About that Roth IRA: Time to Talk About Tax-Advantaged Funds

As President Obama’s advisor Rahm Emmanuel is said to have urged “never let a crisis go to waste.” Some investors could benefit from taking advantage of the tax treatment given to specific investment products, like IRAs.

There’s no doubt that tough times may lay ahead for many in the U.S. And for advisors, that sense of dread may spill over from looking at the nation as a whole to how to best prepare their clients. How can advisors help walk their clients through a thicket of potentially globally changing financial circumstances? When it comes to circumstances that may hit client’s static budget items – like housing, transportation and taxes, advisors may be able to help clients position themselves now for potential problems later by focusing on advantages . In the case of taxes, many states and the federal government may need to update their tax rates to make up for COVID-19's impact on state expenses as well as lack of revenue. This may be especially true for localities who need to make up lost revenue from sales tax by increasing property taxes and may change home budgets.

Back in April of 2020, CNBC reported that States were likely to increase their taxes.  “State and local governments were left out of the $484 billion coronavirus relief bill that President Donald Trump signed into law last week. New York is facing a $13.3 billion shortfall in revenue and New Jersey’s governor noted how widespread the impact of the pandemic was, which include health care and hospitals, housing and food security. That same CNBC report predicted a handful of areas states and localities (like incorporated cities or counties) might look to when choosing to boost taxes. First, corporate income taxes, including folks who work from home in one state but whose employer is located in another – this is common on the East Coast. Second, states and localities may look to sales and excise taxes on online purchasing and streaming. Third, states and localities may increase property taxes. The federal government could increase taxes, though that might be less likely.

Increases in taxes impact investors in the predictable way, if clients think that their taxes are increasing, they may fear that they have less to contribute to retirement, but also in unpredictable ways. Knowing that income tax could be increase may mean that clients can benefit more from Roth IRAs than before.

As President Obama’s advisor Rahm Emmanuel is said to have urged “never let a crisis go to waste.” Some investors could benefit from taking advantage of the tax treatment given to specific investment products, like IRAs. Roth IRAs, specifically, can be beneficial for folks to expect to be in a higher tax bracket in retirement. For some investors, adding money now, when the taxes may be lower than they will be in the future can be beneficial so that interest can grow tax free.

How can advisors help their clients focus on tax advantaged accounts, like IRAs without scaring the proverbial pants off of them about rising tax and inflation rates? One way may be to focus on compound interest…

Another way to reshape the narrative about tax advantaged investments may be to focus on the insurance coverage provided by IRAs. For those investors who worried about banks that were too big to fail (who then failed in 2008/2009) and that worry prevents them from investing, they may take comfort in the insurance coverage through SIPC and FDIC. Unlike other investments, FDIC covers up to $500,000 on all investments in IRAs.

Additionally, advisors could discuss the changes to some long standing aspects of IRA policy that took place in 2017 as a way to note possible future changes. For example, 2017 tax law changes disallowed the recharacterization of a Roth IRA into a traditional IRA. Recharacterization allowed for wiggle room in planning.  It’s possible that if the economic impact of the corona-virus continues to drive unemployment or cuts to salaries that Congress may change the 2017 law that took away recharacterization. Given that recharacterization was given so little air back in 2017, it’s unlikely that its on any law maker’s radar now or in the near future.

For younger investors, the key for advisors is always to discuss compound interest. Advisors may find that discussing compounding interest in terms of tangible things, like ducks, instead of credits to an account, like bucks, may work. For example, “Imagine you loan a farmer 100 ducks. Of those you give, the flock has five new babies. Now the flock you loaned is 105 ducks. Imagine the same thing happens each year, only instead of growing by 5 ducks each year, your flock grows by the same percentage of ducks. So in year two, the flock grows by 7 ducks instead of just 5 for a total of 112 ducks. Same thing in year three, this time moving to 10 ducks, for a total of 122 ducks.  That’s a lot of ducks. . Compounding the interest from year to year can transform a $5,000 investment into a $17,000 asset in 20 years, for a return of more than 50%.  

As we discussed in previous articles on IRAs, many investors, especially younger ones, shy way from IRAs because of confusion. For years, financial advisors and experts have considered Roth IRAs to be an ideal investment option for younger employees.  The differences between Roth and Traditional IRAs may be too much for folks starting out on investing: having two products with nearly opposite rules but similar names puts many potential investors in the TDLR category – its just too much information to parse through so they opt for something else entirely, or nothing at all.

These articles are prepared for general purposes and are not intended to provide advice or encourage specific behavior. Before taking any action, Advisors and Plan Sponsors should consult with their compliance, finance and legal teams.

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