In my line of work, it’s really not uncommon for me to work with multiple generations from the same family. In fact, just this past week I received a call from a longtime client, I’ll call him George, who felt it might be time for his daughter, I’ll call her Courtney, to start to work with a guy like me. George is about 60, grew up outside of Boston, married his high-school girlfriend and they had three daughters together. Courtney, who is the oldest, is 25 and recently engaged. George and his wife moved to East Sandwich about seven years ago, which is when we first met.
I told him I would be glad to talk to her, but you know, I also encouraged her to interview other advisors to make sure she finds the right fit. George and I got to talking about how preparing for retirement is much different now for his daughter, and how the world of retirement planning changes from generation to generation. We both came from a generation that saw our parents work for the same company for their entire career, and they counted on a company-funded pension plan as the cornerstone of their retirement plan. But over our own working careers, direct contribution plans like 401(k)s and self-funded traditional IRAs have replaced pensions as one of the central sources of income in retirement.
It’s very likely that George’s daughters, as well as my three young ladies, will still utilize 401(k)s and IRAs, but many of them may also take advantage of the benefits that a Roth offers, and they should. You see, Roth IRAs and Roth 401(k)s differ from their traditional predecessors in how money is taxed going in and how it is taxed coming out as income. Unlike the traditional IRAs and 401(k)s, Roth contributions are not tax-deductible, but the benefit here is you don’t owe any income tax on the growth of the money as you take out qualified distributions. Folks, with tax rates likely to increase in the very near future, the Roth is garnering a lot of attention as an advanced tax-planning retirement strategy, so this week with our time together, I’d like to dig a bit deeper into the details of the Roth.
First created by Congress in 1997, the Roth has rapidly gained in popularity over the past decade and current events only make them more attractive as a retirement vehicle. Over the past decade, the Roth has seen a substantial influx as people choose to take advantage of their tax-favorable treatment at distribution. Roth investing accounted for $600 billion in assets in 2014 and grew to more than $1 trillion in assets by 2020. So why the rush to the Roth?
Well, folks, few of us like paying more than our fair share of taxes, and we certainly don’t like to see taxes increase. In fact, any politician asking for tax increases over the last few decades was on a fool’s errand. However, that may be changing with Democrats currently in power across the House of Representatives, the Senate and the White House. This political shift in power coupled with our significant national debt and recent substantial stimulus payouts seems to point to a higher future tax environment. And despite our grumblings about taxes, Americans are experiencing one of the lowest overall effective tax brackets in the last century, at least for now.
President Biden recently unveiled the “America’s Job Plan,” which looks to raise the taxes on corporations from the current 21 percent to 28 percent. The second phase of the plan will include increased taxation of Americans making over $400,000 per year. It is still a bit fuzzy on whether his plan is to tax individuals or households. In addition, the Biden plan will look to increase the estate tax and impose a higher capital gains tax on higher wealth individuals.
Other Democratic senators are floating their own proposals to increase taxes, too. The one that should draw the most interest from investors is the Step Act proposed by Senator Chris Van Hollen. The Step Act would eliminate the step up in basis that heirs receive on many inherited investment vehicles, including stocks. Instead, those gains would be realized and taxed upon death. Currently, the proposal would exempt 401(k)s and those with individual estates of $11 million and couples with $22 million estates.
It’s these anticipated tax hikes, coupled with uncertainty, that will likely encourage many people to pay taxes at today’s relatively lower tax rates, and this further increases the appeal of Roths. Those already invested in traditional IRAs and 401(k)s might also feel the pull to convert those plans to Roth vehicles. Converting some or all of your traditional IRA or 401(k) money means a tax bill now, but that will be weighed against the cost of paying potentially higher taxes later when distributions occur in retirement. And many people are already making that move, with Roth conversions up 22 percent in 2019 and 67 percent in 2020.
I finished my conversation with George and Courtney by explaining to them that for younger folks, like Courtney, who are in their lower earning years, using Roths can be a great strategy as a complement or alternative to the traditional 401(k) or IRA, but they should consider all of their options. For example, contributing to the 401(k) often means getting a company match, and this is basically free money they won’t want to lose out on. And for folks, like George, who are further along in their careers, they should make sure to do the appropriate tax-analysis to see if converting to a Roth makes sense.
And as always—be vigilant and stay alert, because you deserve more!
Jeff Cutter, CPA/PFS is president of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, Mansfield. He can be reached at firstname.lastname@example.org.
This article is intended to provide general information. It is not intended to offer or deliver investment advice in any way. Information regarding investment services is provided solely to gain a better understanding of the subject of the article. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy will be profitable. Market data and other cited or linked-to content in this article is based on generally-available information and is believed to be reliable. Cutter Financial does not guarantee the performance of any investment or the accuracy of the information contained in this article. Cutter Financial will provide all prospective clients with a copy of Cutter Financial’s Form ADV 2A and applicable Form ADV 2Bs. Please contact us to request a free copy via .pdf or hardcopy. Insurance instruments offered through CutterInsure, Inc.