by Michelle Cross, CFP®, CPA, CDFA®, AIF®
About this time last year I wrote about our concern that taxes could go up given all of the COVID-related stimulus being packed on to our already skyrocketing federal debt. At the time, $2 trillion had been approved which was triple what was spent to recover from the financial crisis in 2008-2009. Since then, the government has enacted additional bills that bring the total to $5.3 trillion (and counting).
Given all of this, the Allegiant Private Advisors team believes planning for income tax increases is going to be the hot topic of 2021. It's a discussion our advisors welcome as we encourage clients to work with us in evaluating strategies that may be advantageous to each client's individual circumstances.
Some of the ideas we are exploring include:
Roth IRA/401(k) Strategies
- Roth IRA Contributions
For taxpayers whose income qualifies, you can contribute up to $6,000 ($7,000 for those over age 50) of earned income to a Roth IRA. The contribution is made with after-tax dollars and grows tax-free for life. Unlike a traditional pre-tax IRA, most withdrawals are not taxed (with some exceptions). Further, there are no required minimum distributions from the Roth IRA. Taxpayers have up until the tax filing deadline to make a contribution for the previous year. (For the 2020 tax year, the deadline for contributions has been extended to May 17, 2021.)
- Backdoor Roth Contributions
If your income is over the threshold ($139,000 for a single filer and $206,000 for joint filers in 2020), you can not contribute directly to a Roth. However, because there are no income limitations for Roth conversions, you can do what's referred to as a "backdoor Roth contribution."
To utilize this option, you make a nondeductible contribution (up to the same limits as noted above) to a traditional IRA and then convert it to Roth before it has any earnings. As with the direct Roth IRA contributions, the taxpayer must have at least as much earned income as the contribution amount and has until May 17, 2021, to make a contribution for 2020. One important caveat to this strategy is that it works best for taxpayers who do not have any pre-tax IRAs outside of their 401(k)/403(b) plans. For those taxpayers who do have pre-tax IRAs, they are required to factor those balances in during the Roth conversion using the Pro-Rata Rule. Essentially, the Pro-Rata Rule requires the taxpayer to allocate a portion of the amount being converted to pre-tax dollars, which are then taxed at ordinary income rates. So even though the taxpayer contributed after-tax dollars to the traditional IRA, a portion of that amount will be taxable at conversion just because they have a balance in pre-tax IRAs. Again, the Pro-Rata Rule does not apply if the taxpayer only has balances in his/her 401(k)/403(b).
- Roth Conversions
This is when a taxpayer elects to pay taxes on pre-tax IRA money now so that he/she can enjoy tax-free growth going forward as well as no required minimum distributions during his/her lifetime. The same Pro-Rata Rule applies as mentioned above. Unlike the two strategies mentioned above, the taxpayer does not have to be working to do a Roth conversion.
- Electing Roth 401(k) Deferrals Instead of Traditional Pre-Tax
For those working taxpayers who have access to a 401(k) or 403(b), they are able to defer $19,500 ($26,000 if over age 50) of their income into the plan. Typically, these deferrals are made pre-tax but more and more plans have been rewriting their documents to add a Roth feature in recent years. If the plan has this feature, the taxpayer can elect any (or all) of their deferral into the Roth bucket which will be after-tax. There are no income limitations while electing Roth inside an employer-sponsored plan. (Note that if the employer also contributes to the plan through a match or profit-sharing contribution, that contribution will always be pre-tax.)
Other Planning Ideas:
Required Minimum Distributions (RMD)
If the taxpayer does not need the RMD to meet living expenses, he/she could elect to do a qualified charitable distribution (QCD). With a QCD, the taxpayer directs the custodian of the IRA to transfer funds directly to a qualified charity. Any amounts distributed as a QCD are counted towards satisfying your RMD for the year, up to $100,000, and therefore, not included in taxable income.
A 529 savings plan is the Roth IRA equivalent for education funding. After-tax dollars are contributed to the account and the earnings growth tax-free as long as the funds are withdrawn for qualified education expenses. If not, the owner incurs income tax as well as a 10% penalty on the earnings portion of the withdrawal, not the entire withdrawal. Because the owner can change a 529 plan's beneficiary, they have control over whether or not to take a taxable withdrawal. Plus, 529 assets are excluded from the owner's estate, a point that is certainly to become even more important as estate tax exemptions are being critiqued by lawmakers.
Considering Asset Location for Various Investment Types
Investments in a nonqualified brokerage account are taxed differently. Qualified dividends and capital gains are taxed at a lower rate than ordinary income rates (0%, 15%, or 20% depending on the taxpayer's AGI). As such, it would make sense to use dividend-paying stocks in a taxable brokerage account if the objective is current income. Bond interest is generally taxed at ordinary income rates so they are good for pre-tax IRAs because the income is not taxed until the owner takes a distribution. For those investors looking for consistent income in their nonqualified accounts, they should seek to use tax-free municipal bonds because the income is exempt from federal income tax. Annuities are also a way to achieve tax deferral with nonqualified investment assets.
These are just some of the planning topics we look forward to exploring with clients due to the tax implications - and potentials savings - of these tactics. Of course, every family situation is unique and these strategies may not make sense for everyone. If using one or more of these strategies makes sense for your situation, your CPA will also be involved in our discussions. If you have questions about how any of this applies to you, please contact your Allegiant Wealth Advisor to discuss your plan.