Roth Accounts: The Most Underused, but Very Useful, Retirement Tool

Friday, December 14, 2012 at 12pm
By John Friedman

During the 12/12/12 concert a few nights ago I was double-screening — with the big screen tuned to one of the many networks showing the event and the little screen tuned into my own little slice of the Twitterverse.

It’s always interesting to see non-music folks commenting on music. One politics-oriented tweeter said that she thought the Beatles were the most over-rated band of all time — this while Sir Paul was struggling to hit the high note in the first line of Blackbird, about that chunk of the 24-hour period when the Blackbird sings and it’s dark outside.

She is so very wrong, I thought to myself. I’ve half a mind to tweet back to her that she is full of it, and that the real over-ratee on the show was Commander, not-quite-a-Sir Eric of Clapton-on-Thames, who for the past forty years has been playing the same lick over and over and over again, which is bad enough, but all the worse when the lick he’s been playing over and over and over again wasn’t all that interesting the first time through (compared to, say, Jeff Beck on a bad night) — although, admittedly, Commander Eric of C. does have an amazingly beautiful, doing-it-the-hard-way vibrato (his guitar truly can weep) and he totally has the blues scale down cold.

Besides, we all know that the reason the Beatles were what they were was because of the fellow who’s been gone now for 32 years as of 4 days ago, plus a very gifted, non-show-off’y, reverse-handed can-play-drums-inside-of-Beatles-music drummer, plus perhaps the best guitar-accompanist of all time, plus, yes, Sir Paul. The magic was in the mix, and in the songs, which, lord uh mercy, sure did have sophisticated harmonic structures to them and a great combination of the saccharine and the acrid.

But that’s a lot more than 140 characters, right?

Ah, but this whole thought path did get me thinking about how some things are over-rated while others are under-rated, and also how some things are over-used and others under-used.

And the next thing I knew I was thinking about how Roth retirement accounts are both under-rated and under-used, and then a-writing I did go.

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The government, by way of the tax code, provides us with various sorts of vessels in which to stow our stored-up money. There are flex dollar accounts and there are ESPP accounts, both of which represent short-term waystations where some of our salary dollars cool their jets until we use them for some tax-advantaged purpose within a year’s time or less. Many people have never heard of these things. Not to worry if that’s you (though do ask . . .  they are important things).

And then there are the long-term vessels, most of which are retirement accounts which some of us have heard a whole heck of a lot about and most of us have heard at least a smidgen about.  You know: the pension plans, the IRAs, the 401k plans, the 403b plans and all the many others making up the veritable smorgasbord of qualified (i.e., for normal folks) and non-qualified (i.e. for big-earners) retirement accounts.

All of them, however, fall into two basic camps: they are either tax-deferred or they are tax-paid. So I split out all the smorgasbord entrees into two camps: TDAs, which are Tax-Deferred Accounts, and TPAs, which are Tax-Paid Accounts. And then I label all the other sorts of investing accounts as TTAs, which are Totally Taxed Accounts, which, at least for the next 17 days, are not-taxed-very-much-at-all accounts.

Caution: I might have made up these abbreviations. If you use them elsewhere, people might look at you funny and not understand what you’re talking about. Go forth carefully with them.

*  *  *

TDAs are all about instant gratification, in that, when you contribute to a TDA, Uncle Sam will allow you to put a negative number somewhere on the front page of your tax return — or something equivalent to that very thing — which in turn reduces your taxable income on that 1040 and therefore reduces the tax you owe, as if you never made the money you just contributed to the TDA in the first place (for the time being anyway).

It’s as if Uncle Sam contributed part of the money you put into the TDA. Do you see why?

Say that you put $1,000 into an IRA that you set up at Vanguard; you then get to put an entry onto the front page of your 1040 of negative $1,000, and if you are well ensconced within the fat part of the 25% marginal tax bracket, that negative $1,000 entry on your 1040 will reduce your tax bill by $250. So, in a way, $750 of that $1,000 you contributed to your IRA came from you, and $250 came from our favorite (in this context anyway) uncle.

So when you put money into a TDA, you get an instant benefit (instant in tax-code-ese meaning on your tax-return for the current year).

The quid pro quo — the that which you have to fork over for the this — Uncle Sam exacts for this current tax benefit is that once you are in your early 70s, you have to start taking the money out of your TDA. So once you get up there in age you usually have to take out about 4% of your TDA’s previous year’s year-end balance, with that percentage increasing each new year, with the idea being that Uncle Sam really wants you to take all that money out of your TDA before you die, assuming that you die right around when you are statistically supposed to die, and with the ever-increasing percentages designed to do just that.

Why? Why make you take money out of your TDA?

Because Uncle Sam wants you to pay tax on all that money, and because, when it comes to any given dollar inside of one of your TDAs, the only time you pay tax on it is when you take it out of the TDA — when it crosses the threshold between the early part of its life spent inside your TDA and the latter part of its life spent in your own little hands (where it will hopefully reside for a good long while). And when it crosses that threshold, that dollar will then be taxed in that year like your income is being taxed that year (though without payroll taxes and such).

So Uncle Sam lets you defer paying taxes on that dollar of income until sometime much later in your life. But pay tax you shall, and at rates applicable to your then-income.

Wonky Interlude — non-wonks should please skip forward past the next three asterisks.
And, yes, for all you wonks out there, you’re right in thinking that this transforms what otherwise would have been capital gain income (which has just about always been taxed at relatively low rates) into plain ol’ vanilla ordinary income (which has always always been taxed at higher rates than capital gains).

So if you owned, say, nothing but Apple stock inside your IRA and it’s worth $10k more than what you bought it for, and if you then sold the Apple stock and took $10k out of your IRA, the $10k is going to be taxed up the wazoo, as ordinary income, when it comes out of your IRA, even though it would have been taxed lightly if you held your Apple stock instead in a plain ol’ TTA — in a normal brokerage account, where it is subject full-on and all the time to the tax code headwinds (though all of which, when it comes to the appreciation in your Apple stock, is of an opt-in nature, because you only pay tax on the $10k increase in value if your Apple stock if you opt to sell the stock).

TDAs are, then, as I’ve been known to say, OIGs — Ordinary Income Generators, pronounced OYG, as in Oy Gosh, but without the osh.

OYGs are, all things being equal, lousy vessels in which to stow assets that are likely to generate big capital gain income. Why, they turn capital gains into ordinary income! Careers have been built on doing just the opposite — carried interest by they name.

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Tax-Paid Accounts are much newer and far more rare than TDAs. You can easily recognize a TPA because it will always have attached to its label the name of a very well-meaning but very badly-toupee’ed Senator named Roth. 

In 1998, the late Senator William J. Roth spearheaded the creation of a new sort of retirement account investment-stowage vessel that operates mostly in an opposite, inside-out, upside-down fashion compared to how TDAs operate.

So, while TDAs are all about instant gratification, Roth accounts (also known as Tax-Paid Accounts also known as TPAs) are all about delayed gratification, very much along the lines of The Road Less Traveled, as preached by the apparent-scoundrel and very long-term NYT best-selling author M. Scott-Peck.

So forget about getting a negative number on your 1040. With Roth accounts you don’t get one. Ever.

And how about reducing the taxes you pay now? Nope. The money in a Roth account is money on which you’ve already paid taxes — recently or maybe long ago.

Ahhh . . . but how about if, instead, you were able to take some of your dollars out of the purview of the tax code forever?

That’s what Roth accounts are all about. You do not get a current tax benefit, but, aw shucky ducky, do you ever get a gargantuan long-term tax benefit because all the dollars inside of your Roth account — both those you put in and those that grow inside of the account — are forevermore outside the tax code (proviso: this is the tax code, so all this stuff is a lot more intricate than as I am generically and quickly describing all of it here, so do consult your tax expert on this stuff and never act on generalized advice!).

The beauty of Roth accounts, then, is that the dollars your contributed dollars beget inside your Roth account are, if you let them simmer and ferment long enough (similar proviso: we’ll leave the details of what that means for some other time), never going to be taxed at all. They don’t get taxed when you pull them out of the account and they don’t get taxed when they’re sitting inside the account. They never get taxed at all.

So a $10k Roth IRA account is worth a whole lot more than a $10k regular, traditional IRA because one $10k chunk of your dollars has already been taxed all it’s ever going to get taxed, while the other $10k chunk of your dollars is a ticking tax time bomb. A TPA dollar is worth more than a TDA dollar.

The conceptual gist of Roth accounts is that the dollars you put into a Roth account were already taxed and, therefore, that the dollars those already-taxed dollars beget are cut from that same already-taxed bolt of cloth. Neat, eh?

And, at least for Roth IRAs, Uncle Sam is saying these days that he is never going to require you to take the money out, so dollars inside of Roth IRAs can be great gifts to leave to your loved ones as well, Roth wrapper and all.

But you will not get an upfront tax benefit. All the tax benefits come in your later years. All of ’em.

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Can you handle that delay? Are you financially wired that way? Or, more value-judgmentally, are you financially mature enough to delay tax gratification?

Most people cannot and are not.

My experience, however, is that many and perhaps most folks in financial services have a whole heck of a lot of Roth dollars to their names (un-spent HSA dollars, too, but that’s a topic for another time, as is tax-rate-risk diversification).

So what does that tell you? What does it say that financial folks have Roth accounts and you don’t?

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I can get how Sir Paul can be annoying. I can also get how upfront tax benefits are the bees’ knees.

But, please, Beatles-detractor, do give it another listen to see if there’s something you’re missing, and please, biological, living, breathing human beings in the U.S., do think about whether you should have some Roth dollars in your life, OK?

Because they’re both quite fab luv.

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