What You Need to Know
- Tax treatment tends to favor taxable account withdrawals over IRA withdrawals, Morningstar's personal finance expert points out.
- IRA tax deferrals aren't as much of an advantage as they used to be.
- More ETFs today still can be a better bet than using IRAs.
The threat of closing the backdoor Roth IRA through the Democrats’ tax plan is something high earners should be thinking about now, according to Christine Benz, Morningstar’s director of personal investment, wrote in a recent column.
So how should high earners save for retirement instead? The first alternative that comes to mind for many is keeping more after-tax money in a traditional IRA, 401(k) or other tax-advantaged account. But Benz argues that high earners are better off opting for taxable accounts for four reasons.
1. Capital gains are taxed at a lower rate than ordinary income.
Benz points out that the capital gains tax rates paid by investors who sell appreciated stocks in a taxable account are lower than the ordinary income tax rates applied to gains in traditional IRAs.
She provides an example of someone who put after $300,000, after taxes, into an index fund in a traditional IRA 15 years ago, so now the account is worth $1,326,897. The gains of $1,026,897 would be taxed at the ordinary income tax rate, say 32%, so after-tax proceeds would be $998,290.
However, by withdrawing from a taxable account, the individual would pay capital gains tax at 15%, leaving after-tax proceeds of $1,172,862.
As Benz notes, “his tax bill would be less than half of what it was from his IRA withdrawal.”
2. Benefits of tax deferrals have “shrunk in importance.”
Benz notes that her previous example doesn’t take into account the IRA’s tax deferrals over the years that may have shielded the investor from any taxes associated with distributions.