Between 1967 and 1973, psychologist Walter Mischel, a professor at Stanford University, conducted what became his famous “marshmallow test” on delayed gratification.
In the study, children were offered a choice between one small but immediate reward (a marshmallow) or two rewards if they waited for a period of time. After explaining the study to the children, the researchers would leave the room for about 15 minutes and then return.
They found that children who were able to wait to get two marshmallows (that is, being able to delay gratification) vs. just eating the one marshmallow right away (that is, giving in to instant gratification) tended to have better life outcomes, as measured by SAT scores, educational attainment, body mass index (BMI) and other life measures.
Many people don’t realize that decades later, researchers attempted to replicate the study results, working with children from a more diverse population that was over 10 times larger than the original study. The new study revealed only half the effect of the original study in terms of delayed gratification on success in life later.
As a result, in 2020, a team of researchers that included Mischel challenged the predictive power of the marshmallow test.
Delayed Gratification Can Pay Off in Investments, Too
So, what does the marshmallow test have to do with the decision to convert a tax-deferred IRA to a tax-exempt Roth IRA? This relates to the benefits you can derive when you forgo a small financial reward today (by paying tax on an investment now) so you can get a greater reward in the future (not having to pay taxes on your investments or the growth they realize. once they’ve grown).
Compared to a traditional IRA, the main advantage of a Roth IRA is that you won’t have to pay income tax on the money you withdraw in retirement.
Here’s an example. If you defer spending $5,000 today and put it away, you can receive a tax deduction for saving that money. However, when you take those funds out in the future, you will pay tax on the $5,000, plus all earnings related to that money’s growth. Many people believe that tax rates will increase in the future. But even if we assume that tax rates stay the same, the benefit of paying the tax today and avoiding it tomorrow is compelling.
Let’s look at what could happen with a hypothetical tax rate of 20 percent. We save $1,000 today by deferring the spending of $5,000. If that $5,000 account grows to $10,000, we will then have to pay $2,000 in taxes in the future.
In contrast, if we converted that money into a Roth IRA, we would not save paying the $1,000 tax today, but we would avoid paying the $2,000 tax in the future. Moreover, any funds taken from a traditional retirement account may impact your Medicare premium and taxation of Social Security.
Future Growth on Funds in a Roth IRA Is Tax-Exempt
Even if you cannot contribute directly to a Roth IRA because your income exceeds the limits set by the IRS, you may be able to do what’s called a ‘backdoor ROTH’. You can also convert a traditional IRA into a Roth. When you convert an existing tax-deferred account to a Roth tax-exempt account, you will pay income tax on the amount you convert, but all future growth will be tax-exempt.
Although converting a traditional IRA to ROTH can impact the tax on your Social Security and your Medicare premium, paying a little tax today could save you many times that amount in the future. Keep in mind that the potential break-even time on converting will depend on your individual circumstances. That is why it’s important to speak with both your financial advisor and your CPA about the potential impact of any IRA conversion or contributing to a Roth instead of a tax-deferred account.
We believe that effective tax rates may rise in the future, in which case deferring taxes may not make sense. Even if tax rates remain the same, having tax-exempt funds can benefit you and your heirs.
Here are three compelling ways in which forgoing a reward now can lead to more rewards later, when you convert a traditional IRA to a Roth IRA:
- With an IRA, there are mandatory distributions at age 72, while with a Roth IRA, there are not.
- If your heirs inherit an IRA, they will need to pay income tax, whereas with a Roth account, they will not.
- When you draw money from a traditional IRA, it is considered taxable income that can raise your Medicare premium and the tax on your Social Security income. When you draw from a Roth IRA, that money is not considered taxable income.
Sometimes, it’s better to resist one marshmallow today so you can get two in the future.
Randy Carver, CRPC®, CDFA®, is the president and founder of Carver Financial Services, Inc., and is also a registered principal with Raymond James Financial Services, Inc. Randy has more than 32 years of experience in the financial services business. Carver Financial Services, Inc. was established in 1990 and is one of the largest independent financial services offices in the country, managing $2 billion in assets for clients globally, as of May 2021. Randy and his team, work with individuals who are in financial transition as a result of divorce, retirement, or the sale of a business. You may reach Randy at email@example.com.
This information does not purport to be a complete description of the securities, markets or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Randy Carver and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Links are being provided for information purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed websites or their respective sponsors.
Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.