In this episode of Motley Fool Answers, Alison Southwick is joined by Motley Fool personal finance expert Robert Brokamp, to talk about how people took advantage of various benefits afforded by the CARES Act and what they spent money on. Also, get answers to whether it is more beneficial to go with Roth or traditional IRA, what the options available are, and much more.
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This video was recorded on November 10, 2020.
Alison Southwick: This is Motley Fool Answers. I'm Alison Southwick, and I'm joined, as always, by Robert Brokamp, Personal Finance Expert here at The Motley Fool.
Robert Brokamp: Alison, hello!
Southwick: Hello! So, in this week's episode we're going to look at the crucial math behind the Roth versus traditional IRA. If you like wonky stuff, this episode is for you.
Brokamp: You're going to love it, absolutely love it.
Southwick: The rest of you, maybe not so much. [laughs] All that and more on this week's episode of Motley Fool Answers.
Brokamp: So, Alison, what's up?
Southwick: Well, Bro, as you may have heard, we're in the middle of a global pandemic, and as a result, the government made a few decisions a while back to help Americans cope financially with the fallout, such as stimulus checks and the opportunity to take money out of your 401(k). So, what did Americans actually do? A few recent surveys, studies, and articles tried to find out. So, let's start with being able to access your 401(k).
As you recall, and feel free to correct me if I get any of this wrong, the CARES Act allowed savers to take coronavirus-related distributions, emergency withdrawals of up to $100,000 from their retirement plans and IRAs. Those who are under 59.5 can access the money without the usual 10% early withdrawal penalty. Initially it just applied to people who had the coronavirus or their spouses or dependents who had the disease, as well as those who are laid off, furloughed or had hours reduced, those unable to work due to lack of child care, entrepreneurs who had to shutter their business. But it was eventually expanded to people who also had a job start date delayed or an offer rescinded due to COVID-19. So, did Americans take advantage of it?
For that, let's head to The Wall Street Journal and an article by Anne Tergesen and Corrie Driebusch. The title, Americans were given the coronavirus option to raid their 401(k). Most didn't. So, there you go. Moving on then. All right, I'll dig, I'll dissect the article a little bit for you.
So, Fidelity Investments, which is apparently the largest 401(k) provider in the country, has seen 4.6% of eligible people take some money out through September 30th due to the virus, and an additional 1% have taken a so-called hardship distribution that allows withdrawals for reasons, including buying home, preventing foreclosure or paying medical bills. That is compared to about 2%/year that typically take a hardship distribution.
The withdrawal rates are, according to Dave Stinnett, Head of Strategic Retirement Consulting at Vanguard Group, much less dire than we were thinking back in April. He says about 4.5% of eligible people in retirement plans Vanguard administers, took the money out due to the crisis, and 1.5% did so on hardship grounds through September 30th.
So, why didn't many people take advantage of this option? Well, the article also says it right there in the subhead: low income workers who would be most likely to tap a retirement savings account, are least likely to have one. So, for example, we know coronavirus has had a huge impact on the hospitality industry. That's an industry where most employees aren't offered paid time off, let alone 401(k). Overall, about one-third of private sector workers don't have access to a workplace retirement savings plan. And most of those who do have access to one, didn't actually see their income disrupted as a result of the coronavirus. The article goes on to warn more generally about the growing trend of 401(k) leakage.
Okay, I was expecting you to start laughing when I said the word "leakage."
Brokamp: [laughs] I smiled. I didn't want to interrupt you, but I smiled.
Southwick: It's a word that makes us all smirk.
Brokamp: Does that make your 401(k) moist if it's leaking? [laughs]
Southwick: Ahh! Stop it! Ugh! Ew! Okay, let's just keep moving on. I'm not the one who named it, OK? According to analysis by economists at Boston College's Center for Retirement Cash-Outs. [Boston College's Center for Retirement Research] (sic) -- it's a very specific center [laughs] -- 401(k) loan defaults and hardship withdrawals reduced the wealth in U.S. retirement accounts by an estimated 25% when the lost annual savings are compounded for over 30 years.
All right, moving on. What about that coronavirus stimulus check, how did Americans use that? Well, for that we're going to head to Liberty Street Economics which features "insight and analysis from New York Fed economists working at the intersection of research and policy." One of the provisions, just to remind you, in the CARES Act, was that taxpayers earning less than $99,000/year or $198,000/year for couples, were sent checks worth up to $1,200, with an additional $500 for each child. In total, the IRS made 159 million payments worth $265 billion. The hope was that -- can you imagine, wow! That's a lot of money, that's a lot of just doing something too. Sending out 159 million payments.
Anyway, the hope was that consumers would, of course, spend the moola, prop up the economy a bit, which shrank by 9.5% in the second quarter of 2020. So, what did Americans do with the money you might be wondering, I was, the answer is not super-interesting, but here we go. In the special June survey of consumer expectations, 89% of respondents reported that their household received an economic impact payment with the median payment being $2,400. New York Fed's analysis shows that households spent a relatively small share of 29% of these payments by June 2020 and allocated the remaining funds equally between savings, 36%; and paying down debt, 35%.
They are also broken down by age, income, and education, so if you want to know more, you can head there. But for example, if you look at income, those making less than $40,000/year spent 39.8%, so almost 40% on paying down debt, 31.2% went to savings, 21% went to essential spending, and 5% to nonessentials.
So, OK, that's how those with the lowest income did, how about those with the higher income, those making more than $75,000/year. 30% still went paying down debt and 40.8% went to savings, 14.7% was spent on essentials and 9.6% on nonessentials. The Fed didn't go into what kind of debt we're talking about here, credit cards, auto, mortgage, etc., but it's interesting that across the income levels paying down debt is where everyone plowed a lot of money.
So, even though much of it went to paying down debt, the Fed's analysis shows that the economic impact payments have been acting as a significant boost to the economy. Now that the election is sort of in the rearview mirror, maybe side view, rearview, Congress is heading back into the office and lawmakers are now expected to start debating a second round of stimulus, but how much stimulus could be coming and when, stay tuned to find out.
And that, Bro, is what's up.
Brokamp: Wealth management firm Alpha Architect, which also publishes excellent research-based articles, estimated that in 2018 the tax benefits of retirement accounts range between 0.7% and 2.7% per year depending on your tax bracket and your returns. Compound that over decades and you're talking tens of thousands of dollars. Never since the introduction of the Roth account in 1997, investors can further boost the benefits of these accounts by choosing when to realize certain tax savings.
We're hearing more and more about Roth these days, and I get a ton of questions about them when my colleague, Dan Caplinger, and I run a financial planning Q&A every week on Fool Live, which is this all-day Zoom call for Motley Fool premium members. So, we on the Answers team thought we'd devote a whole episode to addressing the Roth versus traditional decision.
But first, a little history of the Roth, which of course, starts with the traditional IRA. The traditional IRA first became available in 1974 with the passage of the Employee Retirement Income Security Act, also known as an ERISA, but then, back then at least, IRAs were only available to folks who didn't have a plan at work. That changed in 1981 with the passage of the Economic Recovery Tax Act, also known as the Kemp-Roth Tax Cut, named after representative Jack Kemp of New York and senator William Roth of Delaware. It lowered the top tax bracket from 70% to 50%. Today the top tax bracket is 37%, but it also made traditional IRAs available to everyone.
Now, Bill Roth was a fiscal conservative who grew up in Montana during The Depression. He became interested in politics because he wasn't an athletic kid, so he would hike to the Capitol to watch legislators in action. He served on MacArthur's staff during World War II, and then went to Harvard for Business School and Law School with the help of the GI Bill, he moved to Delaware in 1954 and got elected to Congress in 1966. He was kind of a mild-mannered guy, he actually wasn't the greatest of public speakers, but he always campaigned with a dog. He said you stand out with a St. Bernard and the kids come over, they want to pet the dog, and it gives you an opportunity to talk to the parents.
Encouraging Americans to save was one of his legislative priorities, along with Senator Bob Packwood, he first proposed the Roth IRA, known then as the IRA Plus in 1989, but it wasn't until the Taxpayer Relief Act of 1997 that it became law. Though Roth was a Republican, it was actually the Democrats' idea to name the IRA after him. Pat Moynihan, the Senator from New York said, "This was Bill Roth's idea, we ought to call it the Roth IRA."
Unfortunately for him, the creation of the Roth IRA didn't prevent him from getting voted out of office in 2000, and he died in 2003, three years before the Roth 401(k) became available. President Elect, Joe Biden, who served with Bill Roth in the Senate for 28 years, said that Roth was "the person I trusted most in my public life." By the way, Roth's wife, Jane, is a Harvard-educated lawyer and accomplished judge who was inducted into the Hall of Fame of Delaware Women in 2013, and at the age of 85, she still sits on the bench. She once said, "When I hear "Roth IRA," I think of my grandson, who was born about the same time the Roth IRA became law. I told my son, he should've called him "Ira" ... but he went with Charlie, which is probably for the best. But every time I see him, I think of the Roth IRA."
Okay. That's all the history, let's get into which type of account you should choose. With the traditional retirement account, contributions lower your taxable income this year, the investments grow tax-deferred, but you pay taxes on withdrawals. With the Roth, you don't get a tax break on contributions, but growth and withdrawals are tax-free as long as you follow the rules, and we'll get to those a little later.
So, the question is, when do you want a tax break, this year or in retirement? If you're in a higher tax bracket this year than you expect to be in retirement, then a tax break this year is more valuable, and thus the traditional might be optimal. If on the other hand, you expect to be in a higher tax bracket in retirement, either because of your income or you expect tax rates to go up, then the Roth makes more sense. The internet is full of tools that can help break this decision down to actual numbers, just do an online search on traditional versus Roth calculator and you'll get plenty of results. However, most of these tools make a very important and I think unrealistic assumption, they assume that the tax savings realized this year by contributing to a traditional account are invested for retirement. So, for example, let's say you're in the 24% tax bracket and you contribute $10,000 to a traditional 401(k), that will lower your tax bill by $2,400, which you then sock away for retirement. In other words, contributing $10,000 to a traditional account actually allows you to save $12,400, whereas you can only save $10,000 if you chose the Roth.
The problem is, most people don't think of it this way, and there's evidence that employees likely aren't investing the tax savings, they're likely spending that money. And from the perspective of which choice results in more after tax wealth in retirement, they would have been better off with the Roth.
Let's illustrate this with three scenarios, again, assuming the investor is in the 24% tax bracket. Scenario one, an investor contributes $10,000 annually to a traditional 401(k), which cuts their taxes by $2,400 and she saves that for retirement. So, in other words, she is saving $12,400/year.
Scenario two, investor contributes $10,000 annually to a traditional 401(k), but spends the $2,400 in tax savings.
And scenario three, investor contributes $10,000 annually to a Roth 401(k).
Now, here are the amounts this investor would have after 15 years, assuming an 8% annual investment return.
Scenario one, contributing to the traditional and investing the savings, you'd have almost $364,000.
Scenario two, contributing to the traditional, but spending the tax savings, $293,000.
Scenario three, the Roth also $293,000. So, no big surprises there. Saving more in scenario one leads to a bigger account. In scenarios two and three have accumulated the same amounts, because they're saving the same amount. But those are before tax amounts, who comes out ahead in retirement after the money is withdrawn and possibly taxed. Here's which scenario takes the gold, silver, or bronze based on three different tax brackets. So, No. 1, a 12% tax bracket in retirement. So, the person was in the 24% tax bracket while working, drops to the 12% when she retires. The winner is scenario one, the investor who saved in traditional and invested the tax savings. Next is the Roth, and the last is scenario two, the traditional account, but the tax savings weren't saved.
So, someone who will drop into a lower tax bracket in retirement benefits from contributing to a traditional account, but only if she invests the tax savings.
Now, who comes out ahead if the retiree ends up in the same tax bracket? According to the calculator I use, it's actually the Roth. And this may be surprising, you might think that it's essentially a breakeven proposition, and a couple of the calculators I used came to that conclusion, but most of the ones I fiddled with favored the Roth. Plus, the Roth has an additional benefit. Roth IRA's are not subject to Required Minimum Distributions at age 72. Roth 401(k)s are subject to RMDs, but you can avoid them by rolling the money over to a Roth IRA with some caveats that I'll touch on later.
And finally, what if a person will be in a higher tax bracket in retirement? The Roth wins hands down. The loser in each of these retirement tax bracket situations, the person who contributed to the traditional account but didn't invest the tax savings.
Okay. Let's get into conversions and some caveats. So, another way to build up the amount you have in Roth assets is by converting money you currently have in traditional accounts to Roth assets. However, the amount that you convert will be added to your taxable income this year, which will result in a higher tax bill, and the math for this is somewhat similar. If someone is in a 24% tax bracket and they're considering a $10,000 conversion, now the analysis would involve the future after-tax value of $12,400 growing without the conversion versus $10,000 growing after the conversion. The $2,400 difference being lost to taxes owed due to the conversion. An online calculator can also help with this with a key factor being where the tax money comes from, the retirement account or other tax savings?
Note also that I've been using 401(k)s in our examples, that's because there are no income restrictions on the deductibility of traditional contributions or the eligibility for Roth contributions. However, this is not true of traditional Roth IRAs, which are subject to income limitations that change every year and there are calculators that help determine which type you're eligible for.
Okay. Let's briefly just get into those pesky Roth rules. Withdrawals of contributions are always tax-free, and withdrawals of earnings are tax-free as long as you're 59.5 and the account has been open for at least five tax years. The five-year Roth rule sounds pretty straight forward, and they mostly are, but there are some differences between Roth IRAs, Roth 401(k)s, and Roth conversions. For example, all your Roth IRAs follow the same five-year clock as the first IRA you opened. But each Roth 401(k) has its own clock, plus if you roll a Roth 401(k) into a Roth IRA, the entire account will follow the IRAs clock. So, let's say, you've been contributing to a Roth 401(k) for 10 years and then you roll it over to a Roth IRA that you just opened and you don't have any other Roth IRAs, you've just reset the clock. So, this can get pretty complicated, so before you take any money out of any Roth account, make sure that you learn the rules or just talk to your accountant or financial advisor, if you have one.
Okay. Let's wrap things up here. The reason the Roth is getting so much attention these days is because tax rates are near historic lows, and with huge government deficits and underfunded entitlements, most people expect rates to go up in the future. So, contributing to a Roth is a hedge against higher tax rates, which frankly, to me, makes a lot of sense. And this isn't an either/or situation, you can contribute to both traditional and Roth accounts as long as you're eligible for both and the combined contributions don't exceed the annual limits. Even if you contribute a little bit to a Roth account, I'm pretty sure your future retired self will be pretty happy with the decision. As IRA expert Ed Slott often says, money in a Roth account is all yours, whereas with money in a traditional account, you're just the co-owner with Uncle Sam having a claim on some of that money. And I think every retiree will be happy to have at least some money that is 100% theirs.
Southwick: A lot of our listeners can't do a Roth, so what's your advice there?
Brokamp: First of all--
Southwick: I'm not trying to make you talk about the backdoor Roth, but I think a lot of our listeners are going to be like, well, you're telling me to put it into a Roth, but I can't.
Brokamp: Right. So, again, if you have an employer-sponsored account, you are eligible. A lot of people think there are income limits on that and you're not, but if you don't have a 401(k) or if your employer doesn't offer the Roth; and about 25% don't. First of all, if you have a 401(k) and the Roth isn't available, just email your HR folks, because there's no reason not for them to offer it. But if for some reason it's not offered or you've maxed it out, you want more Roth assets. There is something called the backdoor Roth, which is contributing to a nondeductible traditional IRA and immediately making the conversion. Which is super easy to do, unless you own other traditional IRAs, then it gets more complicated and it will lead to more taxes. Every financial services firm has been handling the backdoor Roth for years now. So, if you have a broker and you're interested in the backdoor Roth, call them and they will walk you through the process. But again, if you don't have any other traditional IRAs, it is super, super simple, and definitely a way to get around the income eligibility rules for the Roth IRA.
Southwick: Well, that's the show. It's edited wonkily by Rick Engdahl. Our email is [email protected] We do have a mailbag episode right around the corner, as usual, so drop us a line, ask us a question or just tell us something, I don't know, whatever, we're bored, we've got time on our hands, we miss connecting with people.
For Robert Brokamp, I'm Alison Southwick, stay Foolish everybody!