The Case for Roth

In part one of a two-part series, we explain why Roth accounts are more compelling than ever.

Roth accounts are more compelling than ever now, thanks to lower income tax rates in the Tax Cuts and Jobs Act (TCJA) of 2017. Under TCJA, most individual tax brackets have been reduced slightly, with a top rate of 37%. In 2019, the top 37% tax marginal bracket “kicks in” at $510,301 for individuals ($612,351 for married couples filing jointly.)

However, unlike corporate tax reform, which is permanent, the bill includes a “sunset” provision that all individual tax changes will lapse after 2025.  We may never see federal tax rates this low again. On January 1, 2026, a majority of changes to individual income taxes rates will revert to the rules that were in effect prior to the TCJA.

The new temporary “low” tax environment has increased advisor, plan sponsor, and participant interest in establishing Roth accounts—both IRAs and 401(k) employer plans. Why? The driver of “to Roth or not to Roth” (contribution and/or conversion) is the determination of what your tax rate will be in your retirement years versus today’s rates. Therefore, if today’s rates would be lower than future rates you would otherwise pay, then a Roth account is often the best available option. Will your top tax rate in retirement be higher than the top federal tax rate of 37%? Also don’t overlook the impact state taxes have on retirement savings.

With the potential for higher tax rates starting in tax year 2026 and beyond, individuals should consider funding and/or converting to Roth accounts (IRA and/or 401(k)), where your investments grow tax deferred and, if certain requirements are met, are distributed free of taxes (earnings included).

Moreover, Roth IRAs are not subject to minimum required distribution (RMD) rules starting at age 70½. However, designated Roth 401(k) values are subject to RMDs.

Many retirees are surprised about the numerous ways RMDs can hurt their financial plan. For example, RMDs increase adjusted gross income, which could set off the “perfect storm” of events, potentially pushing the retiree into a higher tax bracket. RMDs can also result in more of their Social Security Benefits becoming taxable, increase Medicare Part B premiums, and additional 3.8% investment tax.

A problem that rears its head is, “my future tax rate is an unknown.” Therefore, the best we can do is “guesstimate.” That said, some clients prefer “tax diversification,” so a portion of their retirement accounts are invested in a Roth account as a tax hedge against rising rates. Conversely, for those taxpayers that are confident that their future tax rate will be lower than the rate they pay today, a Roth account may not be appropriate.

Another change in the TCJA is the elimination of a recharacterization of a Roth IRA conversion. Prior to TJCA, an individual had the ability to recharacterize a conversion up until October 15^th in the year following the year that the conversion was made. Notably, recharacterizations of Roth contributions are still permitted for the 2018 tax year. So those taxpayers who funded a Roth IRA in the 2018 tax year, but their modified adjusted gross income (MAGI) lands above the government imposed threshold, can still recharacterize the Roth contribution (plus earnings) back to a traditional IRA.  

Roth accounts are undeniably complex. Therefore, next week’s column will cover Roth IRA, Roth 401(k), 403(b), 457(b) and TSP eligibility, transfer, rollover, distribution and conversion rules.

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

Modified adjusted gross income (MAGI) includes wages, interest, capital gains, income from retirement accounts and alimony paid received by the taxpayer adjusted downward by specific deductions, including contributions to deductible retirement accounts and alimony paid by the taxpayer; but not including standard and itemized deductions.