The Only Thing Inevitable is the Author’ s Use of the Trite Aphorism: “The Only Things that are Inevitable are Death and Taxes?”
Only one subject will figure prominently in this newsletter. The topic will be the Roth IRA and how to employ it effectively in your retirement planning.
To begin the discussion, lets take a look the limits for Traditional and Roth IRA contributions.
They are set out below:
| 2017 | 2016 | |
| Roth IRA Contribution Limit | $5,500 | $5,500 |
| Roth IRA Contribution Limit if 50 or over | $6,500 | $6,500 |
| Traditional IRA Contribution Limit | $5,500 | $5,500 |
| Traditional IRA Contribution Limit if 50 or over | $6,500 | $6,500 |
| Roth IRA Income Limits (for single filers) | Phase-out starts at $118,000; ineligible at $133,000 | Phase-out starts at $117,000; ineligible at $132,000 |
| Roth IRA Income Limits (for married filing jointly and qualifying widow(er) filers) | Phase-out starts at $186,000; ineligible at $196,000 | Phase-out starts at $184,000; ineligible at $194,000 |
Before we take up the Roth IRA, let’s do a review of the Traditional IRA. A Traditional IRA, around since the 1970s, allows an income earner to put money into a tax-deferred account.
Subject to certain restrictions, the IRA account holder then has his adjusted gross income reduced by the amount of his IRA contribution. Basically, the Traditional IRA contribution goes in tax-free. The returns on the IRA account grow tax-free until the account holder withdraws funds from the account. When she withdraws funds, the withdrawals are then taxed at her ordinary income tax rate.
A Traditional IRA holder cannot, subject to certain exceptions, make withdrawals prior to age 59-1/2 without paying a 10% penalt y. A Traditional IRA holder must begin withdrawals at age 70-1/2. Further, the beneficiary of the IRA, upon the account holder’s death, must begin to make withdrawals. In short, a Traditional IRA holder defers, but does not eliminate taxes on the account returns. Sounds good so far, so what’s the catch?
Here are the catches. The intervening years between the 1970s and today have seen huge changes in the tax code that have reduced the anticipated benefits of the Traditional IRA. Also, a key assumption that underlay the rationale for the Traditional IRA was apparently incorrect. Let’s take a look at what went wrong:
1. Tax Bracket Compression. When the IRA law was enacted, individual tax rates were higher Marginal rates could be very high[3]. And there were numerous tax brackets. If you were in a high tax bracket before retirement, you could generally assume you would fall into a lower tax bracket after retirement and pay lower taxes on your IRA withdrawals. Your Traditional IRA would not eliminate taxes, but it would reduce them.
Congress, in the intervening years, has cut top rates and reduced the number of tax brackets. There are now six federal tax brackets, And if you listen to Donald Trump and the republican house and senate, the rates will be further compressed and lowered to three. And reduce exemptions and deductions. Of course this White House and Congress have been spectactuarly ineffective at moving any legislation through. So let's not hold our collective breath.
And as tax rates compress, there are less tax savings available for your traditional IRA withdrawals. And if the flat-tax advocates get their way, there would be no bracket reductions to lower your IRA withdrawals.[4] But of course the flat-tax advocates are about as effective as flat-earth advocates as advancing their position.
2. What Cut in Retirement Income? In the 1970s it was generally assumed that nearly all Americans would have reduced income in retirement. Few Americans had amassed large retirement savings. Most folks relied on Social Security and a pension. Although the data is somewhat scant, economists are finding that retirees with Traditional IRAs are not taking substantial cuts in income in at least their first few years of retirement. This could be a confluence of two factors. One is the result of tax bracket compression set out in 1, above. The other factor could be that individuals who took advantage of Traditional IRAs and are now retiring are high-net worth individuals that initially saw the value of Traditional IRAs in the 1970s and 1980s.
And it should additionally be considered that people who began investing in the late 1970s and early 1980s rode the strongest Secular Bull Market in history to unprecedented gains. When it rains, says the versatile aphorism, it pours.
If there are so many things wrong with the Traditional IRA, what is right with the Roth IRA?
The Author is Temporarily out of Alliterative Allusions and Terrific Tropes
The first and foremost advantage of the Roth IRA is that the proceeds are tax-free. All of the returns will be tax-free. The account holder’s contributions are after-tax, so there is not upfront savings. But the long-term benefit far outweighs up-front taxability. The only other concern with the Roth IRA is that high-income individuals cannot take advantage of a ROTH. These limitations are set out above.
Some Examples: (Important Note. These figures are a few years old, but the divergence still holds up.)
Josh and Jenna White are 35 years old. They plan to retire at 35, so they have 30 years until retirement. They do not have a pension plan at work. They can either contribute $8,000 to a Traditional IRA or $8,000 to a Roth IRA. We will assume that when they retire they will be in the 25% tax bracket. If they take a lump-sum distribution when they retire the lump-sum amount will push them into the 35% tax bracket. We will also assume they will get an 8% annualized return.
When Josh and Jenna retire, their IRA balance, Roth or Traditional, will be:
$264, 711 If they have a Traditional IRA and take out the entire lump sum, the amount, after taxes at the 35% rate is:
$172, 062. If they withdraw an equal amount of the proceeds over ten years, taxed at 25%, their annual withdrawal will be: $19, 853 per year.
Here is where the Roth IRA advantage becomes clear. If Josh and Jenna have a Roth, there are no taxes. They keep the ENTIRE $264, 711.
Tim and Trina Brown are 30 years old. They plan to retire at 70, so they have 40 years until retirement. They have 401(k) plans at their work and each employer matches 401(k) contributions up to 3%. They currently contribute $10,000 to their 401(k)s. Should Tim and Trina max out their 401(k) contributions? Or should they contribute to their 401(k)s only to the extent of the company match and put the rest into a Roth IRA? (The gentle readers should already know the answer, but here comes that math.)
If Tim and Trina continue putting $10,000 into their 401(k)s, they will have $296, 839, as a lump-sum (after tax) 401(k) withdrawal. If they take the proceeds over 10 years, they will get $34,251 per year.
However, if Tim and Trina limit their 401(k) contributions to only the company-matching amount, they will retire with $379,041. If they take it out over 10 years, they will get $38,817 per year. (These amounts include the taxes on the taxable 401(k) proceeds.)
$82,202! That is the difference. 27% more than the 401(k) strategy. Put another way, 2.4 more years of income than the 401(k) strategy. A simple strategy that anyone can take advantage of.
Here is a link to a site that that will demonstrate the financial difference between contributions to a Roth IRA and a Traditional IRA. https://www.moneyunder30.com/best-investment-accounts
And if a 401(k) participant takes advantage of the company-match amount, and then reaches the Roth limit, he can still put more funds in his 401(k) up to his 401(k) limit. It is a great strategy
The Author Has Just Shown You The Elephant[5]
The purpose of this newsletter is to dispense financial and investment advice, to help readers understand the investment and financial environment we face, and to entertain. Nothing the Author has said to date about Secular and Cyclical markets, interest rates, high price/earnings ratios, sector and market relative strength is as important as the foregoing discussion of the Roth IRA, the Traditional IRA, and the 401(k) max strategy. No investment strategy can even approach the wealth building effect that the proper deployment of these strategies can deliver. By using good tax avoidance strategies, you get a 25-35% return out of the gate.
[1] The title of this Newsletter, “Welcome to the Desert of the Real”, comes from the 1998 film “The Matrix”. The world in the Matrix is a Simulacrum, a computer–generated illusion. It only “looks” and “feels” like the late 20th century. Instead, human beings are enslaved in tanks of fluid, wired to the Matrix. Also, readers steeped in post-structuralist philosophy may recognize the title as a paraphrase of a quote in Jean Baudrilliard’s 1981 book, “Simulacra and Simulacrum”.
[3] Tax deductions were more generous, however.
[4]A concern of Roth IRA holders is that the federal government may decide at some point in the future to tax Roth IRA withdrawals, limit the amount of Roth IRA withdrawals that are tax-exempt, or phase-out the exemption for high-income earners. This seems unlikely given the original promise of the Roth IRA that the proceeds be tax-free and the political power of retirees making Roth IRA withdrawals.
However, by non-direct means, the federal government has “raised” the taxes on traditional IRA withdrawals by compressing the tax brackets. And the trend toward tax bracket compression will probably continue under the pretense of “tax simplification”.
“Tax simplification” is a Washington canard, a glittering generality that has no meaning outside of a politician’s lexicon of trickery, or “Chumpery”. Chumpery (no relation to champerty) is when a politician addresses a hot-button issue with no intent (or real ability) to actually do anything about the issue. Prominent examples of Chumpery would include “Balanced Budget Amendment”, “Term Limits”, Flag Burning Amendment”, “Defense of Marriage Amendment”, or “Health Care Reform”. From the foregoing one could conclude that anytime a politician proposes something that would require a Constitutional amendment they are automatically engaging in Chumpery.
[5] “Seeing the Elephant” was a 19th century term for seeing or doing something unique or valuable. However, Civil War soldiers would also say that new men who first experienced combat "saw the Elephant."
STOCK UPDATE
The Quantum Multiplier Portfolio is short on stocks. A handful of stocks Here are the long stock holdings:
FDX 218.51 48.5%
AMAT 43.54 22.25%
CE 96.14 9.54%
Nearly all of the Author's activity has been options, and most of that with short positions. The returns have been stellar. But this site provides only general advice and cannot recommend individual positions for specific situations.
DESERT OF THE REAL ECONOMICS IS A MEMBER OF THE FEIGHTNER CONSULTING LLC FAMILY OF COMPANIES AND IS ALSO AN ASSUMED BUSINESS NAME OF FEIGHTNER CONSULTING LLC. (DAMNED LAWYERS ALWAYS WANT SOMETHING OUT OUT OF US.)
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