“Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” – Supreme Court Justice Learned Hand in Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934).
Often, I like to remind clients gently that their money eventually will go to one of four places: the government, a nursing home, a charity, or the family. Which one would they like? Funny how the answer is always the same…not the first two. But to make that happen, we need to do some planning.
How would you like to accumulate another $300,000 to $500,000 by the time you and your spouse are 90 years old? This extra money could cushion against further longevity, to transfer a larger inheritance to your heirs, or to make a larger donation to charity at your death. And imagine you could do this without working longer, spending less, or taking more investment risk…sounds interesting, right?
In a newsletter format, I certainly cannot say that we can do this for you. But I will tell you that my typical married clients can do this. The opportunity, however, will begin dwindling over the next couple of years.[1] Clients of this office are typical “millionaire next door” types who have done everything correctly but are, unfortunately, a little heavy in their 401k or IRAs. As you know, funds in 401k plans and IRAs must be distributed and taxed eventually…there is no way around that.
The way we help clients create this additional wealth is by converting $50,000 to $100,000 per year from their IRA accounts to Roth IRA accounts and paying the taxes from an outside source (i.e., a savings account or another non-IRA investment account). It works because tax rates for married people are set to increase in 2026…please read on.
Basics of Roth IRAs
The Roth IRA became a savings option in 1998. Unlike a traditional IRA, Roth IRA distributions are tax-free if you play by the rules of a Roth. In contrast, while the growth of a traditional IRA is tax-deferred, the distributions are always taxable.
There are two ways to get funds into a Roth IRA. You can either contribute or convert. Contributions are limited based on the annual contribution limit and your income. Employers have also been able to offer a Roth 401k option since 2006 that ease but, do not eliminate, the restrictions. But one can convert an unlimited amount from a traditional IRA regardless of income. Now, there are practical limits to how much one might convert, but there are no restrictions like there are on contributions.
Conversions cause the amount converted to become taxable income in the year of conversion (while contributions must be made with after-tax funds). Let’s assume Mr. and Mrs. Saver, both recently retired, have over $1 million in their traditional IRA accounts and, after speaking with their very sharp financial planner, decide to convert $100,000 to a Roth IRA. Mr. and Mrs. Saver also have $90,000 in a savings account earning very little interest and a small brokerage account worth $60,000. Their other income consists of Social Security and pension income that totals $80,000 per year. By converting $100,000 to a Roth IRA, the Savers will have to report an additional $100,000 on their taxes for 2021 and will now pay taxes on $180,000 of income (less standard or itemized deductions). For most people in Colorado, this means that the Savers will owe an additional $26,000 to $29,000 in tax. But that $100,000, which is now in a Roth IRA may grow tax-free for them and their heirs.
Tax Cuts to be Eliminated in 2026
The Tax Cuts and Jobs Act of 2017 (“2017 Act”) reduced tax rates for married people. For my clients, the reduction is generally 12% to 15%. So if they were paying $1,000 in tax, now they’re paying $850 to $880. A provision in the 2017 Act states that these lower tax rates will “sunset” in 2026 – meaning that they will expire, and we will revert to the old, higher tax rates in 2026. Now, Congress could do anything, including extending the lower rates or passing altogether new tax laws. But gridlock and a return to the old rates seems likely.
A Stunner for Mr. and Mrs. Saver
Now imagine Mr. and Mrs. Saver sitting there wondering whether they should accelerate the tax burden and pay taxes over the next five years rather than waiting to withdraw their funds when the tax rates are scheduled to increase in 2026. The 24% tax bracket for married people filing joint under the 2017 Act currently goes to $329,850 for 2021. When that sharp financial planner for Mr. and Mrs. Saver ran the projections into the future, the Savers said they were “stunned” to see that they could have another $364,000 in total assets by the time they reached their early 90s.[2] “Finally!”, Mr. Saver shouted, “I can justify the fees I’m paying you.” “You’re funny, Mr. Saver,” said the financial planner relieved that the Saver’s were seeing the wisdom in doing this.
But wait, it gets better because the Savers have children. Right before Covid struck, Congress passed the SECURE Act in December 2019. Without wading into politics, this was, in essence, an estate tax aimed at people like Mr. and Mrs. Saver. That’s because, when they both pass away, their IRA accounts must be emptied within ten years if going to their adult children. For Mr. and Mrs. Saver, they anticipate that their two children will be in their high-income years when inheriting their IRA accounts. If the IRA accounts must be emptied within ten years during the time when their kids are in their high income-earnings years, it’s easy to understand that much of this money will end up going to the government.
“Now wait just another minute,” said Mr. Saver, “there’s more?!” Actually, there is, said the financial planner. From doing proper planning, it is clear that the Savers will not need 100% of their required minimum distributions (RMDs) during retirement to live their life and fund their goals. Funds held inside Roth IRAs do NOT have a RMD requirement.[3] Even if they did, there would be no tax due. But more importantly, the funds can continue to grow tax-free inside the Roth IRA while the Savers are alive (and for ten years with their children).
Mr. and Mrs. Saver Decide to Convert
Once they understood things, Mr. and Mrs. Saver decided to convert $100,000 this year to a Roth IRA, and they are now planning to do the same for the years 2022 through 2025. By paying the taxes sooner, they remove future earnings from being taxed AND their RMDs will be less, so therefore less tax payments for the government. The Savers will still have traditional IRA funds when they pass away. But after talking it over, they like the idea that they can give this money to charity while their kids (on an after-tax basis) inherit the same amount of money in Roth IRA accounts. The Savers nod approvingly when they realize that only the government is losing on this strategy.
When Mr. and Mrs. Saver were first told about this strategy, Mr. Saver resisted. “I’ve always been told that you defer, defer, defer taxes. Why on earth should I pay taxes now when I can wait? Plus, I’m 65 years old. This is for younger people.” “I get it,” said the empathetic financial planner. “That has been the traditional way of thinking about these conversions, and other clients have expressed similar concerns.” But even Mr. Saver finally admitted that, once he understood things, the benefits were too large to ignore. As Mr. Saver was leaving the financial planner’s office, he was laughing and said, “It took me a while, but now I’m convinced. You sure are a lot smarter than you look!” “You’re funny, Mr. Saver”, the financial planner said again, knowing that the amount of good he was doing for this family would be intergenerational.
Beware Some Potential Issues
This new approach to their financial plan sounds great, but their sharp – and admittedly handsome – financial planner told them that they must consider some potential issues. First, there is a 5-year rule that says they cannot withdraw earnings for five years after a conversion. They can withdraw principal, but not earnings. Second, if they end up with more income than they anticipate in any given year, they could trigger higher Medicare Part B premiums. The conversion would remain very much a net positive for the Savers, but the financial planner admitted that people are, shall we say, less than enthusiastic about paying more for their Medicare premiums. Third, there is 3.8% Medicare tax that, depending on other assets and income, could be triggered if the Savers’ income exceeds $250,000. Again, the conversion should most likely go forward – but this tax must be considered. Lastly, the Savers are told to talk with their tax preparer and make sure that they pay any estimated taxes due during the year of a conversion. Otherwise, a tax penalty could be assessed.
Summary
I don’t know of any better way than this to boost financial security for a married couple without taking additional investment risk, telling them to work longer, or to spend less. I want to emphasize that everyone’s situation will be different than Mr. and Mrs. Saver. But if you have interest in exploring this topic, then please reach out to schedule some time to talk.
Nobody can predict what Congress will do with tax rates. But the law as it stands today is that we will revert back to higher rates in 2026 for married people. You’ve been warned, so please act. I have read through the Biden tax proposals that were released on September 13th, and there is nothing in this release that indicates they are going to disturb this strategy.[4]
Bottom Line: Do yourself and your kids (and possibly a charity) a favor and consider converting traditional IRA funds to a Roth IRA. The temporary, lower tax rates in effect through 2025 are providing a unique opportunity to build wealth at the government’s expense.
