Scott Sumner  

Please don't pay me to research tax loopholes

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This is a response to Bryan's recent post.

I've always been a critic of our income tax regime, which is extremely wasteful for all sorts of reasons:

1. Lots of wasteful paperwork.
2. Leads to wasteful expenditures on rent seeking in DC.
3. Discourages saving and investment.

While doing my taxes last week, I noticed another huge inefficiency; our tax system encourages us to research the intricacies of taxes, something I very much don't want to do.

I recently discovered that there is effectively no income limit on contributions to Roth IRAs, at least since 2010. All this time I had taken the government at its word, and assumed that families with incomes above a certain cutoff point could not contribute to Roth IRAs. In fact, they merely have to set up a non-deductible IRA, and then one day later convert it to a Roth IRA. This backdoor into the Roth is completely legal. So why not just eliminate the income threshold entirely? That would be the sensible thing to do. (Insert joke here).

Now let's suppose that since 2010 my wife and I have contributed about $60,000 less to Roth IRAs than if we had known about this loophole. In future decades, we would have saved lots of money had we known about the loophole, because you don't have to pay taxes on investment earnings from Roth IRAs. I'm not sure how much we would have saved, but over several decades it might have been several tens of thousands of dollars.

OK, I don't really need the money, so perhaps it's not a great loss. But here's the problem. The government was essentially offering to pay people thousands of dollars to do more research on the tax system. But I find that system to be really boring, and I'd rather spend my time trying to educate the public on monetary policy, or perhaps doing fun things. The government has also offered me tens of thousands of dollars to divorce my wife, and continue living with her in a "common law" situation. I don't like getting these offers from the government; they are annoying. I know someone who took that offer and I wish him well. But I still don't like the whole idea of a marriage penalty.

I'm told that in Sweden everyone files as single and it takes about 5 minutes to do one's taxes. I'd be willing to pay slightly more taxes, if we had that sort of system.

Disclaimer. This post is not offering tax advice, and there are restrictions on the backdoor into a Roth IRA, especially for those who already have tax-deductible IRAs. Consult your tax adviser before trying any of this.


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COMMENTS (19 to date)
RobertB writes:

Next you're going to tell us that you've been making your charitable contributions in cash rather than appreciated securities!

Scott Sumner writes:

Robert, Oops.

ThaomasH writes:

More to the point, why not just remove the limits on IRAs and make the income tax a consumption tax?

Floccina writes:

I second ThaomasH's suggestion. I hate tax time. Lately I pay more in taxes that I spend each year maybe about double. I was fairly low income for a long time.

Sieben writes:

Shouldn't there be an algorithm online that is regularly updated that can maximize your tax strategy?

maynardGkeynes writes:

Speaking of wasting time on loopholes, when I looked into the backdoor conversion, I found there were so many potential pitfalls if you have other IRAs (traditional or on-deductible) that it wasn't worth my time to figure it out. This is a pretty good explanation of the daunting dos and don'ts from a Bogleheads star named Finance Buff: thefinancebuff.com/the-backdoor-roth-ira-a-complete-how-to.html

One related thing I did conclude along the way is that conversion from a traditional IRA to a Roth was way over-hyped by the media finance gurus. It's pretty close to a wash if your tax bracket is as high as it's ever going to be -- ie., you are going to retire pretty soon. The biggest advantage is that you can end up sheltering a bit more money in the your converted Roth -- provided you still have some money left left after you get hit with the whopping tax bill for the conversion.

Last tax point, tangentially related, but it came up on Bogleheads while I was looking -- a fundamental rule of tax avoidance is to not put a tax advantaged asset (eg., equities) into an IRA or a 401K. Yet, everyone does it (me too). The government must love these retirement accounts, because they do such a great job of converting capital gains to ordinary income, which are taxed at a much higher rate (at least for now). (In IRA/401Ks, all gains are taxed as ordinary income, even those that would have been capital gains in a taxable account.) Converting to a Roth avoids this problem going forward, which I suppose may be its biggest plus.

The professor is right -- too boring to think about, unless you have no other interests in life, or are so rich you can pay someone else to do it.

Philo writes:

@ maynardGkeynes:

Do "not put a tax advantaged asset (eg., equities) into an IRA or a 401K"? That's right, if the asset is going to *stay tax-advantaged*. But at any time the government can (e.g.) revert to taxing capital gains as ordinary income, or even at a rate higher than that on ordinary income. In consequence tax planning is quite a guessing game.

Matthew Moore writes:

The UK's tax code is at least as complex as the US, but at least if you just work a single job as an employee, you don't have to do any tax return. All deductions are done at source.

Mark Barbieri writes:

That's just the tip of the iceberg. If your employer allows you to make after tax contributions to your 401K and allows in-service withdrawals of those contributions, you can funnel tens of thousands each year into a Roth using the "Mega Backdoor Roth" strategy. Just make sure to roll any pre-tax IRA money you have into a 401K that takes rollovers to avoid the proportionality rules.

If you switch to a high deductible health plan, you can avoid income taxes on $6,650 of contributions to a health savings account each year. But don't use that money to pay medical expenses. Save your medical expense receipts and leave the money in there so that it can grow. Take it out decades from now to reimburse you for those ancient medical bills.

Set up a 529 College Savings plan as another state income tax deduction and a way to defer more federal income taxes. It can also be useful for avoiding estate taxes.

If you plan on doing any gambling with high frequency stock trading, don't do that in a taxable account. Do that in a retirement account to avoid capital gains taxes.

There are all sorts of these quirks that you can exploit if you take the time to learn them. What better way to engage the creative energies of high income people than to have them spend time gaming the tax system? You wouldn't want them being more productive because they would take more people's jobs. (yes, that last bit was sarcasm)

Mike W writes:

But I find that system to be really boring, and I'd rather spend my time trying to educate the public on monetary policy...

Really? Which, education on tax intricacies or monetary policy, has the most potential to impact the lives of "the public"?

JK Brown writes:

My sentiments exactly. I hate tax time mostly because we have an entire industry with lots of advertising to make one feel they are being cheated by the tax code. Worse than buying a car.

BC writes:

@maynardGkeynes, the Roth IRA conversion is good for people that have made a lot of non-deductible contributions to a traditional IRA. Since those are after-tax dollars anyways, it makes sense to convert them into a Roth so that one won't be taxed when withdrawing investment earnings during retirement. The gotcha though is that, if the traditional IRA contains both after-tax and pre-tax dollars, then one can't just convert only the after-tax dollars. Any conversions have to be attributed pro-rata between the pre-tax and after-tax dollars, and one has to pay taxes on the pre-tax portion of the conversion.

@Mark Barbieri is right about the HSAs. Just because something is called a "health savings account", it doesn't mean that one should use it for health expenditures. (That's something an irrational person would do. Google "mental accounting". :) ) An HSA is just a tax-sheltered account. Pay for medical (and all other) expenses using funds from a taxable account first. I believe that, after one reaches age 65, one can make tax and penalty free withdrawals from an HSA even for non-medical expenses.

It's interesting that some tax optimizations are deemed exploiting "loopholes" while others are deemed avoiding "penalties", e.g., marriage penalty. The tax-minimizing strategy results in the "right" amount of taxes paid under Congress's revealed preference, so there's really no such thing as a "loophole". Instead, we have lots of victims of pitfalls arising from our complicated tax code. The tax code penalizes people for not spending a lot of time studying it.

AS writes:

Complexity is a feature, not a bug. Missed deductions increase revenue for Congress, and complexity increases the IRS budget and demand for tax consulting services. These groups all benefit, so will lobby for more complexity.

Roger Sweeny writes:

AS complains that complexity "increases ... the demand for tax consulting services." Hey, the people who provide those services have college or graduate degrees. This is one way society keeps the promise that if you do well in school, you will be rewarded later. And it helps them pay off their education loans.

The same can be said of the industries that develop to help people deal with other government regulation.

ColoComment writes:

Back when I had a decent income (worked for a financial institution - wages at a FI are far more generous than non-FI, but I digress), and my children were each newly financially independent, I established and initially funded ("gifted") Roth IRAs for each of them.
I figured that they could add contributions as & when their incomes increased, and at the very least the principal would grow over several decades completely tax-free (all laws remaining unchanged, of course.)
I thought it was a great wealth-transfer strategy for a middle-income parent.

ColoComment writes:

"...after one reaches age 65, one can make tax and penalty free withdrawals from an HSA even for non-medical expenses."

A quick Google search reveals that post-65 withdrawals may indeed be penalty-free, but ARE taxable as ordinary income.

Matt writes:
Last tax point, tangentially related, but it came up on Bogleheads while I was looking -- a fundamental rule of tax avoidance is to not put a tax advantaged asset (eg., equities) into an IRA or a 401K. Yet, everyone does it (me too). The government must love these retirement accounts, because they do such a great job of converting capital gains to ordinary income, which are taxed at a much higher rate (at least for now). (In IRA/401Ks, all gains are taxed as ordinary income, even those that would have been capital gains in a taxable account.) Converting to a Roth avoids this problem going forward, which I suppose may be its biggest plus.
This is a common fallacy. You are generally not hurt by putting equities into an IRA or 401k, except insofar as you're using tax-advantaged space that could have been devoted to other assets that need it more. In particular, you are not somehow losing because retirement accounts are "converting capital gains to ordinary income".

Think about it this way. Suppose your marginal tax rate is 35% both now and in retirement. Now consider two options:

Option 1. You take income, pay 35% in taxes on it at the beginning, and then invest in equities over a 30-year horizon, coughing up about 0.3% in dividend taxes every year and 12% in capital gains when you sell (since by then, most of nominal value of the portfolio will be nominal capital gains). Overall, relative to a no-tax world, you are left with 0.65*0.997^30*0.88 = 0.52 of what you would get.

Option 2. You take income, pay 35% in taxes in it at the beginning and put it in a Roth, and then follow the same strategy as option 1. Or you take income, put it in a regular IRA, and then follow the same strategy, paying 35% in taxes when you withdraw. In either case, you're left with 0.65 of what you would get in a no-tax world. This is clearly better than the previous case, where you had 0.52.

Why are you better off with the traditional IRA than a taxable account, even though the IRA taxes your gains at 35% at the end, whereas the taxable account only taxes them at the 15% capital gains rate? Because in the taxable account, you had 35% taken off the top at the very beginning, and all of your assets have been effectively scaled down by that amount. The 15% capital gains tax, after this initial hit, represents an additional dose of pain, not some kind of tax break relative to ordinary income.

(If your MTR is higher or lower in retirement than when working, of course, the analysis is a bit different. But this is the usual traditional vs. Roth optimization, and is a separate question.)

It is true that fixed income assets are less tax-advantaged and should be placed in IRAs before equities, although with low interest rates this is no longer nearly as big a deal as it used to be. But for those of us who don't have enough fixed income assets to fill our tax-advantaged space, because we're young and trying to take advantage of the equity premium, it totally makes sense to put equities in there.

Scott Sumner writes:

Thaomas, I agree.

Mark, Thanks for all that info, but you are just depressing me more and more.

Everyone, Thanks for that info.

Benjamin Cole writes:

I ditto Scott Sumner in every regard on this. I hate tax-finagling so much I do not know if I could have saved money or not.

I threw in the towel a few years and just hired an accountant. I refuse to do anything but pay him and sign the forms.

The tax code is an abomination.

I wish the law was, "The tax code can say anything, but only in 1,200 words or less."

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