound interest ironically does not change the math. The math works just as simply. (We have a longer blog post here, Are Roth IRAs and 401(k)s Really a Good Deal , that explains how compound interest affects the calculations.)
And now let’s step through the alternatives you can consider in place of a Roth-IRA or Roth-401(k). Because you probably have options available you don’t know about. Or Roth alternatives you haven’t fully appreciated.
Roth Alternative #1: An IRA or 401(k) Less than 90th Percentile
For example, let’s start with an option often hiding in plain sight: A regular old IRA or 401(k). For most people? This option counts as a great Roth alternative. And the reason? For 80 to 90 percent of the population, a Roth account delivers zero or nearly zero tax savings.
But let me explain. Suppose you’re single, take the standard deduction and receive $30,000 of Social Security benefits. In this scenario, you can draw $16,000 a year from an IRA or 401(k) basically without paying any federal income taxes. So an appropriate annual draw from a traditional tax-deferred IRA with a $400,0000-ish balance. Which means a Roth account may deliver zero benefit if you end up with a balance that’s $400,000 or less.
If you’re married? The numbers bump up by about 50 percent. If you two take the standard deduction and receive $45,000 of Social Security benefits and draw $24,000 a year? Basically you guys pay zero federal income taxes. Even though this scenario reflects you drawing down a traditional tax-deferred IRA with, gosh, maybe as large a balance as $600,000. Which again means a Roth accout may deliver zero benefit if you end up with tax-deferred accounts of $600,000 or less.
By the way, based on Federal Reserve data, about 80 to 90 percent of people possess wealth that puts them under the account balance thresholds mentioned in the preceding paragraphs. Which means 80 to 90 percent of our friends and family get a great result from a traditional tax-deferred account.
Roth Alternative #2: Qualified Opportunity Zones
Not everyone wants or can save using a tax deferred account, however. So let me mention quickly a couple of tax planning opportunities that, like a Roth account, allow entrepreneurs and active investors to enjoy income tax free.
The first tax planning opportunity? Making an investment in a qualified opportunity zone and then, key to this gambit, hanging on to the investment for a decade or longer.
We’ve got a longer blog post here that explains how qualified opportunity zone investments work. And this tax planning gambit isn’t without extra costs and severe limitations. Especially if an investor uses a qualified opportunity zone to delay paying the capital gains taxes on some earlier, profitable investment.
Note: An active investor or entrepreneur can reinvest capital gains from another investment and thereby delay having to pay taxes and even in some cases reduce taxes.
But in a nutshell, qualified opportunity zones work this way: If you invest in an economically distressed area, you may be able to avoid paying taxes on capital gains.
If that sounds crazy, it may help to understand that Congress created this “loophole” to incent entrepreneurs to invest time and money into those neighborhoods and communities where limited economic opportunities exist.
Rother Alternative #3: Qualified Small Business Stock
Another de facto alternative to a Roth-style account? Investing directly in a corporation’s stock when the corporation’s shares qualify as Section 1202 stock.
If you invest directly in some small corporation and it qualifies for Section 1202 status, you can under Section 1202 exclude some or even all of the gain you enjoy from taxes.
Rules exist, of course. The corporation’s business needs to not be a professional service or investment holding company. You need to hold the stock for at least five years. Further, the stock needs to be original issue stock–not stock you bought from some other investor.
Also, limitations exist. Under current laws, your excluded gain equals the lesser of either $10,000,000 or ten times your original basis but not more than $50,000,000. Also, the exclusion hasn’t always been 100%, as it is now. Further, Congress is discussing changing this chunk of tax law. (The Build Back Better Act that Congress disscussed earlier this year proposed that high income taxpayers don’t get a 100% or 75% exclusion. Only a 50% exclusion. High income taxpayers are folks who earn more than $400,000 a year.)
In any case, for some small businesses, the Section 1202 qualified small busines stock exclusion provides an alternative to the Roth account.
Note: We have a couple of longer posts that explain how Section 1202 works here and here.
Roth Alternative #4: Qualified Charitable Distributions
Part of the attraction of Roth-style accounts? Extracting money without paying income taxes. But taxpayers sometimes have other ways to withdraw money in tax-deferred accounts without paying income taxes.
For example, an easy idea for taxpayers aged 70.5 and older who do charitable giving? You can instruct your IRA custodian to make the charitable contribution for you directly.
In effect, this removes the money from your IRA without you needing to report the withdrawal as income.
For example, if you direct your IRA custodian to directly pay $10,000 to a local qualified charity, you disclose the distribution and charitable contribution on your tax return. But two amounts zero each other out. The final taxable amount equals zero (More details here.)
Roth Alternative #5: Deductible Medical Expenses
A similar approach can sometimes allow withdrawals from IRA used for medical expenses to escape most taxation.
Suppose a taxpayer incurs a $10,000 monthly expense for nursing care.
To keep things simply, assume the only income the taxpayer realizes comes from a $10,000 monthly IRA distribution.
In this scenario, the taxpayer reports $120,000 of the IRA withdrawals over a year as income. But the taxpayer’s nursing home expenses add a $108,000 itemized deduction to the return.
That will nearly zero out or even totally zero out the taxpayer’s taxable income.
Roth Alternative #6: Tax Smart Portfolio Construction
Something we’ve noticed when helping clients solve the Roth conversion puzzle…
How someone constructs their portfolio can impact the attraction of or need for Roth conversions if someone worries about required minimum distributions pushing them into higher tax rate brackets.
You need to model this notion. But say someone with $1,000,000 of retirement savings invests 60% in stocks and 40% in bonds.
Further, assume that 80% of the retirement nest egg, or $800,000, sits in an IRA and the $200,000 reminder sits in a taxable account.
In a situation like this, if bonds sit in the IRA (so that $800,000 IRA holds $400,000 of bonds and $400,000 of stocks)? And then the $200,000 of taxable investments represent 100% stocks and that amount sits in a taxable account?
That construction approach probably dials down the need for or attractiveness of a Roth conversion.
Someone in this situation who draws, say, $40,000 a year from their retirement nest egg may just draw the dividends and long-term capital gains from the taxable account. (In this example, that might be $10,000 or $12,000 annually and this income will probably be taxed at a zero-percent rate). And then the person can draw the last bit of needed income–$28,000 to $30,000 in this example–from their IRA. That amount should be very lightly taxed.
A married couple might use their standard deduction to shelter nearly all of this income.
This approach probably results in some federal income taxes. Mostly because the Social Security benefits end up partially taxable. But the overall tax burden should be very low. Maybe 2 or 3 percent?
Roth Alternative #7: Delay Social Security
Taxpayers regularly consider how to optimize the timing of their Social Security benefits.
A common tactic (which we agree with) is to delay starting Social Security benefits to get a bigger benefit, bigger tax-free income and also to hedge against the risk of living a long time.
But delayed Social Security benefits can in effect become a “Roth alternative.”
If someone who delays taking Social Security also draws larger amounts from their IRA in the years before they receive Social Security? That arrangement, because it siphons off extra funds early on, may also reduce the attractiveness or need for a Roth account or Roth conversion due to large late-in-life required minimum distributions.
Roth Alternative #8: Disclaim IRA
A Roth conversion alternative for folks who inherit IRAs? They may want to disclaim an IRA if that means the IRA then goes to secondary beneficiaries who can and will use the required IRA withdrawals to stuff their own IRA or 401(k) accounts.
For example, a widow could disclaim an IRA with a $200,000 balance to her two children. Over a decade, those children might be able to each annually withdraw an amount that funds the largest possible 401(k) contribution or IRA contribution… and thereby move the money from their parent’s retirement account to their own.
Such a gambit mostly functions as an estate planning maneuver. But the gambit also allows a taxpayer with large unneeded IRA balances to right-size their portfolio and shrink their required minimum distributions.
Roth Alternative #9: Leave the Balance and Problem for Beneficiaries
A related idea? Someone might just choose to not worry about the tax liability embedded in their tax-deferred retirement accounts.
This approach leaves the “problem” if you want to call it that for the heirs. But that may make sense for a couple of reasons.
First, in a very real sense, your (and my) tax rates drop to zero once we’re dead. So anything we leave in a tax-deferred retirement account is tax free to us. (Sorry, but that’s the reality.)
Second, even if you or I want to think about heirs’ tax burdens, heirs may pay a lower tax rate during their drawdown than the sort of parents who find themselves planning for the “I’m worried about taxes during retirement” scenario.
Roth Alternative #10: Adjust Expected Returns
One other final Roth alternative? You may want to model your retirement numbers (including your expected draws and taxable income) using a lower expected rate of return.
Stock market valuations appear very high. As I’m writing this, the cyclically adjusted price earnings ratio approaches 40.
Interest rates look very low.
If your or my portfolio generates a return that is, say, 80% of what we originally planned? We may end up fine in terms of our retirement lifestyle. (I think we can and probably will.)
But we will all also have a smaller tax problem if returns and nest eggs shrink. And that smaller tax problem? It also reduces the need for and attractiveness of Roth conversions.
Final Comments
A couple of quick comments to close. First, the discussion above ignores state income taxes. So you want to include those in your analysis. Don’t forget them. Unless you live someplace that doesn’t tax income or doesn’t tax retirement benefits. Or unless you plan to move to state in retirement that doesn’t levy an income tax.
A second thing to note: If you’re covered by Medicare, you want to consider the impact of any income-related monthly adjustment amount (IRMAA). For upper-middle-class and upper-class Medicare beneficiaries, one’s income can push up the cost of Medicare. (More details here.)
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