CommentaryJanuary 2021 Commentary

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Do You Want to Pay Taxes on the Seed, or Taxes on the Harvest?

If you’ve worked with us a while or at least been reading our website blog posts, you know we often talk about the study with the children with the marshmallows. Psychologists place children in a room full of toys for 5 minutes. They also have a few marshmallows place on the table for them. If they can wait 5 minutes before eating the marshmallows, they get those and more. Most kids don’t make it. The ones who do, tend to have much better lives- personally and professionally. In other words, people who develop the ability to delay gratification do better.

Beginning in 1998, the Roth IRA (named after Senator William Roth) allowed people with lower income thresholds to contribute after-tax contributions up to $2000 to an account that would grow federally tax-free for the purpose of their retirement funding. The irony was many people who were eligible for Roth IRAs may or may not have benefited from them as their income in retirement may have been at a lower tax level than in their working years. Further, many people in the lower income brackets had a much harder time saving for the long term, especially without an immediate deduction. But the legislative seed was planted and ready to grow.

While the income limits to make annual contributions have risen with inflation, there are now lots more ways to grow federally tax-free income with the expansion of Roth rules. A person can convert any pre-tax IRA money they wish to- no matter what their personal income is- in any given year, if they are willing to pay the taxes on that conversion amount at their current rate the year of conversion. A person with a 401k that has a Roth election, as many do now, can defer their 401k contributions, up to the annual limit (plus the catch-up contribution), to the Roth portion. There are other ways for high-income or high asset people to get money into a Roth as well but are too complex for a short blog.

High-income, high asset people have the most to gain from the Roth tax law.

First, the younger they are, the longer they have for the money to compound tax-free. If they pay taxes on an $18,500 retirement plan contribution in their 40s, but then take out that contribution, and all of the compounding that hopefully came with it in their 70s or 80s- that can be a big lifetime tax savings.

Further, pre-tax IRAs and retirement plans have required minimum distributions at age 72. If these accounts are large, coupled with social security, pension income, and other investment income, it can force retirees into higher brackets than they need to be in retirement. The Roth has no Required Minimum Distribution to worry about.

Lastly, and this is just an educated guess, tax rates themselves may be higher in the future. Before 1984, the top bracket was never below 70%. The Boomers in the work force, and the changing political mood to not worry as much about public debt has kept tax rates, particularly for the top brackets, down since then. With the Boomers aging and the interest on the debt increasing, we may be in for at least incremental tax increases to keep the leader of the global economy in the leadership position. If tax rates rise, money that follows the Roth law could be even more valuable than it is now.

Roth is not without tradeoffs and is not for everyone. However, the younger the investor is, coupled with higher income and ability to save, and the more likely a person is to have forced income at 72 that they do not need or want, the more likely it is that Roth could benefit them. Paying the taxes on the seed money to contribute to Roth based investments could reap a bountiful, tax-free harvest on the back end. A little delayed gratification can make a big, compounded impact for the rest of your life- just the same as if you are the kind of person to leave the marshmallows alone for 5 minutes.

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The Planned Approach, Inc.

420 W. 98th Street
Kansas City, MO 64114
(816) 941-0098

Our Disclosures/CRS FORM

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The Planned Approach, Inc.

420 W. 98th Street
Kansas City, MO 64114
(816) 941-0098

Our Important Disclosures

Insights for Your Life Stage

The Planned Approach, Inc. is an Investment Advisor registered with the Securities and Exchange Commission. No client or prospective client should assume that any information presented or made available on or through this website, is a receipt of, or a substitute for personalized financial planning consulting advice. Financial planning consulting advice can only be rendered after the following conditions are met: 1. Delivery of our Form CRS, Form ADV Part 2A and 2B to you; 2. Execution of an Investment Advisory and/or Financial Planning Engagement Letter between us. You may obtain a copy of our ADV Part 2A Disclosure Brochure containing similar information by sending a written request to The Planned Approach, Inc., 420 W. 98th Street, Kansas City, MO 64114. Additionally, please note that hyperlinks included throughout this site are provided as a matter of convenience and we disclaim any and all responsibility for information, services or products found on websites linked hereto. Please contact the firm for further information. The Planned Approach, Inc. is not engaged in the practice of law and does not provide legal advice. Always consult with an attorney regarding your specific legal situation. The Planned Approach, Inc. is not engaged in the practice of tax consulting. Always consult with your tax advisor regarding your specific tax situation.