My own brother did not believe me…
Earlier this week I received an advertisement via email. Like so many advertisements I receive, it’s a reminder of everything that we believe is wrong with our industry. This one was from a company named Addepar. And I quote, “Does it take too much time to find each client’s bank exposure and make it difficult to be proactive during market volatility? Wealth managers using Addepar find this information in seconds.”
Let me reassure all of our individual clients: No one on the investment team at Iron Capital needed a software package to reveal our clients’ bank exposure. So, we are not a prospect for Addepar. There are multiple triggers in this advert: First, the realization that a company like this exists because the vast majority of “wealth managers” have no idea how each of their clients is invested; and second, the use of the term “wealth managers.” I often talk about the evolution of the financial services industry, and this example is a case in point. Historically, brokers evolved to be financial advisers because they were not allowed to call themselves investment advisers. In those days, most investment advisers actually referred to themselves as money managers, because that is what they do – manage their clients’ money. Brokers don’t actually do that and are thus not allowed to use that language, so the marketing departments came up with “wealth manager.” People often think I am just making this stuff up, until they get a taste of reality.
That email this week, triggered by the banking tumult, reminded me of similar email ads when our government rolled out the Roth IRA. Unlike a traditional IRA or a 401(k) plan, the Roth did not provide an immediate tax deduction, but the money could grow tax-deferred, as in a traditional plan, and it could be withdrawn tax-free. As an incentive to convert from traditional plans to the Roth, the government allowed a limited window in which investors could transition from traditional retirement plans into Roth IRAs and defer the tax consequence of doing so over several years. My brother, who is an estate attorney, asked me about it, as he was hearing from every broker he knew that this was a once-in-a-lifetime opportunity.
I explained that we did not think that the Roth made sense. The lure of tax-free income in retirement does not outweigh the loss of the immediate tax deduction today. He questioned our analysis, because all these other financial people were saying the opposite. I told him that it was a money grab. This was a once-in-a-lifetime opportunity, yes – but not for investors; for brokers. They could move large sums of money into Roth IRAs and get paid huge commissions on these transactions. He didn’t believe me; he thought I was exaggerating the nature of this industry.
Shortly after that conversation with my brother, I returned to my office to find an email advertisement waiting for me touting the once-in-a-lifetime opportunity to collect huge commissions on the Roth conversion frenzy. I sent it to my brother. He believes me now. Iron Capital was then and still is fee-only, but we still get those advertisements, just as we get advertisements today targeted to brokers who don’t know what investments they sold when. Not much has changed.
Our view that investors are better off in traditional retirement plans than in Roth plans was in the minority. The problem with judging things like this is that one must make assumptions about the future of tax policy. Those in favor of Roth assume that tax rates will rise; that is the only way one can get the math to work. To assume one is better off in the Roth, then she would have to have a higher tax rate in retirement, or at least be taxed the same.
We do not think that is a realistic assumption. Those who disagree point to the current fiscal mess that is our government and simply say that taxes must go up. Fair enough, but taxes in general going up is much different than an individual paying more taxes in retirement. The vast majority of retirees will make less money in retirement than when working and will be in a lower tax bracket. This is consistent with the current reality. To successfully retire, the rule of thumb is that one must replace approximately 70 percent of the pre-retirement income. Tax rates could go up across the board and it would still be unlikely for a retiree to pay more in taxes than when she was working.
That is, of course, if politicians just decide to raise taxes on everyone. When was the last time you witnessed that? Politicians don’t just raise taxes honestly, they look for back doors. They raise only on the “rich,” or they do away with a deduction, or they add a tax onto consumption, and so on.
A perfect example is the new Secure Act 2.0 retirement legislation that passed at year-end 2022. One of the 90+ clauses of this law is an increase in the so-called catch-up contributions in retirement plans: Participants over the age of 50 are allowed to contribute an additional $7,500 over and above the maximum of $22,500 to “catch up” as they are getting nearer retirement. Starting in 2024, those catch-up contributions will have to be deposited into a Roth-type account for any employee making $145,000 or more.
The government is doing this because they know they will get more taxes from a Roth than a traditional account. This is how taxes are raised. It is far more likely that the government will tax the income from one’s Roth than it is that they will raise taxes on every rank-and-file voter. For those saving for retirement, the traditional plan is the best option.
However, the Roth is not without some benefits. For those who are not just defined as “rich” by the IRS but are actually well off and in no need of retirement plan income, the Roth is an excellent estate planning tool to pass along wealth to the next generation. Traditional accounts have required distributions as the investor ages, but Roth accounts do not. In addition, under current law, a non-spouse (children or grandchildren) who inherits a traditional retirement account must take the money out of that account over a 10-year period and pay taxes on those distributions, yet as of now, the same beneficiary of a Roth would not pay taxes on those distributions.
So the Roth could be an attractive option for someone with no plans to use his retirement account to fund his retirement, but for the average retirement investor, the traditional account is still the way to go. Secure Act 2.0 should put an end to any doubt.
Warm regards,
Chuck Osborne, CFA
Managing Director
