Ed Slott: The Case for Roth IRA Contributions

Key Takeaways

• Since you pay taxes upfront, Roths can give you a more accurate value of your retirement savings.
• Because Roths don’t have required minimum distributions, the money in the account can grow tax-free for the rest of the accountholder’s life.
• Unlike tax-deferred accounts, Roth accounts take advantage of known tax rates.
• The government benefits from the taxes that it receives upfront from Roth contributions.
• If you hit the income limits for opening a Roth, you can contribute to a nondeductible IRA and convert it to a Roth.

Christine Benz: Hi, I’m Christine Benz for Morningstar. If you’re funding an IRA this year, you may be debating about whether to make traditional tax-deferred or Roth contributions. Tax and retirement expert Ed Slott has long been bullish on Roth contributions. He’s here to share his perspective. Ed, thank you so much for being here.

Ed Slott: Great to be back with you, Christine. Thanks.

Differences in Tax Treatment

Benz: It’s great to have you. Investors are rushing in their 2024 IRA contributions before the April 15 deadline. You think, and you’ve made this assertion on many occasions, that most people should be making Roth contributions versus those traditional tax-deferred ones. Before we get into the case for Roth, which I know you’re happy to make, can you outline the key differences in tax treatment for Roth and traditional tax-deferred accounts?

Slott: Yes, the difference is easy. No pain, no gain. IRA, you may or may not get a deduction, and if you do, people love that. But again, I think that’s shortsighted, especially when rates are relatively low. The deduction is worth less than it would be at high rates, where with the Roth IRA contribution, you get no deduction. You pay the tax upfront, which drives people crazy. But look at the long-term big picture. When you do planning, any kind of good planning, you should be always planning with the end in mind. Where do you want to end up? Not what does it cost me, or what do I save now? What can I get later when I’ll need it most in retirement? And it’s pretty nice having a growing, building tax-free, income tax-free Roth growing and growing each year, looking at that statement, knowing it will never be hit for income taxes when you’ll need the money most in retirement, as opposed to an IRA, which will also grow. It will also grow, but it’s growing partly, and I always tell people this, for the joint owner. People say, what do you mean a joint owner?

I remember a client coming in. I’ve had lots of clients like this over the years. But I remember this one guy telling me he was so happy he came in years ago, and he brought his IRA statement. He says, Ed, look, I finally hit $1 million in my IRA. And I said, give me that statement. What is that? You’re showing me. That’s not your money. That’s just temporarily on your letterhead. You’re not keeping most of that. And then I said, give me that. Let’s say his name was Jim Smith. It says Jim Smith. Let me fill in the joint owner, Jim Smith and Uncle Sam. This is a joint account. He said, you mean like with my wife? No, no, a joint account with your wife is 50-50. Everybody knows that. Uncle Sam is a special kind of joint owner. He can say what portion will be his when he needs the money the most. And look at the history of tax rates. It may be more than 50%. So the point is you’re building an account, but a lot of that is going right back to an unknown amount of taxes in the future.

How RMDs Play a Role in Tax Planning With Roth Accounts

Benz: I hear a lot of tax professionals say that the right type of contribution really depends on several different factors. They are a little more gray on this versus black and white. I think you just laid out the case for why you’re so bullish on Roth contributions and much less so on traditional tax-deferred. But would the role of required minimum distributions also fit into your thinking that the Roth accounts don’t have RMDs? Does that make them a little easier for you to like, too?

Slott: Oh, yeah. People light up with that. I mean, nobody likes RMDs because you’re forced to take the money. It’s out of your control. Nobody likes that. You talk to anybody who’s in RMDs, and I’ve had a lot of clients over the years, and they get the 1099, and they just can’t do anything about it. They have to add the income and pay tax even though they don’t even need the money and it just goes into some other account. They wish they didn’t have RMDs. Matter of fact, when Roth’s came out, I had clients over the years convert everything just because they couldn’t stand RMDs. Regardless of the taxes, they didn’t want to figure it out. They wanted no part of that. It’s such a great breath of freedom to hit 73 with a Roth IRA—that’s the RMD, required minimum distribution age—and not have to do anything. There are no required minimum distributions for a Roth IRA owner during their lifetime. So, that money can grow income tax-free for the rest of your life, and even under the Secure Act, 10 years beyond for your beneficiary. So it does double duty. But there are reasons some people might say to keep some traditional IRAs and I can give you a few if you want. Well, one big one to keep traditional IRAs is if people tell me they’re giving a lot to charity, and I’m talking about QCDs, qualified charitable distributions. One of the greatest provisions in the tax code. The only negative is it only applies to IRA owners who are 70.5 years old or older.

So, it doesn’t apply to enough people. But if you’re over 70.5 and you’re giving to charity anyway, you’re probably getting no tax benefit for that gift because you probably take the standard deduction. With the QCD the IRA goes directly to the charity. So, you’re getting the standard deduction and getting that money out of your IRA income tax-free at 0% taxes. Yes, it goes to the charity but can also satisfy part of an RMD. And IRAs are the best, traditional IRAs—this is where you want to keep some and not convert—traditional IRAs are the best assets to give to charity both during life and even after death. If you want to make a bequest to charitable organizations. That may be a reason to keep some traditional IRAs. Give the charities the worst possible assets ever. Those, the dregs loaded with taxes because the charity doesn’t care. If you give the charity $100,000 traditional IRA, they get $100,000. There’s no tax. To them, it’s great money. To you, it’s horrible money because it’s loaded with taxes.

Plus, if you’re giving to charity and you give the IRA, that’s more other money you can give to your family. That’s better non-IRA money that gets a step up and basis, things like that. So that would be one reason to keep some traditional IRAs. If you’re telling people, “Well, I give to charity and I have a regular giving program and it’s important to me,” use the traditional IRA. Keep some of that. However, much you think, maybe a few hundred thousand, I don’t know, a few tens of thousands, whatever your number is, don’t convert it all.

Another reason to keep a traditional IRA might be if, and this one you don’t know if you’re going to have maybe heavy medical bills, but it seems to happen to everybody. It’s a horrible thing now. Even the last few years I was doing tax returns, it wasn’t unusual to see people, older people claiming over $100,000 of medical expenses every year.

I had it with my own mother. Even simple things like the trips, the ambulance, paying trips to the doctor in the hospital, and the home aides, and the nurse’s aides, in the nursing home, and medical home improvements, installing ramps and railings and chairlifts and stairlifts and widening hallways and doorways and kitchen and bathroom modifications. These things just go on and on. But nobody knows, but as you get older and we are all living longer, it’s more likely than not there will be some heavy medical bills. So, for that reason, you may want to keep some of those traditional IRAs and take them down in years, even when you’re subject to RMDs, use those RMDs and offset it, not completely because you have the 7.5% limitation, but that would be a good use of that money when you know you’re going to have heavy medical bills.

Why a Traditional Tax-Deferred Account Works Better for Investors Retiring Into a Lower Tax Bracket

Benz: Those are good examples, Ed. I want to follow up. When we’re talking about people who are making contributions, you mentioned young folks, the Roth looks to you close to a no-brainer, but it seems like a really good use case for traditional tax-deferred contributions would be if someone is 50 and older and they don’t have much in retirement savings, which is a pretty common profile. So, they’re unlikely to be in a higher tax bracket in retirement than when they’re earning an income. Would you favor tax-deferred contributions, traditional tax-deferred contributions versus Roth in that situation?

Slott: Yes, because then you win the bet. And the bet is on the Roth, all your betting is that future tax rates, not the actual tax rates, but your future marginal rates will be higher in retirement than they are now. And if some people haven’t built a retirement account, that happens, you make a good point there because people are raising kids, paying off mortgages, have all these expenses, all of a sudden they’re in their 50s and maybe that’s ebbed a little, I don’t know, and they’re starting to have disposable income where they can put into a retirement account. And it might be a good shot that their income will be lower in retirement, but again, we don’t know what future tax rates are. See, that’s the unknown, that’s the X factor. And even though you think you may be in a low bracket, remember, you have to watch it because you may do well and you build up and build up, and then all of a sudden you have RMDs at 73 or whatever the age is at that point. And now your income could be higher and tax rates could be higher. See, that’s the thing, you don’t know what future tax rates are. When you do Roth, you take advantage of known rates, which are very low right now.

Generational Preferences for Retirement Accounts

Benz: Do you think that this could become something of a nonissue going forward? It seems like baby boomers and maybe Gen Xers are likely to have a lot wrapped up in their tax-deferred accounts, the traditional type, but younger investors seem much more likely to have prioritized Roth. Is that your experience as well?

Slott: I think they’ve been hit over the head probably by people like me and everybody else saying every young person, that is a no-brainer. Every young person entering the workforce should only be doing Roth 401(k)s and Roth IRAs. Why would they want to build a taxable account when this is available? So yes, long after we’re gone, yes, they’ll all be Roths and who knows what the tax rules will be then. And that’s what people worry about, by the way. Are there reasons not to do a Roth? I get these questions from consumers. The number-one question I always get “Ed, all the stuff you talk about Roth sounds great, but can I trust the government to keep their word that Roths will always be tax-free?” And the older people, and I’m old, but they’re way older, and the older people will always say, “Do you remember when they said they’ll never tax Social Security? Well, now they tax it.” That happened like 30 years ago, and they still remember, they won’t let it go. It’s in their heads that they can’t trust the government.

So, when they ask me, “Can you trust the government?” I say, absolutely not. We have a saying as CPAs, tax laws are written in pencil. You never know what’s going to come out. But I’m going to tell you a secret why I think the Roth will hold. Secretly, lucky for us, Congress are the worst financial planners on earth. They’re shortsighted. They just look at revenue coming in to fund their tax bills, and the Roth brings in money upfront. So, secretly, they love Roths. Look at how Congress has expanded Roths: Roth, SEP Roth IRA, simple Roth IRAs, 529 to Roth, expanded matching, catch-up—all to Roths. They went Roth crazy over the years, expanding Roth 401(k) access. They love Roths because it brings in money upfront. And if you saw an actual tax bill, if you look even at the last one, the big one, the Secure 2.0, the last big one, if you look at the actual bill, which you could look at online, you’ll see where all the Roth provisions are. They’re under a giant font heading that says revenue provisions. That’s how Congress thinks about the Roth. They use it as a money grab, a revenue raise, and pay for everything else they have in the front of the bill. So, I don’t think they’re going to kill the Golden Goose. They might trim around the edges, but if they go too far and kill that Golden Goose, they’ll kill one of their biggest sources of tax revenue that people actually like.

What Is a Backdoor Roth Contribution?

Benz: How about the practical impediment for people who are funding an IRA? If you’re over a certain income threshold, and that goes up a little bit every year, you can’t make that direct Roth contribution. Can you discuss the work-around, this backdoor Roth contribution that lets those higher-income folks get into a Roth IRA indirectly?

Slott: We call it a backdoor Roth, and it’s totally legal. People say, “Well, is it really legal?” Yes. Even in the Tax Cuts and Jobs Act, not in the actual law, that’s the one they’re talking about now, extending back from 2017. In the conference committee reports, the congressional committee reports, they said right in there, yes, you can contribute to a nondeductible IRA and convert it to a Roth. There’s no question for years that you can do that. But it’s ridiculous, just my opinion now, that you have to do that. I don’t know why there are income limits on who can have a Roth IRA when it’s so easy to get around it. And what you do is you make a contribution to a nondeductible traditional IRA, and there are no income limits on that, and then you convert it to a Roth, and now you’re back where you are. But if you’re listening to this now and say, wait a minute, I didn’t do a Roth for last year in 2024, this could help me. No, it won’t because you’re making a traditional nondeductible IRA contribution now. Yes, that can be for 2024 if you want, but the conversion to the Roth will be in 2025.

You can’t backdate a conversion. So, the money won’t technically get into the Roth until 2025. But it’s still a good move if you can do it, and you just have to be aware there could be some tax if you have other IRAs. There’s this pro-rata rule without getting into the weeds, but some of that conversion can be taxable. But you’re not talking about big dollars. The most you can put in in ’25 is $7,000 into an IRA or $8,000 if you’re 50 or over. So that’s all we’re talking about. And I think Congress should probably eliminate the income limits for Roth IRAs. I don’t see any purpose for it. Plus, they would get tons more money.

Why Doesn’t Congress Remove the Income Limit for Roths?

Benz: That’s what I wanted to ask about, Ed, because we’ve had this backdoor thing going since what, 2010 or something like that?

Slott: Yes.

Benz: Why doesn’t Congress just remove that income limit entirely? Because it does seem like a lot of people are taking advantage of this opportunity to do the backdoor Roth when they could just simplify this a little bit.

Slott: Maybe nobody’s told them that: “Hey, Congress, check out Morningstar. Check out this video.” All you need is somebody to say something to a congressman, or maybe when they see their own accountants, and their accountants say, “Why do we even have to do this?” That’s how these things happen. Crazy things happen. I remember an accountant telling me, this is years ago on the ’86 Tax Act, how little the legislators knew about the tax law. And this is when sales tax was deductible. I don’t know if you remember those days. That went away, I think, in the ’86 Tax Act. Anyway, the accountant was telling me, a colleague of mine, he says, I have a client who’s a congressman, and he complained when I did his taxes that I didn’t deduct the sales tax. And I told him, you eliminated it. Who did that? So maybe you have to communicate with Congress. There’s no reason for it. Plus, the way to communicate to Congress, what’s in it for them? Because the income limits are high. If you remove them, more high-income people with the disposable income will contribute to Roth. So you get your money upfront. Remember, the only money that can get into Roths, I’m talking to Congress now, the only money that can get into Roth is already taxed money. You like money upfront. You get your money upfront. It’s a no-brainer. Maybe they’ll change it once they see this.

Benz: My hope is someone is listening, Ed. Thank you so much for sharing your perspective on why you are perennially bullish on Roths. Thank you so much.

Slott: Thanks, Christine.

Watch Ed Slott: How You Can Turn Tax-Time Pain Into a Win for more from Christine Benz.