Why Roth Accounts Are Better Than Traditional For Generational Wealth Building

For someone who focuses so much on the long term, I have been incredibly short sighted on my overall long term wealth building strategy.  I have focused on me, when I should have been focusing on my children and grandchildren. Not only that, but I have been focused on THIS year over 20 years, 30 years, and 50 years from now. Here’s why I have come to realize that Roth is best for generational wealth building. Years ago I wrote about why you should abandon the Roth, now it seems, at least in my situation, that Roth accounts are the way to go.

My Wealth Building Strategy So Far:

I have been ignoring my Roth accounts for several years because I didn’t realize how much Roth accounts are better than traditional accounts for generational wealth building.  For the past 5 years my strategy in a nutshell has been this: Load up on tax deferred accounts because:

1. I get the tax break now, of 16.25% (12% federal 4.25% state of MI). This has allowed us to pay no federal income taxes at all and even receive a substantial refund.
2. I will never pay taxes on this money: In retirement, under the current tax brackets, the first $24,400 of income is not taxed at all for a married couple (standard deduction).  Using a 5% withdrawal rate, this means that the first $488,000 of savings should all be in traditional IRA and 401K accounts because we get a tax break on the front end, and pay no taxes on the back end.
3. If rates stay the same, it is also advantageous to go with traditional accounts for the 10% bracket as well, since my current bracket is 12%, the 10% bracket is $0 to $19,400, representing another $388,000 at a 5% withdrawal rate.
4. By contributing heavily to tax deferred accounts I lower my health insurance costs. Contributing only to tax deferred IRA and 401K accounts allows us to hit <200% of the federal poverty level by Adjusted Gross Income, which saves us thousands a year on medical costs.
5. Claiming exempt.  I LOVE claiming exempt of my federal income tax withholdings.  To do this you have to have had no tax liability last year and expect no tax liability this year.  I earn a lot of money in a short amount of time, so when I have a large paycheck for a 75 hour week, I don’t want the feds taking a big chunk.  Claiming exempt keeps it all in my pockets and I don’t have to worry about the refund later, especially since our refund has been delayed twice due to someone fraudulently claiming our nephews on their taxes.

All of this makes sense right?  I had a fully thought out rationale for contributing solely to tax deferred accounts.  What I didn’t account for is me and Mrs. C. starting rental real estate investing. Rental real estate investing has a lot of positive tax treatments, but we will certainly be incurring rental income that will fill up our standard deduction and some, if not all of our 10% bracket when we get to 10 houses total (our current goal).  Since we will have this rental income it totally negates points 2 and 3 above. Our rental income will fill up our 0% bracket and most likely our 10% bracket.

We really wanted Mrs. C. to be able to quit her job.  One of the reasons for keeping it was that we had the ability to fill her 401K folder with tax deferred investing. We’ve been earning more money and it has gotten more and more difficult to hit 200% of AGI through contributing to our tax deferred accounts.  With her quitting her job it is unlikely we will have enough capacity in our available tax deferred accounts to hit <200% of FPL.  It looks like in the near future I might become a staff employee with my current contract employer.  This will result in me being offered health insurance through work and negating any need to jump through hoops for the ACA exchanges.  Goodbye point 4.

As far as withholding of taxes go, by following the W4 form I can legit claim Married and 14 on my taxes, which eliminates a lot of the bite.  For what they do withhold, these days it is a rounding error in our overall budget, even if there is a delay in getting our refund. By switching to Roth contributions we will greatly lower our expected refund anyways. Goodbye point 5.

As for point 1, the tax deduction is huge, however it is also a small part of our overall savings, and for someone who is as against Federal budget deficits as I am, going from receiving a 4 figure refund to paying in 4 figures is something we probably should be doing anyways. If we lived just off of our rental income and let the retirement accounts keep growing, with a traditional we would be subject to required minimum distributions (RMDs) at age 70 1/2 and would most likely be bumped into the 22% tax bracket. It’s better to pay the taxes now.

Why Roth Accounts are Better For Building Generational Wealth:

1. I can withdrawal Roth contributions at any point in time with no taxes or penalties. While living this is extremely important because Mrs. C. and I will be retired, or at least semi-retired for 15 to 20 years before we could withdrawal from our traditional accounts (barring use of the SEPP plan). The SEPP plan handcuffs you to a very small and unchangeable withdrawal amount.  By not having any strings we can use our Roth IRA to transfer wealth while we are living to our heirs during this early retirement time frame of 40 to 59 1/2.  We can use our Roths to fund our children’s Roths, or even to fund taxable brokerage accounts for our grandchildren. Think about this, with 8% average annual compounded gains, gifting $10,000 at age 20 is the same as gifting $320,000 at age 65. Gifting $10,000 at birth for a grandchild will grow to $1.5 million by age 65!
2. Roth accounts are better because they are not subject to RMDs.  If I don’t want to take any money out, I don’t have to, I can let it sit and grow tax free. Being able to allow the money to sit without RMDs is a big feature, especially since people are living longer and there is a very good change that Mrs C and I could live to be over 100 years old.  RMDs would wreak havoc on such a long lifespan.
3. Roths are much more flexible when inherited.  A non spouse who inherits a Roth IRA can either take all the money at once with no taxes owed (as long as the Roth existed for at least 5 years), can take the money over a 5 year period, OR can take RMDs based on their age over their lifetime (in certain situations). All options with no taxes being owed.  For traditional tax deferred accounts RMDs are required and taxes are owed on anything taken out.
4. The SECURE Act has passed the house of representatives and is likely to pass the senate. This bill was touted for expanding access to retirement accounts and increasing the age at which RMDs have to start.  In the fine print this act requires inherited IRAs to be fully withdrawn within 10 years of the inheritance, rather than having withdrawals take place over the beneficiaries lifespan.  This will result in large tax hits for inherited traditional IRAs due to the shortened time frame, while beneficiaries of Roths will receive the money tax free.

My Plan:

For the remainder of 2019 I’m going to pause contributions and use a lot of free cash flow to pay down on our house. This year our savings will be roughly 75% mortgage pay down and 25% retirement accounts. For 2020 I will switch to 100% Roth contributions for our investment accounts and total savings will be around 60/40 house payoff to retirement. 2020 should be the last year we have primary residence mortgage debt. if any is remaining in 2021 it will be paid off before the end of Q2.

While doing this, we will slowly convert traditional accounts to Roth accounts up to filling the 12% federal tax bracket. So regardless of our income we will show taxable income of $78,950.  If it would have been $60,000 then we do a conversion of $18,950, if our income would have been $70,000 we do a conversion of $8,950.  This will have us paying about $3,100 a year in federal income taxes for 6 years, then it will increase to $5,100 when our 2nd child is 16 and we won’t get the child tax credit anymore. Depending on how the market does and where our income falls this conversion process can take anywhere from 5 years to 15 years.

Use Roths for matching contributions for our children’s Roth’s: We may choose to do this out of our ordinary income, but it is good to have the option to fund our children’s Roth accounts through our own Roth accounts. Once your kids have earned income they can start a Roth IRA, and the sooner you start the better.  Check out The Kid’s ROTH IRA Handbook: Securing Tax-Free Wealth From a Child’s First Paycheck.

Use Roths to transfer tax free wealth at our deaths: Roth accounts pass to heirs 100% tax free.  The more tax free money we can pass to our heirs, the better. Roth accounts, along with rental real estate, are the best assets to pass to children and grandchildren to build generational wealth.

Real estate is also another major part of our wealth and our plan for building generational wealth.  Real estate that we have fully depreciated when inherited will go to heirs tax free, they will have a stepped up basis to the current value of the house, AND will owe no depreciation recapture.

If we bought a house for $20,000 and put $10,000 into it our basis is $30,000.  If this house in 50 years is worth $100,000 our heirs can inherit it owing no taxes and their basis would not be $100,000, not the $30,000.

When Traditional IRAs are more appropriate:

For anyone who plans to have additional income in retirement other than Social Security, Roth accounts are better than traditional.  If you plan on having no other taxable income in retirement, rentals, part time work, etc. then filling up the first 2 tax brackets with traditional tax deferred accounts is still the best deal.  You get a tax break now and pay little to no taxes in the future. For high earners it is especially beneficial to contribute to tax deferred accounts.

If you have no heirs and plan to gift your IRA to a charitable organization upon your death or any time after age 70 1/2,  traditional tax deferred plans are certainly beneficial. Current IRS rules allow for Qualified Charitable Distributions (QCDs) after age 70 1/2.  A maximum of $100,000 per year per person can be distributed through this method.  The distribution incurs no taxes to either party and does not show up as ordinary income on the individuals tax return, as any other distribution would.

A QCD counts towards your RMD, which is a big deal.  Instead of you having to take a withdrawal and a tax hit, you can choose to donate that amount through a QCD, owe no taxes, and not show a higher income/AGI as you would with taking the RMD.  If we have anything in traditional accounts at 70 1/2 this is certainly what we would do with our RMDs.

Do you contribute to Roth or to Traditional accounts?  What is your long term strategy for retirement and for generational wealth building?