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Financial Planning > UHNW Client Services > UHNW Client Advice

Backdoor Roth Closing? 4 Reasons Taxable Accounts Beat IRAs, 401(k)s: Morningstar's Benz

By Ginger Szala

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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.

“That’s nothing to sneeze at, but the composition of investment returns has changed over the years,” she writes. The benefits of tax deferral in a traditional IRA has changed, she notes, and “the big reason is the prevailing yields have changed: While the dividend yield on the S&P 500 is about the same as it was in 2010, bond yields have dropped through the floor.”

Today’s 10-year Treasury yields about 1.5%, versus 6% in 2000. “Most investments just aren’t distributing that much in gains for investors to benefit from the tax deferral that an IRA wrapper affords,” she says. “Without the sweetener of deductible contributions or tax-free withdrawals, which is what contributors of after-tax funds to an IRA could be left with in a post-backdoor Roth world, benefits of tax deferral have shrunk in importance.”

3) Highly tax-efficient options have emerged.

Low yields have shown how equity ETFs can “reduce the drag of taxes on an ongoing basis,” Benz points out, noting that many large-blend ETFs have tax-cost ratios of just 40 or 50 basis points.

But when taking in account those costs on a yearly basis, the taxable account holder, using the above example, would have $1,098,637, still better than an IRA.

Benz cautions that using “tax-inefficient” investments, like junk bonds and REITs, would be better within an IRA. “But investors who are buying and holding plain vanilla equity funds, especially ETFs without a dividend focus, the taxable account is hard to beat,” she says.

4) Taxable accounts have no contribution, income or withdrawal limits.

When it comes to flexibility and estate planning, taxable assets are better than IRAs, Benz says. They also have an advantage for the next generation: “heirs received a step-up in cost basis upon the death of the account owner, effectively washing out the tax burden associated with the appreciation of the investment.”

Ginger Szala

@gingerszalaink

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