There are numerous benefits to earning more and more income. Being able to afford the monocle and top hat, having the time to get acquainted with friends and family members that you did not even know you had, and opening the hood of your car to store groceries instead of the trunk are just some of the perks of having extra 0s at the end of your paycheck. All of the perks of having a comma or two on your tax return do come with some costs: cleaning supplies for the monocle, public embarrassment from popping the trunk instead of the hood, and increased taxes. However, making too much money is a problem everyone wishes they had. Your favorite long-lost relative, Uncle Sam, will certainly throw you a party!
If your income is above certain thresholds, the IRS does not allow you to deduct contributions into Traditional IRAs nor contribute into a Roth IRA. However, the IRS still allows you to make a contribution of after-tax money into a Traditional IRA account. In part 1, we will explore the tradeoffs of making after-tax contributions into a Traditional IRA. In part 2, we will explore the advantages of converting these monies over to a Roth IRA and methods to reduce taxes on the Roth conversion process. The goal is to minimize taxes in both the present and the future.
The IRS limits the ability to make contributions into Roth IRAs if your modified adjusted gross income (MAGI) is above a certain threshold[i]. In addition, the IRS also limits your ability to deduct Traditional IRA contributions if your MAGI is too high as well[ii]. Table 1 and 2, below, outline the MAGI limits for the ability to contribute to a Roth IRA and the deductibility of Traditional IRA contributions. The tables below are for the 2018 tax year.
It is important to note that Table 2, Traditional IRA deduction limits, assumes that you have a retirement plan at work. If there is no workplace retirement plan, income limits do not apply and the contributions are deductible in most cases.
Going forward, we will follow the journey of Mr. Legume. Mr. Legume is single, 40 years of age, has a MAGI of $125,000, and sports a fashionable monocle and top hat. Mr. Legume earns too much to contribute to a Roth IRA and has decided to make after-tax contributions into his Traditional IRA. He makes after-tax contributions of $5,500 ($6,500 after 50 years of age) until he reaches the age of 65. A total of $159,000 in after-tax money will have been contributed over this 25-year-period.
It is important to note that Mr. Legume will not have to pay taxes on the $159,000 in after-tax contributions made into the Traditional IRA. However, he will have to pay income tax on the earnings. In addition, when Mr. Legume goes to withdraw money from the Traditional IRA in retirement, the IRS does not allow him to selectively choose pre- or post-tax money upon withdrawal. Instead, he must take a proportionate amount of both.
The first question Mr. Legume should contemplate is whether the tax-deferred growth worth trading investment tax for income tax. Effectively, making an after-tax contribution into a retirement account is trading lower annual investment taxes for tax-deferred growth that is taxed as income in the future.
With the recent tax law change, investment tax on qualified dividends and long-term capital gains are no longer directly linked to income ranges for tax brackets. Table 3, below, outlines the income ranges for the preferential treatment of long-term investments. It is also important to note that the 3.8% Medicare tax still applies to investment taxes for individuals making more than $200,000 and married couples making more than $250,000. Non-qualified dividends, interest, and short-term capital gains are still taxed as income. It is also important to note that in 2018, the ability to recharacterize Roth conversions is no longer available.
Mr. Legume is in the 24% marginal tax bracket and the difference between tax-efficient investing (qualified dividends and long-term capital gains) and income tax is 9%. My previous article, Investor's Alpha: Proper Asset Location, covers how to allocate asset classes to invest in a tax-efficient manner.
In evaluating the tax tradeoff, the following assumptions are going to be made for simplicity:
- Mr. Legume is in the 24% tax bracket, currently and in retirement.
- The investment is going to return 5%.
- Dividends & Interest will be re-invested after tax. ($100 in dividends = $85 re-invested after tax)
This leads to the basic formula for calculating after-tax returns:
If we have an investment with an expected return of 5% that pays a 2% yield of qualified dividends, the after-tax return is:
Chart 1 illustrates the foreseeable conclusion that not paying taxes on dividends year over year results in a larger portfolio value. The final balances of the Traditional IRA and taxable account are ~$408,000 and ~$385,000, respectively. After 31 years, the tax-advantaged account is only ~$23,000 more than the account subject to annual taxes.
Diving further into the taxes, the true final value of the account is after all of the taxes have been paid. The Traditional IRA has a built-in liability of income taxes and the taxable account has capital gains taxes. It is important to point out that the basis in a Traditional IRA account does not increase, while the basis of the taxable account increases since taxes have been paid on the re-invested dividends.
Table 5, below, illustrates the built-in tax liability for both the Traditional IRA and taxable account. This assumes Mr. Legume is still in the 24% tax bracket when he hangs up the monocle and top hat. In a surprising twist, the taxable account has a larger value after accounting for the built-in tax liability.
Prior to ceasing non-deductible contributions into a Traditional IRA account, it is important to point out a couple of factors that lead to this conclusion. The primary factor is the ability to invest in an extremely tax-efficient fund that only pays out qualified dividends. The second driver is the asset allocation to an investment that has similar characteristics to an S&P 500 index. Lastly, this does not take into consideration any transfers of wealth that provide an additional tax benefit: charitable giving, inter-generational gifting, etc.
Expanding this analysis to examine the characteristics of other investment types, we see a trend emerge that follows the principles of tax-efficient asset location. Very simply, non-deductible contributions that are invested in tax-efficient assets do not realize tax alpha.
Table 6, below, outlines the after-tax value of various investments in a taxable account. All of the investments below have an expected return of 5%. The first column with a 0% yield mimics an individual stock that does not pay distributions similar to Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). The second and third columns would be similar to an S&P 500 index and a dividend-focused fund or stock portfolio, respectively. The last two columns would be a broad bond index and a corporate bond fund.
Keeping in mind that the after-tax value of the IRA account is ~$349,000, the results above indicate that exchanging investment tax for deferred income taxation is not an optimal trade for tax-efficient investments. Investments or portfolios that pay tax-inefficient distributions (non-qualified dividends, interest, and short-term capital gains) will benefit more from the tax-deferred growth. This is driven by the larger tax drag created by the annual income tax on distributions. For further perspective, if Mr. Legume is able to drop down a tax bracket in retirement, the after-tax value of the IRA account is ~$354,000.
This leads to a couple of general conclusions for investing in a taxable account versus a Traditional IRA:
- Larger differentials between investment tax and income tax
- At the extreme this is as large as 16.2% (income is ~$425,000)
- Highly tax-efficient investments
- Lower distribution yield
- Smaller differential in current versus future income tax rates.
- Lower portfolio turnover (i.e., low amount of short-term capital gains from trading)
It is important to point out a couple of realities that are not accounted for in this analysis: rebalancing tax drag, tax loss harvesting, and changing asset allocation. This analysis ignored the cost of selling high and triggering capital gains tax over the hypothetical 31-year-period to realign a portfolio back to its targeted risk level. This additional tax drag would reduce the ending value of the taxable account. The benefits from tax loss harvesting were omitted as well. This would increase the value of the taxable account. Generally, asset allocations transition from aggressive to conservative with age, and this typically then decreases the tax efficiency of the portfolio as more is allocated to fixed income investments. These factors were omitted due to their high dependence upon the inputted assumptions.
Even though there are assumptions made (or not made) that can skew the cost-benefit analysis of making a non-deductible contribution into a Traditional IRA account, it is important to evaluate the impact of taxes on a portfolio. The basic foundation of game theory is to think ahead and reason backwards. In the case of Mr. Legume, that means thinking ahead 30 to 40 years to estimate the tax implications of making a non-deductible contribution and reasoning backwards to evaluate the optimal investment and where to locate that investment.
In part 2, we will explore the value of Roth conversions to move after-tax monies from a Traditional IRA. This conversion process can act as a hedge against changing future tax rates, reduce taxable income in retirement, and mitigate the tax implications of a changing asset allocation. In addition, we will provide a framework for making these backdoor Roth IRA conversions as tax efficient as possible.
At the end of the day, it is important to keep in mind that the dilemma of making an after-tax contribution into a Traditional IRA is caused by having a large income. Congratulations, you make too much money! At least you will have one more topic of conversation on your yacht, that is if you can decide which one to take out on the water!
We hope our this article is helpful to you, the investor, or to advisors in communicating with your clients. Any questions or feedback is always appreciated.
Disclosure: I am/we are long VTI, VXUS, VCSH, VCIT, VMBS, VFIIX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Peak Capital Research & Management's clients are long the following positions in either Vanguard ETFs or Mutual Funds or utilizing a similar iShares ETF. Broad US Index, Broad International Index, short-term corporate bonds, intermediate-term corporate bonds, and GNMAs.