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Roth-Lite: A Skeptic’s Strategy for Tax Reform

My former life as an auditor has left me with an ever-questioning and critical mind, especially when it comes to money.  Though I tend to be a skeptic with a very analytical way of thinking, that doesn’t mean that I’m not open to new ideas.  Actually, it’s quite the contrary.  I make a point of keeping my eyes open for innovative ways of approaching personal finance in hopes of learning something new and using that knowledge to grow as a person.

With that being said, today’s topic is one that a lot of Americans are cautiously watching: tax reform.

SHORT-TERM SOLUTION, LONG-TERM PROBLEM

Putting less money towards paying taxes means more money in our bank accounts, right?  Though that’s what most people have been led to believe, we should expect to pay some form of taxes for bare necessities.  Otherwise, tax increases will come back to haunt us.

To be quite blunt, the ‘Cut Cut Cut’ bill (as the President calls it) seems to be cutting taxes rather than reforming them.  Much like the Chinese philosophical system of Feng Shui, the government has mastered the art of rearranging policies and legislation to maintain their current spending levels. This, ladies and gentlemen, is the “neutrality” effect within reform.

Tax reform aims to strengthen the economy through tax revenue-neutrality.  This concept of revenue-neutrality increases and decreases various tax revenue streams that achieve a zero-sum game.  Since it is highly unlikely that any politician would ever vote for a decrease in government spending, especially if it threatens promises made on the campaign trail, the deficit continues.

So, if there’s a popular bill that promises tax breaks for the all, but no one in Washington is willing compromise on true reform, are we headed for increased taxes in the future?

ROTH-LITE

A topic that has gained quite a bit of attention during the early discussions of tax bill is the concept of Rothification.

Essentially, the Rothification model involves decreasing the up-front benefits of contributing to a 401(k) or an IRA. Instead, contributions would be directed into Roth-type accounts. In theory, Roth 401(k) owners would benefit from the tax-free growth and immediate contribution withdrawals that Roth accounts provide (5-year rule for earnings). Meanwhile, the government enjoys the windfall of revenues from higher taxable incomes.

Ultimately, Rothification was squashed and everyone was able to step back from the ledge with the knowledge that their tax-advantaged account contributions were safe once again. Even so, this situation got me thinking: In a low tax rate environment, is it possible that Rothification (or similar approach) actually holds some merit?

Okay, hear me out:

While tax cuts sunset over 10 years, it is possible that tax increases and other policy changes will take effect upon the bill’s expiration. In this scenario, it would make sense to pay taxes while in the low rate environment and invest in Roth-type accounts or other tax-free streams of income. If all plays out accordingly, a low tax or tax-free retirement could be achieved.  Consequently, missing this opportunity could result in higher tax assessments against those tax-deferred accounts later in life.  That is sure to put a damper on that retirement party.

Don’t get me wrong, I’m a huge fan of 401(k)s and IRAs (see my Net Worth).  I would be a fool not to acknowledge the power of compounding pretax is dollars and an even bigger fool if I chose to ignore what is on the horizon.  Overreacting, with a complete Rothification makeover, is not the answer.  I believe, a more prudent approach would be something in the middle that is tax great and less filling – a Roth-Lite!

Only the finest ingredients of pre and post tax dollars are used to make a rich batch of Roth-Lite.  Refreshing from the start and perfectly converted at the Backdoor Brewing Company.  While there may be more simple and/or efficient methods out there achieving the same results, Roth-Lite makers stand by their techniques.

One maker’s technique is described as: only to contribute up to what the company matches rather than maxing out the 401(k).  Invest the low-taxed difference, between the match and max, into a Roth account (or other tax-free investment).  Just before the tax cuts expire, work the backdoor Roth conversion on the traditional tax-deferred accounts.  Enjoy responsibly.

Why would anyone consider doing this?

  1. Greater Liquidity. What is the one thing that enables people to be financially independent or to retire early in life? Liquid assets.  The chance of someone retiring before the age of 59 ½ because they have $1,000,000+ in their 401(k) and IRA is very slim.  Roth-Lite converts non-liquid to liquid in a low tax environment.
  2. Increased Investment Options. Compared to a traditional 401(k), Roth-IRAs and brokerage accounts are more flexible and have a greater selection of investments options. There are also no limitations on the number of transactions that can be executed each month. 401(k) plans, on the other hand, may not always offer the best nor the lowest cost funds,
  3. Lower Fees. Large financial institutions such as Vanguard and Fidelity charge a percentage of assets under management.  They would prefer non-Rothified retirement accounts over brokerage accounts due to the fierce competition in that category. Making your dollars work at the lowest possible cost is smart money, and
  4. Lower Taxes During Retirement. If the theory of a high tax rate environment proves to be true (especially for those who are retired) being invested in a Roth account or other tax-free streams of income should keep you in one of the lower tax brackets albeit in a high tax environment.

SUMMARY

At the moment, arguments for and against the current bill will continue to rage on.  Concessions will ultimately be made and no matter which party you associate with, there will be winners and losers.  The best way to navigate muddy waters is to plan ahead.  Periodically review your financial plan, make adjustments as necessary and never be afraid to say, “Please explain, I don’t understand“.

 What are your views on the proposed tax reform bill?  How does it shape your thoughts for your financial plan in 5, 10, 20+ years?

 

 

 

Edited by Brianna Roney

2 comments

  1. Great post. Your auditing background shows in your analysis. My fear of going mostly Roth is that the government will try to tax it in the future or place some type of RMD on accounts. With a combination of having both a traditional 401k and Roth IRA I can diversity my tax strategy and have both short and long term benefits.

    • Dave, thank you for your thoughts. You fear the Roth may one day get taxed just as I believe we haven’t heard the end of reducing 401(k) contributions. It was brought up once, it will get brought up again. I 100% agree with you that one should have a combination of retirement accounts which is why I thought a Roth-Lite strategy instead of a complete Rothification makeover would make more sense.

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