Trends Accelerating the Appeal of Roth Savings
Happy New Year! If you are like me, I bet you are glad to wave the year 2020 goodbye as it has been one of the saddest and strangest of times for our country. If you have lost a loved one or friend to COVID-19, please accept my condolences. Let us all wish for a speedy rollout of vaccines that bring this pandemic to a swift close.
As for the economy and investing, COVID-19 caused both predictable and surprising impacts. On the predictable side entire sectors of our economy, particularly hospitality and travel, fell into deep recession and will likely not reach 2019’s level of activity for years. Social distancing accelerated trends that were already in evidence such as buying online, remote work, and entertainment on demand via streaming. Shutting down the economy to fight the virus led to recession and a bear-market drop that registered more than 40%, ending the longest bull-market in history at eleven years.
On the surprising side, the pandemic spurred a boom in housing construction and remodeling, the opposite of what normally happens in recession, as people forced into remote work decided they needed more space. Housing also got an assist from historically low mortgage borrowing costs due to Federal Reserve actions to cut interest rates. Healthcare spending declined as people held off on non-essential treatments and deferred routine care. The market saw the shortest time in history to both fall into bear market territory and recover fully back to the previous peak. Corporate profits fell hard, not surprisingly, but the market put together a double-digit advance for 2020, a startling disconnect.
For many years I’ve been preaching the best way to build long-term wealth is to consistently save in the stock market while avoiding market timing by staying fully invested at all times. This strategy unlocks the power of compounding: the consistent layering of return-on-return year-after-year, perfect for long-term savings goals such as paying for children’s college educations and, especially, retirement.
I’ve been maximizing contributions to tax deferred savings vehicles my entire life. It was really difficult in my 20s and 30s as life’s competing uses for our income, like saving for a down payment on a house, my wife’s and my continuing education, and our young family, took priority. But for what I could save, I always had in the back of my mind the power of compounding and how it would have a big impact on our retirement, especially if I could keep funds away from the tax man until later.
In my early career the traditional, pre-tax IRA/401(k) was the primary tax-advantaged investment account available. I thought it was great to save some money on taxes while letting those compounded returns grow. However, in 1997 the Roth IRA was introduced and, later, employers added the Roth 401(k). The Roth quickly became my favorite long-term savings vehicle as investment gains aren’t taxed, there are no Required Minimum Distributions (RMDs), and contributions, plus even some investment gain, can be taken tax- and penalty-free before retirement for various purposes. The tradeoff is that contributions are made with after-tax dollars, but with a long enough time horizon and the power of compounding, the Roth usually builds greater wealth.
I started my career in the mid-1980s when Roth savings wasn’t an option. Further, Federal tax rates were historically low as President Reagan led tax cuts that substantially reduced marginal tax rates, with the top rate dropping from 70% to 50% in 1981 and further to 28% in 1986. Even with these lower rates, I saved in Traditional accounts because I thought the power of compounding would still swamp the later taxes I’d owe once I began taking withdrawals.
However, looking back over the past three decades it has become obvious to me that Federal (and many state) tax rates have no direction to go but up. I’ve written several Viewpoints over the years on tax-advantaged savings vehicles, particularly Roth and Health Savings Accounts, the latter providing the greatest tax savings as contributions also avoid tax. Looking back on those articles I’ve seen that tax rates have indeed increased, as the top marginal rate has gone from 28%, to 35%, to 39.6%. The 2017 tax cuts did reduce the highest rate to 37% but that is currently set to revert to 39.6% after 2025.
When I started my career in 1986, the U.S. Federal debt had finished the previous fiscal year (ended September 30, 1985) at $1.8 trillion. At the end of fiscal year 2019, 33 years later and before this year’s additional COVID-related spending, federal debt was $22.8 trillion, an average growth of 8% per year. Much of this additional debt has occurred in response to the deep recession caused by the 2008/2009 financial crisis, but over the past few years attitudes about Federal deficit spending have been relaxed on both sides of the political aisle.
For debtors like the U.S. government, the power of compounding works in reverse: higher interest costs cause deficit spending that gets added to the debt, leading to ever higher debt requiring higher interest costs. Eventually lenders, particularly other countries, won’t have faith these debts can be refinanced. We seem far away from this day of reckoning and being an optimist, I believe we will get our fiscal house in order and stabilize, as happened in the 1990s. However, it is likely that part of that solution will result in higher tax rates than those we enjoy today.
Recent trends have only accelerated my higher tax rate view. Before the pandemic Congress and the President worked in a bi-partisan manor on the SECURE Act, designed to help employees and retirees save more for longer lifetimes. The principal achievement of the legislation was to delay RMDs from age 70½ to 72. However, to pay for just 18 months of RMD delay the government took away the “Stretch” IRA for beneficiaries, speeding up access to tax revenue by shortening the full distribution of these IRAs to 10 years. This is essentially a backdoor tax increase.
The pandemic response will turbocharge the pressure on higher tax rates. The additional spending from the CARES Act, at $3.0 trillion, is about 2/3rds of entire year 2019 Federal spending of $4.45 trillion. Recently, in response to increasing COVID outbreak and further economic restrictions, another $900 billion of spending is on the way, about half of which uses repurposed CARES Act funds. Excluding the repurposed funds, this spending still nets another 10% of annual Federal outlays. The politicians likely aren’t done as both President-Elect Joe Biden and Senate leader Mitch McConnell have talked about further aid in early 2021. Because the Federal budget is already in deficit all of this will be funded by additional national debt.
As you look at your own tax situation, I’d encourage you to examine the Roth as your preferred long-term savings vehicle. If you are retired, a Traditional IRA to Roth conversion could help minimize future taxes, but timing is important as illustrated by the market’s rollercoaster 2020. If you are working, look at your current tax rate with the eye toward what tax rates might look like by the time you retire: does the pre-tax deduction make sense? If you have kids, particularly those early in their careers or that have some taxable income, like my college-aged children, help them understand the power of the Roth and even show them by helping fund an account. As always, reach out to us if we can help you look at the Roth given your unique set of circumstances.
Daniel J. Boyle, CFA