Category Archives for "Tax Planning"

Year End Tax Planning Opportunities

By Chris Chen CFP | Financial Planning , Retirement Planning , Tax Planning

The Tax Cut and Jobs Act of 2017 (TCJA) was the most consequential tax reform package in this generation. It changed many of the ways that we think about reducing taxes.

According to the Tax Policy Center, we know that about 80% of taxpayers pay less income tax in 2018 than before the TCJA , about 5% pay more, and the balance of taxpayers pay about the same amount. On balance, the TCJA seems to have delivered on its promises.

A key item of the TCJA is that it increased the standard deduction, reducing the impact of the elimination of State and Local Taxes (SALT) under $10,000 and the elimination of personal deductions. As a result, about 84% of taxpayers claim the standard deduction and do not itemize. By comparison, about 56% of taxpayers itemized before the enactment of the TCJA. The vast majority of taxpayers are no longer subject to the Alternative Minimum Tax (AMT), since two of its key drivers, the deductibility of state and local taxes and personal deductions, are no longer a practical issue for most people. And in 2018, only 1,700 estates were subject to the federal estate and gift tax. So for most people, the TCJA has made taxes simpler to deal with. What’s there not to like about a simpler tax return ?

Source: Congressional Budget Office

Impact of the TCJA on the Federal Deficit

As predicted, the TCJA worsened the federal deficit bringing it to nearly a trillion dollars in fiscal year 2019. That was in spite of an increase in tax revenue due to the continuing improvement in the economic climate. Of course, the federal deficit continues to be driven by federal spending on the sacred cows of modern US politics: Defense, Social Security, and Medicare. Interest on the federal debt is also a major budget item that needs to be paid. While our continuing regime of low interest rates is helping control the interest on the debt, it is clear that the future may change that.

What will happen to tax rates?

Tax rates are lower now than they have been since the 1970s and 80s. Hence, industry insiders tend to think that tax rates have nowhere to go but up.  That is also what’s is predicted by the TCJA, which is largely designed to sunset in 2025. Should the American people turn on Republicans at the 2020 election, it’s possible that the TCJA will see a premature end. However, it seems that the possibility that the American people might elect a progressive in 2020 is largely discounted when it comes to tax rate forecasting: most people assume that tax rates will increase.

Year-End Planning

Political forecasting aside, there are still things that we can do to lower our taxes . It should be noted that many of the techniques in this article are not limited to the year-end. Furthermore, we all have different situations that may or may not be appropriate for these techniques. 

Tax Loss Harvesting

Even though we have had a pretty good year overall, many of us may still have positions in which we have paper losses. Tax-loss harvesting consists of selling these positions to realize the losses. This becomes valuable when you sell the equivalent amount of shares in which you have gains. So if you sell some shares with $10,000 in losses, and some with $10,000 in gains, you have effectively canceled out the taxes on the gains.

You then have to reinvest the shares sold into another investment. Be careful not to buy back the exact same shares that you sold. That would disallow the tax loss harvesting!

At the same time, it makes sense to review your portfolio and see if there are other changes that you would like to make. We are not fans of frequent changes for its own sake. However, periodically our needs change, the markets change, and we need to adapt.

Income Tax Planning

While tax loss harvesting is mostly about managing Capital Gains taxes, it is also important to keep an eye on income tax planning . This is a good time of year to estimate your income and your taxes for the year. When comparing your estimated Adjusted Gross Income with the tax tables, you will see if you might be creeping up into the next tax bracket. For instance, if you are single and your estimated AGI is $169,501 (and you have no other complexity), you are right at the 32% tax bracket (after you remove the $12,000 standard deduction).  In this example, that means that for every dollar above that amount you would owe 32 cents in federal income tax, and a little bit more for state income tax, if that applies to you.

If your income is from a business, you may possibly defer some of that income to next year. If your income comes from wages, another way to manage this is to plan an additional contribution to a retirement account. In the best of cases your $1,000 contribution would reduce your taxes by $320, and a little bit more for state taxes.

In some cases, you might have a significant dip in income. Perhaps if you have a business, you reported some large purchases, or you booked a loss or just had a bad year for income. It may make sense at this point to take advantage of your temporarily low tax rate to do a Roth conversion. Check with your wealth manager or tax preparer.

If your income does not straddle two tax brackets, the decision to invest in a Traditional IRA or a Roth IRA is still worth considering.

Charitable Contributions

By increasing standard deductions, the TCJA has made it more difficult for people to deduct charitable contributions . As a result, charitable contributions bring few if any tax benefits for most people.

One way around that situation is to bundle or lump charitable gifts. Instead of giving every year, you can give 2, 3 or more years worth of donations at one time. That would allow your charity to receive the contribution, and, potentially, for you to take a tax deduction. 

Pushing the bundling concept further, you could give even more to a Donor Advised Fund (DAF). With that option, you could take a tax deduction, and give every year from the DAF. That allows you to control your donations, reduce your income in the year that you donate, and potentially reduce income taxes and Medicare premiums. Consult your wealth strategist to ensure that taxes, income, and donations are optimized.

Retirement Accounts

First, it is important to review Required Minimum Distribution (RMDs). Anyone who is 70 ½ years of age or older is subject to RMDs. Please make sure to connect with your financial advisor to make sure that the RMD is properly withdrawn before the year-end.

The RMD is a perennial subject of irritation for people . Obviously, if your retirement income plan includes the use of RMDs, it’s not so much of an issue. However, if it is not required, it can be irritating. That is because RMD distributions are subject to income taxes that may even push you into the next tax bracket or increase your Medicare premium. There are, however, some ways that you can deal with that.  

For instance, if you take a Qualified Charitable Distribution (QCD) from your IRA and have the distribution given directly to a charity, the distribution will not be income to you. Hence you won’t pay income taxes on that distribution, and it will not be counted toward the income used to calculate your Medicare premium. However, it will fulfill your RMD, thus taking care of that pesky issue.

Generally, we advocate planning for lifetime taxes rather than for any one given year. Lifetime financial planning has the potential to result in even more benefits. It should be noted that many of the possibilities outlined in this article can be used throughout the year, not just at year-end. We encourage you to have that conversation with your wealth management team to plan for the long term!

Is A Health Savings Account Right For You?

By Chris Chen CFP | Divorce Planning , Financial Planning , Investment Planning , Tax Planning

It is health insurance plan signup season . Whether you subscribe to your employer’s health care insurance plan or you buy your own directly, it is the time of the year when you have to sign up all over again. Unless you have specific circumstances such as a change of employer, a divorce, or new baby, this is the one time in the year when you get to change your health care insurance plan.

If you have been keeping abreast of the popular financial media, you may have come across the Health Savings Account (HSA).  According to AHIP (America’s Health Insurance Plans), 22 million people had HSA accounts in 2018.  Financial Planners love HSA. It is potentially the most tax advantageous vehicle that exists.  Contributions to HSAs are pre-tax, the money is invested tax-free, and distributions are tax-free if used for health purposes. Triple tax-free. HSAs are even better than Roth retirement accounts !

The reality is that we all have health care expenses, and they can be substantial . Having the ability to pay with tax-free money is a critical advantage. If you have to pay a $100 hospital invoice, you might have to earn $150 or more first, pay Federal income taxes, Social security taxes, state income taxes, before you can have $100 to pay your bill. With an HSA, there is no income tax, you pay with $100 of your earnings. 

A Health Savings Account is effectively an alternative to the Flexible Spending Account (FSA) , the more traditional way to pay for health care expenses that are not covered by insurance. The FSA allows employees to save pre-tax from earnings, and then to spend it on health care expenses without paying taxes on the earnings.  Money in FSAs, however, is not invested, and it must be spent by year-end or be forfeited. It has to be spent, or it will be lost. HSA funds, on the other hand, can be invested, and funds from HSA accounts can be carried over into the future. Thus, HSAs can be spent in a way that is similar to other retirement savings accounts such as the IRA or the Roth IRA.

1. If used as intended for retirement, education or health expenses respectively

What’s in it for the employer?

In order to contribute to an HSA, you must have chosen a High Deductible Health Plan with your employer. 

According to the IRS, for 2019, a high deductible is defined as $1,350  ($1,400 in 2020) for an individual or $2,700 for a family ($2,800 in 2020.) On top of this high deductible, annual out of pocket expenses (including deductibles, copayments, and coinsurance) cannot exceed $6,750 for an individual or $13,500 for a family. Those numbers increase in 2020 to $6,900 for an individual and $13,800 for a family. 

For employers, offering high deductible health insurance plans is more cost effective than other plans. Therefore, they will prefer that their employees sign up for high deductible plans. Many employers will contribute directly to HSA accounts to encourage their workforce to choose a high deductible health insurance plan.

Theoretically, if employees have to pay out of pocket or out of their HSA for their health care expenses, they will be more careful about their choices.  While the funds in the HSA remain available to be used for health care expenses immediately if needed, the designers of the HSA believe that the ability to carry over HSA balances to future years will motivate employees to be better health care shoppers when choosing treatments or, indeed, when choosing to be treated in the first place. The net result is that high deductible health plans help employers contain health care expenses, and shift the burden on their employees. 

From an employee’s point of view, high deductible plans can make a lot of sense . If you don’t believe that you will need (much) health care in the coming year, you can benefit from a lower cost plan, and from the savings and investment opportunity.  

Financial Benefit 

And how do you maximize the value of the HSA? By contributing to the maximum, and investing it. A dollar contributed may be worth many times its value in the future when invested.

The Internal Revenue Service allows individuals in 2020 to contribute up to $3,550 to their HSAs. Families may contribute up to $7,100.  Both individuals and families can benefit from a catch-up provision of $1,100 if they are over 55.

According to Debbie Taylor, a CPA and tax expert, many people make the mistake of not investing their HSA contributions and keeping them in money market. Because one of the key benefits of HSAs is that the contributions can grow tax-free , not investing them is a grievous and expensive mistake. 

However, it’s worth noting that an HSA may need to be invested differently from your retirement accounts , especially if you plan to use your HSA at different times than you might use your retirement accounts. Consult your wealth manager for more insight.

If you are choosing the high deductible plan to save money, but you are not able to contribute to your HSA, you are putting yourself at risk if you have an unforeseen health event. Not having enough saved to cover the cost of the health care you need means that you may have to go into debt until you have met your plan’s deductible. 

So, if you have a tight budget, please think twice before trying to save money with a high deductible plan. It may just backfire on you.

Unintended Consequences

A question that is often minimized at enrollment time is what happens to the HSA if you have miscalculated, and you happen to have a significant health care expense in the year that you are contributing? 

First, if it is a major event, you may consider using funds in your HSA account. However the health care insurance will eventually kick in and cover most of the cost. So as a subscriber to a high deductible plan, you are still protected from the catastrophic consequences of an unexpected health issue. While you may not harvest all the benefits of the HSA, and you will likely lose the cost savings of choosing a high deductible plan, you are protected from financial disaster.

What if it is not a really major event, just a somewhat major event like, say, a trip to the emergency room for a temporary issue that you will easily recover from?

In that case, you also have the option to use your funds in the HSA to pay for those expenses. Your contributions will have been pre-tax as with an FSA. You will not have enjoyed much investment growth. Your distribution will still be tax-free. You are giving up the future benefits of the HSA, but you are dealing with your more immediate issues. Basically, your HSA will have functioned like an FSA. You will also lose the savings benefits of choosing a lower cost high deductible plan over a higher cost low deductible plan.

What if instead, you decide to pay for your trip to the emergency room out of pocket with post-tax savings and save your HSA for the future, as your wealth manager told you that you should? The real cost of your $5,000 trip depends on your income and tax bracket. If you happen to be in the 32% Federal tax bracket and you live in Massachusetts, the cost of the $5,000 emergency room trip will be around 58% higher.  

HSAs provide some tremendous benefits that should be considered by everyone who is looking to enhance their health care and their retirement situation. However, the decision to choose a Health Savings Account should be based on more than just taxes and the cost of your health care insurance. It is important to consider the very real costs of unforeseen events and to be realistic about your health insurance needs. 

Do You Have To Pay Taxes in Retirement?

By Chris Chen CFP | Financial Planning , Retirement Planning , Tax Planning

Do You Have To Pay Taxes in Retirement?

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Many people mistakenly look forward to not having to pay income taxes in retirement. It is understandable that after a lifetime of paying taxes, retirees would feel that they deserve a break. 

Unfortunately, that is not generally how income taxes work! In this article, I categorize nine sources of income and their corresponding level of taxes. 

It may seem at times that taxes are hitting us from all directions.  However, a variety of tax rules can also give retirees, or ideally pre-retirees, opportunities to plan such that they can optimize their lifetime taxes, and avoid paying more than their fair share .

Social Security

For those filing as single with income below $25,000, or married filing jointly with income below $32,000, social security income is income tax-free. However, single filer retirees with income up to $34,000 or $44,000 for married filing jointly will find that 50% of their social security becomes taxable.  When income increases over $34,000, or $44,000 for married filing jointly then 85% becomes taxable. 

So while it is correct that a portion of their social security income will be income tax-free, many retirees find that they will pay some taxes on their social security income

Retirement Accounts

Retirement accounts such as 401(k), 403(b), and IRAs are an important source of income for retirees.  Income from these accounts is taxed as ordinary income, as if it was being earned in a job, with tax rates ranging from 10% to 37% at the federal level. That is because the initial contribution to those accounts helped to reduce taxable income at the time.  That means that the money in these retirement accounts was never taxed. 

To complicate the matter, distributions from some accounts may be exempt from State taxes. For instance, 403(b) accounts earned in New Jersey are exempt from New Jersey State income taxes at distribution. Similarly, IRA distributions from accounts that were established by Massachusetts taxpayers are exempt from State income taxes. These peculiarities vary from State to State. It’s important to verify how they may apply in your State rather than making an assumption.  

Pensions

Many retirees still receive pension income. Some of the more common ones include state, federal and military pensions. Although private pensions have been in decline for several decades now, there continue to be many people who receive payments from these pensions.

Retirees are often surprised to find that their pension income is taxable as ordinary income at the federal level, just as other retirement account income. As with other retirement income sources, there may be exceptions for state taxes that vary from state to state and pension to pension.

Roth Accounts

Income from Roth accounts is not taxed in retirement.  That is because the initial contribution came from after-tax money. In other words, the income used to make the contribution was taxed on the full amount before the contribution was made. I like to say that “Roth accounts are not tax-free, they are just taxed differently“.

A key benefit of Roth accounts is that their distributions do not count toward high-income surcharges for Medicare Part B and Part D premiums. 

Retirees find that Roth accounts can be tremendously useful to optimize taxes in retirement by strategically combining income from Roth accounts with income from taxable accounts .

As a result, effective retirement planning should include considering saving in Traditional vs Roth accounts and strategically converting Traditional to Roth accounts, when appropriate.

Before jumping into making a Roth conversion, it is important to understand that the point of a Roth account contribution should not be to avoid taxes in retirement per se.  Instead, it should be to reduce lifetime taxes . It is possible that a badly timed Roth contribution would increase lifetime taxes, while also reducing retirement income taxes. A strategic plan is important to think through and implement. 

Municipal Bonds

Income received from municipal bonds is federal tax-free.  Like a Roth contribution, an investment in municipal bonds is made with after-tax money. If you own municipal bonds from the state of your residence, the interest is also state tax-free. However, if you own municipal bonds from states other than your residence, their interest is usually taxable at the state level.

People also wonder what happens when they sell their municipal bonds.  When that happens, the price of the bond can be higher or lower than the face value, known as a premium or a discount. When the price is at a premium, the difference between the premium and the face value can be taxed. That can often be an impediment to a sale as people don’t want to be taxed.  

Investments

When held for one year or longer, investments outside of retirement accounts are subject to long term capital gains taxes. They can range from 0% to 23.8%, including potential Medicare surcharges.  In 2019, for a married couple filing jointly with taxable income up to $78,750, long term capital gains are taxed at 0% federally ($39,375 for people filing as single).

Therefore investments can potentially be taxed less than other sources of income such as retirement accounts. Balancing distributions from investments in conjunction with Traditional retirement and Roth accounts can be a valuable tax optimization tool.

For people preparing to retire, it may make sense to divert investments from retirement accounts to brokerage accounts . Since taxes cannot be entirely avoided, it is about creating a strategy that optimizes investment vehicles to reduce lifetime taxes.

Annuities

Any income from annuities held inside qualified retirement accounts such as an IRA will be taxable as ordinary income in its entirety.

Income from annuities that are not held in qualified retirement accounts is partially taxable as ordinary income. The amount of the distribution that represents your original investment is considered tax-free. 

Therefore, the taxation of annuity income falls somewhat below that the taxation of income from retirement accounts. 

Life Insurance

Loans from the cash value of an insurance policy are considered tax free. That is because, as any loans, they are not considered income. That is a critical point made at the time that an insurance sale occurs.  It should be noted, however, that life insurance is an instance when the tax issues are so prevalent in the discussion that they obscure the other costs of cash value life insurance. The loan from the policy is tax-free, but that in an of itself does not necessarily make life insurance cost-effective or appropriate for your needs.

Earned Income

Income earned in retirement is taxed as any other earned income before retirement. Some retirees continue to earn work income, from part-time jobs or from consulting gigs for example. That income is taxed as earned income as if they were not retired, including Social Security and Medicare. Unfortunately, there is no tax break for working in retirement!

The reality for most of us is that we will owe taxes in retirement. The multiplication of tax situations can make planning difficult for a retiree.

The challenge is to plan our income situation strategically, manipulate it if you will, in order to minimize lifetime taxes. 

Fortunately, wealth planning done properly is a very feasible endeavor that  may help you keep more of what you earned in your pockets!

McKenzie Bezos: 4 Wealth Strategy Concerns

By Chris Chen CFP | Divorce Planning , Financial Planning , Tax Planning

McKenzie Bezos: 4 Wealth Strategy Concerns

On April 4th, it was announced that McKenzie Bezos would be receiving 36 billion dollars worth of assets from her divorce from Jeff.  

First of all, congratulations to Jeff and McKenzie for keeping this divorce process short, out of the media as much as possible, and out of the courts. We are not going to know the details of the Bezos’ agreement. However, some information has been disclosed in the press.

As reported by CNN, McKenzie is keeping 4% of their Amazon stock, worth approximately 36 billion dollars. Jeff retains voting power for her shares as well as ownership of the Washington Post and Blue Origin, their space exploration venture. According to The Economist, this makes the Bezos divorce the most expensive in history by a long shot.

Unsurprisingly, McKenzie’s wealth is concentrated in AMZN stock. That has worked out well for the Bezos’ for the past several years. It is likely to continue to be a great source of wealth for both of them in the future. As it stands, McKenzie is now the third richest woman in the world. Who knows, if she holds onto AMZN stock, she could become the richest woman in the world one day! McKenzie’s concerns with budgeting, taxes, and wealth strategy will soon be in a class of their own.

There are, however, some lingering considerations for McKenzie, particularly when it comes to capital gains taxes, portfolio management, philanthropy and wealth transfer.

Capital Gains Taxes

McKenzie probably has an enormous tax liability built into her AMZN holdings. While I am not privy to her cost basis, it is not unreasonable to assume that it is close to zero since the Bezos’ have owned Amazon stock since the company’s inception. Should McKenzie sell her AMZN stock, the entire amount would likely be subject to capital gains taxes. As such McKenzie may not be worth quite $36 Billion after taxes are accounted for .

A benefit of keeping the stock until her death is that her estate will benefit from a step up in cost basis. This would mean that the IRS would consider the cost of the stock to be equal to the value at her death. This favorable tax treatment would wipe out her capital gains tax liability.

Portfolio Management

Nevertheless, the standard advice that wealth strategists give clients with ordinary wealth applies to Ms. Bezos as well: it would be in McKenzie’s best financial interest to diversify her holdings. Diversifying would help her reduce the risk of having her wealth concentrated into a single stock. It is a problem that McKenzie (and Jeff) share with many employees of technology and biotech startups.

McKenzie might not want to sell all of her AMZN stock or even most of it. Although we have not read their separation agreement, she has probably agreed with Jeff that she would retain the bulk of her holding. She may also believe enough in AMZN and Jeff’s leadership to sincerely want to keep it. Regardless, McKenzie should still diversify her portfolio to protect herself against AMZN specific risks.

Philanthropy

An advantage of having more money than you need is that you have the option to use the excess to have a measurable impact on the world through philanthropy. In 2018, Jeff and McKenzie created a $2B fund, the Bezos Day One Fund, to help fight homelessness. Given that the home page of the fund now only features Jeff’s signature, this may mean that Jeff is keeping this also. McKenzie will likely organize her own charity. What will her cause be?

Wealth Transfer

McKenzie’s net worth is far in excess of the current limits of federal and state estate taxes. Unless she previously planned for it during her marriage, she will have to revise her estate plan.  Even though she would benefit from a step up in basis on her AMZN stock if she chooses not to diversify, she would still be subject to estate taxes, potentially in the billions of dollars.

Of course, no matter how much estate tax McKenzie ends up paying, it is likely that she will have plenty to leave to her heirs.

A version of this post appeared in Kiplinger on April 12, 2019

Seven Year End Wealth Management Strategies

By Chris Chen CFP | Financial Planning , Investment Planning , Retirement Planning , Tax Planning

As we approach the end of a lackluster year in the financial markets, there is still time to improve your financial position with a few well placed year-end moves .

Maybe because we are working against a deadline, many year-end planning opportunities seem to be tax related .  Tax moves, however, should be made with your overall long-term financial and investment planning context in mind. Make sure to check in with your financial and tax advisors.

Here are seven important moves to focus your efforts on that will help you make the best of the rest of your financial year .

1) Harvest your Tax Losses in Your Taxable Accounts

As of[ October 26, the Dow Jones is up 1.65%, and the S&P500 is up just 0.98% ]for the year. Unfortunately, many stocks and mutual funds are down for the year. Therefore you are likely to have a number of items in your portfolio that show up in red when you check the “unrealized gains and losses” column on your brokerage statement.

You can still make an omelet out of these cracked eggs by harvesting your losses for tax purposes . The IRS individual deduction for capital losses is limited to a maximum of $3,000 for 2018.  So, if you only dispose of your losers, you could end up with a tax loss carryforward, i.e., tax losses you would have to use in future years. This is not an ideal scenario!

However, you can also offset your losses against gains. For example, if you were to sell some losers and hypothetically accumulate $10,000 in losses, you could then also sell some winners. If the gains in your winners add to $10,000, you have offset your gains with losses, and you will not owe capital gain taxes on that joint trade!

This could be a great tool to help you rebalance your portfolio with a low tax impact. Beware though that you have to wait 30 days before buying back the positions that you have sold to stay clear of the wash sale rule.

2) Reassess your Investment Planning

Tax loss harvesting is a great tactic to use for short-term advantage. As an important side benefit, it allows you to focus on more fundamental issues. Why did you buy these securities that you just sold? Presumably, they played an important role in your investing strategy. And now that you have accumulated cash, it’s important to re-invest mindfully.

You may be tempted to stay on the sideline for a while and see how the market shakes out.  Although we may have been spoiled into complacency after the Great Recession, the last month has reminded us that volatility happens.

No one knows when the next bear market will happen , if it has not started already. It is high time to ask yourself whether you and your portfolio are ready for a significant potential downturn.

Take the opportunity to review your goals, ensure that your portfolio risk matches your goals and that your asset allocation matches your risk target..

3) Check on your Retirement Planning

It is not too late to top out your retirement account!  In 2018, you may contribute a maximum of $18,500 from your salary, including employer match to a 401(k), TSP, 403(b), or 457 retirement plan, subject to the terms of your plan. Those who are age 50 or over may contribute an additional $6,000 for the year.

If you have contributed less than the limit to your plan, there may still be time! You have until December 31 to maximize contributions for 2018, reduce your 2018 taxable income (if you contribute to a Traditional plan), and give a boost to your retirement planning.

Alternatively to deferring a portion of your salary to your employer’s Traditional plan on a pre-tax basis, you may be able to contribute to a Roth account if that is a plan option for your employer. As with a Roth IRA, contributions to the Roth 401(k) are made after tax, while distributions in retirement are tax-free.

Many employers have added the Roth feature to their employee retirement plans. If yours has not, have a chat with your HR department!

Although the media has popularized the Roth account as tax-free, bear in mind that it is not. Roth accounts are merely taxed differently . Check in with your Certified Financial Planner practitioner to determine whether electing to defer a portion of your salary to on a pre-tax basis or to a Roth account on a post-tax basis would suit your situation better.

4) Roth Conversions

The current tax environment is especially favorable to Roth conversions . Under the current law, income tax rates are scheduled to go back up in 2026; hence Roth conversions could be suitable for more people until then.

With a Roth conversion, you withdraw money from a Traditional retirement account where assets grow tax-deferred, pay income taxes on the withdrawal, and roll the assets into a Roth account. Once in a Roth account, the assets can grow and be withdrawn tax-free, provided certain requirements are met. If you believe that your tax bracket will be higher in the future than it is now, you could be a good candidate for a Roth conversion .

Read more about the new tax law and Roth conversions

5) Pick your Health Plan Carefully

It is health insurance re-enrollment season! The annual ritual of picking a health insurance plan is on to us. This could be one of your more significant financial decisions for the short term. Not only is health insurance expensive, it is only getting more so.

First, you need to decide whether to subscribe to a traditional plan that has a “low” deductible or to a high deductible option.  The tradeoff is that the high deductible option has a less expensive premium. However, should you have a lot of health issues you might end up spending more.  High deductible plans are paired with Health Savings Accounts (HSA).

The HSA is a unique instrument. It allows you to save money pre-tax and to pay for qualified healthcare expenses tax-free. Unlike Flexible Spending Accounts (FSAs), balances in HSAs may be carried over to future years and invested to allow for potential earnings growth. This last feature is really exciting to wealth managers: in the right situation clients could end up saving a lot of money.

If you pick a high deductible plan, make sure to fund your HSA to the maximum. Employers will often contribute also to encourage you to choose that option.  If you select a low deductible plan, make sure to put the appropriate amount in your Flexible Spending Account. FSAs are used to pay for medical expenses on a pretax basis. Unlike with an HSA, you cannot rollover unspent amounts to future years.

6) If you are past 70, plan your RMDs

If you are past 70, make sure that you take your Required Minimum Distributions (RMDs) each year. The 50% penalty for not taking the RMD is steep. You must withdraw your first minimum distribution by April 1 of the year following the year in which you turn 70 ½, and then by December 31 for each year after.

Perhaps you don’t need the RMD? You may want to redirect the money to another cause. For instance, you may want to fund a grandchild’s 529 educational account. 529 accounts are tax-advantaged accounts for education. Although contributions are post-tax, growth and distributions are tax-free if they are used for educational purposes.

Or, you may want to plan for a Qualified Charitable Distribution from the IRA and take a tax deduction. The distribution must be directly from the IRA to the charity. It is excluded from taxable income and can count towards your RMD under certain conditions.

7) Plan your charitable donations

Speaking of charitable donations, they can also be used to reduce taxable income and provide financial planning benefits. However, as a result of the Tax Cut and Jobs Act of 2017 (TCJA), it may be more complicated than in previous years. One significant difference of the TCJA is that standard deductions went up to $12,000 for individuals and $24,000 for married filing jointly. Practically what that means is that you need to accumulate $12,000 or $24,000 of deductible items before you can feel the tax savings benefit.

In other words, if a married couple filing jointly has $8,000 in real estate taxes and $5,000 of state income taxes for a total of $13,000 of deductions, they are better off taking the standard $24,000 deduction. They would have to donate $7,000 before they could start to feel the tax benefit of their donation.  One way to deal with that is to bundle your gifts in a given year instead of spreading them over many years.

For instance, if you plan to give in 2018 and also in 2019, consider bundling your donations and giving just in 2019. In this way, you are more likely to be able to exceed the standard deduction limit.

If your thinking wheels are running after reading this article, you may want to check in with your wealth manager or financial planner: there may be other things that you could or should do before the end of the year!

Check these other wealth management posts:

Is the TCJA an opportunity for Roth conversions?

New Year Resolution

How to Implement a New Year Resolution

Tax Season Dilemna: Invest ina Traditional IRA or a Roth IRA 

Note: The information herein is general and educational in nature and should not be construed as legal, tax, or investment advice. We make no representation as to the accuracy or completeness of the information presented.  To determine investments that may be appropriate for you, consult with your financial planner before investing. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions.We make no representation as to the completeness or accuracy of information provided at the websites linked in this newsletter. When you access one of these websites, you assume total responsibility and risk for your use of the websites to which you are linking. We are not liable for any direct or indirect technical or system issues or any consequences arising out of your access to or your use of third-party technologies, websites, information, and programs made available through this website.  

Financial Planner or Estate Planner: Which Do You Need?

By Anna Byrne | Financial Planning , Retirement Planning , Tax Planning

Financial Planners and Estate Planners are two different professions that are often confused. There is some overlap between professionals in these fields, but their roles are rather distinct. When you are striving to make a long-term plan for a strong financial future, both financial planners and estate planners play a crucial role.

In fact, when you consider some of the most recent personal finance statistics, it becomes very clear that many Americans could really benefit from retaining the services of both a financial planner AND an estate planner. For instance, 33% of Americans have no money saved for retirement, 60% lack any form of an estate plan, and only 46% have money saved for emergencies. Better planning starts with understanding what both types of planners do.

What is a Financial Planner?

A financial planner is a professional who offers a wide range of services that can assist both individuals and businesses to accomplish their long-term financial goals and accumulate wealth. They fall into two categories:

• Registered Investment Advisor
• Certified Financial Planner

Certified Financial Planners (CFP) are required to comply with the Certified Financial Planner Board of Standards, which means they have a basic level of expertise backed by a larger organization. Ethically they have to work in your best interest.

Services provided by both financial advisors and CFPs include:

• Insurance and tax planning
• Financial risk management
• Retirement planning
• Investment planning
• Cash flow management

What is an Estate Planner?

The goal of a financial planner is to assist with wealth accumulation. On the other hand, an estate planner can help you to make financial plans associated with your passing, which includes protecting the wealth that you have accumulated .

While you might believe only wealthy individuals need to work with an estate planner, you should consider the fact that everything you have accumulated in your life comprises your estate. Accumulated assets such as vehicles, furniture, bank accounts, life insurance, your home, and other personal possessions are all included in your estate.

Your assets become the property of the state if you die without a will or an estate plan in place , and your family members will not be able to claim them without paying legal fees and taxes. They will also have to face the stress of potential disagreements with other family members over how your property should be divided.

Besides planning for your passing, estate planning also involves creating a clear plan for your care if you become disabled , and it also covers naming guardians for underage children. Estate planning is a way to protect your family and your assets while reducing taxes and legal fees .

Which Do You Need?

The roles of financial planners and estate planners are unique, and for this reason, you will benefit from working with both . While your financial planner helps you accumulate wealth, he or she can also prepare you for a meeting with an estate planner as part of your long-term strategy. This includes providing the estate planner with lists of beneficiaries, tax return documentation, lists of investments and a breakdown of income and expenses.

When you work with both a financial planner and an estate planner, they will keep you accountable by periodically reviewing your documentation and beneficiaries and making sure everything is updated and reviewed as necessary. By taking the time to work with both these professionals, no important decisions will be overlooked, and you will take control of your financial future.

Note: This article was authored by Kristin Dzialo, a partner at Eckert Byrne LLC, a Cambridge, MA law firm that provides tailored estate planning. Eckert Byrne LLC and Insight Financial Strategists LLC are separate and unaffiliated companies. This article is provided for educational and informational purposes only. While Insight Financial Strategists LLC believes the sources to be reliable, it makes no representations or warranties as to this or other third party content it makes available on its website and/or newsletter,  nor does it explicitly or implicitly endorse or approve the information provided.  

Doing the Solo 401k or SEP IRA dance

By Chris Chen CFP | Financial Planning , Retirement Planning , Tax Planning

If you are self-employed, one of your many tasks is to plan for your own retirement. While most Americans can rely on their employer’s 401(k) for retirement savings, this is not the case for self-employed people.

In some respects, that is an advantage: most employees barely pay any attention to their 401(k). It is an opportunity for the self-employed to make the best choices possible for their business and personal situation.

The most obvious benefit of saving for retirement is that you will have to retire anyway, one day, and you will need a source of income then. With a retirement account, most people appreciate that it is specifically meant to save for retirement. People also appreciate the tax benefits of the SEP IRA and Solo 401(k).

The more immediate benefit is that retirement savings in tax-deferred accounts help reduce current taxes, possibly one of the greatest source of costs for small businesses. Of course, the tax saved with your contribution will have to be paid eventually when you take retirement distributions from the SEP-IRA.

When it comes to tax-deferred retirement savings vehicles for the self-employed and owner and spouse businesses, two of them stand out due to their high contribution limits and flexible annual contributions: the SEP IRA and the Solo 401(k). These two vehicles provide a combination of convenience, flexibility, and efficiency for the task.

SEP IRA

The SEP IRA is better known by its initials than its full name (Simplified Employee Plan IRA). For 2018 the SEP IRA contribution limits are the lesser of 25% of compensation up to $275,000, or $55,000 whichever is less. You may note that this is significantly higher than the limit for most 401(k)s plans, except those that have a profit sharing option. SEP IRA rules generally allow contributions to be deductible from the business’ income, subject to certain SEP IRA IRS rules.

One of the wrinkles of SEP IRA eligibility is that it applies to employees: you have to make a contribution of the same percentage of compensation as you are contributing for yourself. So if you have employees, another plan such as a Solo 401(k) might be a better choice.

And for fans of the Roth option, unfortunately, the SEP IRA doesn’t have one. When comparing the SEP IRA vs Roth IRA, the two clearly address different needs.

Solo 401(k)

The Solo 401(k) also known as the individual 401(k) brings large company features to the self-employed. It generally makes sense for businesses with no common law employees. One of the Solo 401k benefits is that just owners and their spouses, if involved in the business, are eligible. Employees are not. So, if you are interested in just your own retirement plan (and your spouse’s), a Solo 401(k) may work better for you than a SEP IRA. If your business expands to include employees and you want to offer an employer-sponsored retirement plan as a benefit to them, then you should consider a traditional company 401(k) option.

The Traditional Solo 401k rules work in the same way as the SEP IRA: it defers income taxes to retirement. It makes sense if you believe that you will be in an equal or lower tax bracket in retirement. Those who think that they may be in a higher tax bracket in retirement should consider a Roth option for their Solo 401(k): it will allow you to contribute now on an after-tax basis, and you will benefit from tax-free distributions from the account after retirement. A Roth 401k calculator may be required to compare the benefits. Again, the Roth option is not available in SEP accounts.

Solo 401k contribution limits permit you to contribute the same amount as you might in its corporate cousins: up to 100% of compensation, up to $18,500 a year when you are younger than 50 years old, with an additional $6,000 annual catch-up contribution for those over 50 years of age.

In addition, profit sharing can be contributed to the Solo 401(k). The Solo 401k limits for contributions are up to 25% of compensation (based on maximum compensation of $275,000) for a maximum from all contributions of $55,000 for those under 50 years of age and $61,000 for those over 50 years of age.

Another difference with the SEP IRA is that the Solo 401(k) can be set up to allow loans. In that way, you are able to access your savings if needed without suffering a tax penalty.

So Which Plan Is Best for You?

The SEP IRA is simpler to set up and administer. However, the Solo 401(k) provides more flexibility, especially for contribution amounts. Given that the amount saved is one of the key factors for retirement success, that should be a consideration.

Comparing the Solo 401k with the traditional employer 401k, you may no longer have to ask how to open a Roth 401k.  You will have control of that. On the other hand you will be entirely responsible for figuring out your Roth 401k employer match.

As could be expected, administration of the Solo 401(k) is slightly more onerous than that of the SEP IRA.

Solo 401(k) and SEP IRA

A Last Word

If you don’t have a plan get one. It is easy. It reduces current taxes. And it will help you plan for a successful retirement. The SEP IRA and the Solo 401(k) were designed specifically for small businesses and the self-employed. Although we have reviewed some of the features of the plan here, there are more details that you should be aware of. Beware of the complexities!

Once you decide on the type of plan, it will be time to choose a provider that offers the features that you need, the investment choices that you need, and the guidance to help you maximize your hard earned savings.

At Insight Financial Strategists we help figure out what works for you and your retirement plansand show you how to set up a Solo 401k or a SEP IRA!

7 IRA Rules That Could Save You Time and Money

By Chris Chen CFP | Financial Planning , Investment Planning , Retirement Planning , Tax Planning

People often end up with several different retirement accounts that are spread between one or more 401(k)s, 403(b)s, IRAs and other retirement accounts.

Treating these various retirement accounts as one, known as “aggregating”, will often make sense.  IRA aggregation can allow more efficient planning for distributions and more efficient investment strategy management . Note that aggregation means treating several accounts as one, not necessarily actually combining them. Nonetheless, there are situations where aggregating IRAs is not permitted and can cause negative tax consequences and could result in penalties .

In general, when IRA aggregation is permissible for distribution purposes, all the Traditional IRAs, SEP IRAs, and SIMPLE IRAs of an individual are treated as one traditional IRA. Similarly, all of an individual’s Roth IRAs are treated as a single Roth IRA.

The following are seven key aggregation rules for IRAs that could save you time and money . The key learning is that it takes strong recordkeeping and awareness of the rules to avoid the pitfalls of aggregation. You should be aware of the requirements, observe them or get help from your Wealth Manager.

1. IRA Aggregation does not apply to the return of excess IRA contributions

The IRA contribution limit for individuals is based on earned income. Individuals under 50 years of age can contribute up to $5,500 a year of earned income. Those older than 50 years of age are allowed an additional catch up contribution of $1,000. The contribution limit is a joint limit that applies to the combination of Traditional and Roth IRAs.

When the IRA contribution happens to be in excess of the $5,500 or the $6,500 limit (for people over 50), the excess contributions, including net attributable income (NIA), ie the growth generated by the excess contribution, must be returned before the IRA owner’s tax filing due date, or extended tax filing due date. Those who file their returns before the due date receive an automatic six-month extension to correct the excess contributions.

2. Mandatory aggregation applies to the application of bases for Traditional IRAs

Contributions to Traditional IRAs are usually pre-tax. Thus, distributions from IRAs are taxable as income.  In addition, distributions prior to 59.5 years of age are also subject to a 10% penalty.

However, individuals may also contribute to a Traditional IRA on a non-deductible basis , ie with after-tax income. Similarly, contributions to an employer-sponsored retirement plan can also be made on an after-tax basis (where allowed by the retirement plan) , and potentially rolled over to an IRA where they would retain their non-deductible character.

After-tax contributions to an IRA, but not the earnings thereof, may be distributed prior to 59 ½ years of age without the customary 10% penalty. Distributions from an IRA that contains after-tax contributions are usually prorated to include a proportionate amount of after-tax basis (amount contributed) and pre-tax balance (pro rata rule).

Some IRA owners will choose to keep non-deductible IRA contributions in a separate IRA which simplifies tracking and administration. However, that has no impact on distributions, because, when applying the pro-rata rule, all of an individual’s Traditional IRAs, SEP IRAs, and SIMPLE IRAs are aggregated and treated as one.

Suppose that Janice has contributed $700 to a non-deductible Traditional IRA, and it has grown to $1,400.  If Janice takes a distribution of $500, one half of the distribution is returnable on a non-taxable basis, and the other half is taxable and subject to the 10% penalty if Janice happens to be under 59½ years of age. You can see why Janice would want to keep accurate records of her transaction in order to document the taxable and non-taxable portions of her IRA.

3. Limited aggregation applies for inherited Traditional IRAs

Inherited IRAs should be kept separate from non-inherited IRAs . The basis in the latter cannot be aggregated with the basis of an inherited IRA.

In practice, it means that if Johnny inherited two IRAs from his Mom and another from his Dad, Johnny must take the Required Minimum Distributions for his Mom’s two IRAs separately from his Dad’s, and also separately from his own IRAs.

Furthermore, IRAs inherited from different people must also be kept separate from one another. They can only be aggregated if they are inherited from the same person.  In addition, inheriting an IRA with basis must be reported to the IRS for each person.

4. Mandatory aggregation applies to qualified Roth IRA distributions

Qualified distributions from Roth IRAs are tax-free. In addition, the 10% early distribution penalty does not apply to qualified distributions from Roth IRAs.  

Roth IRA distributions are qualified if:

– they are taken at least five years after the individual’s first Roth IRA is funded;

– no more than $10,000 is taken for a qualified first time home purchase;

– the IRA owner is disabled at the time of distribution;

– the distribution is made from an inherited Roth IRA; or

– the IRA owner is 59½ or older at the time of the distribution.

If Dawn has two Roth IRAs, she must consider both of them when she takes a distribution.  For instance, if Dawn takes a distribution for a first time home purchase, she can only take a total $10,000 from her two Roth IRAs

5. Optional aggregation applies to required minimum distributions

Owners of Traditional IRAs must start taking required minimum distributions (RMD) every year starting with the year in which they reach age 70½ . The RMD is calculated by dividing the IRA’s preceding year-end value by the IRA owner’s distribution period for the RMD year.

An individual’s Traditional, SEP and SIMPLE IRAs can be aggregated for RMD purposes .

The RMD for each IRA must be calculated separately; however, the owner can choose whether to take the aggregate distribution from one or more of his Traditional, SEP or SIMPLE IRAs.

So, if Mike has a Traditional, a SIMPLE and a SEP IRA, he would calculate the RMD for each of the accounts separately.  He could then take the RMD from one, two or three accounts in the proportions that make sense for him.

As a reminder, Roth IRA owners are not subject to RMDs.

6. Limited aggregation applies to Inherited IRAs

Beneficiaries must take RMDs from the Traditional and Roth IRAs that they inherit with the exception of spouse beneficiaries that elect to treat an inherited IRA as their own.

With this latter exception, RMD rules apply as if the spouse was the original owner of the IRA.

When a beneficiary inherits multiple Traditional IRAs from one person, he or she can choose to aggregate the RMD for those inherited IRAs and take it from one or more of the inherited Traditional IRAs. The same aggregation rule applies to Roth IRAs that are inherited from the same person.

Suppose again that Johnny has inherited two IRAs from his Mom and one from his Dad. Johnny can calculate the RMDs for the two IRAs inherited from his Mom, and take it from just one.  Johnny must calculate the RMD from the IRA inherited from his Dad separately, and take it from that IRA.

If in addition, Johnny has inherited an IRA from his wife, he may aggregate that IRA with his own.

It is important to note that RMDs for inherited IRAs cannot be aggregated with RMDs for non-inherited IRAs , and RMDs inherited from different people cannot be aggregated together.

7. One per year limit on IRA to IRA rollovers

If an IRA distribution is rolled over to the same type of IRA from which the distribution was made within 60 days, that distribution is excluded from income.

Such a rollover can be done only once during a 12-month period.

In this kind of situation, all IRAs regardless of types (Roth and non-Roth) must be aggregated. For instance, if an individual rolls over a Traditional IRA to another Traditional IRA, no other IRA to IRA (Roth or non-Roth) rollover is permitted for the next 12 months.

Conclusion: What you should keep in mind

These are some of the more common IRA aggregation rules.  There are others including rules for substantially equal periodic payments programs (an exception to the 10% early distribution penalty), and those that apply to Roth IRAs when the owner is not eligible for a qualified distribution.

Although IRAs are familiar to most of us, many of the rules surrounding are not . It is still helpful to check with a professional when dealing with them.

Lastly, many of the potential problems that people may face with IRA aggregation can be avoided with proper documentation. Recordkeeping is essential. Individuals can do it themselves or they can rely on their Wealth Managers. In the case where you have to change financial professionals, make sure that you have documented the history of your IRAs.   

Is the new Tax Law an opportunity for Roth conversions?

By Chris Chen CFP | Financial Planning , Investment Planning , Retirement Planning , Tax Planning

The New Tax Law, known as the Tax Cuts and Jobs Act (TCJA) was passed in December 2017. Its aim was to reduce income taxes on as many constituencies as possible. One of the well known implementations of that desire has been the temporary reduction of individual income tax rates. That provision of the law is scheduled to sunset in 2025. Starting in 2026, individual income tax rates will revert back to 2017 levels, resulting in a significant tax increase on many Americans, following 8 years of reduced tax rates.  

Assuming Congress doesn’t take future action to extend the tax cut, how can the damage of the TCJA’s scheduled tax increase be mitigated? One way to mitigate the damage of the TCJA scheduled tax increase could to switch some retirement contributions from Traditional accounts to Roth accounts from 2018 to 2025 , and switching back to Traditional accounts in 2026 when income tax bracket increase again.  

Another way to blunt the impact of theTCJA is to consider effecting Roth conversions between 2018 to 2025 .

The TCJA has a tax increase built into it

It’s well known that contributions to and withdrawals from Roth IRAs and Roth 401(k)s are taxed differently than their Traditional cousins .  One of the major factors to consider when deciding between a Roth IRA or a Roth 401(k) and a Traditional IRA or Traditional 401(k) are income tax rates during working years and in retirement.  

Generally speaking, Roth accounts are funded post tax, whereas a Traditional accounts are funded pre-tax .  As a result, funding a Traditional 401(k) account reduces current taxable income , usually resulting in lower current taxes. Similarly, you may be able to deduct your contributions to a Traditional IRA from your current tax liability depending on your income, filing status, whether you are covered by a retirement plan at work, and whether you receive social security benefits.   Income taxes must be paid eventually, so retirement distributions from Traditional IRAs and 401(k)s are taxed in the year in which they are withdrawn. In fact, the Internal Revenue Service so wants retirement savers to pay income taxes that it mandates Required Minimum Distributions (RMD) from Traditional accounts after age 70 1/2 . RMDs are taxed as ordinary income in the year they are distributed.

On the other hand Roth accounts are funded with post-tax money and result in retirement distributions that are tax free, provided all requirements are met.  

Roth IRAs and Roth 401(k)s

When working year taxes are lower than projected tax rates in retirement , it usually makes sense to contribute to a Roth account . In this situation, paying taxes upfront results in lower projected lifetime taxes. For instance, assuming that Vanessa is in the 24% tax bracket, she will need to earn $7,236 to make a $5,500 contribution to a Roth IRA. That is because, she will owe federal taxes of $1,736 on her earnings (not counting state taxes where applicable), leaving her with $5,500 to contribute. However, Vanessa’s distributions in retirement would be tax free.  If her marginal tax rate in retirement is greater than 24%, she would have saved on her distributions.

It’s important to note that you can only contribute to a Roth 401(k) plan if your employer offers one as a company benefit . Married individuals filing jointly and  making over $196,000, married individuals filing singly and making over $10,000, and single filers making over $133,000 cannot contribute to a Roth IRA, but may contribute to a Roth 401(k).

Traditional Accounts

When working year tax rates are higher than projected tax rates in retirement, it usually makes sense to contribute to a Traditional IRA or Traditional 401(k) .  Contributing to a Traditional account in that situation generally results in a reduction in taxes in the year of contribution; taxes will be due when the assets are withdrawn from the account, hopefully in retirement. For instance, If Vanessa contributes $5,500 to a Traditional IRA can result in a reduction in taxable income of $5,500. If she is in the 24% federal income tax bracket, Vanessa would save $1,320 in federal income taxes (not counting potential applicable state income taxes).  If Vanessa is in the 12% marginal federal tax bracket in retirement, when she takes $5,500 in distribution, she would then owe federal income taxes of $660.

Most working people are in higher tax brackets while working than they will be in retirement; hence it usually makes sense for them to contribute to Traditional accounts . That is not true for everyone, of course, as individual circumstances can significantly affect taxes owed.

The New Tax Law

The new Tax law, aka the Tax Cut and Jobs Act or TCJA, passed in December 2017, comes with a number of features, including a permanent reduction in corporate taxes. Most important for individuals and families, it significantly reduces individual tax brackets starting in 2018.  

Table 3: 2018 Federal  Tax Brackets

However, while the tax decrease for corporations is permanent, the TCJA tax decrease for individuals and families is temporary. Starting in 2026, individual tax rates will be back to their 2017 levels .

In practice this will result in a large tax hike in 2026 for many individuals and families.  For instance if Susanna and Kevin make $150,000 and file “Married Filing Jointly”, they might be in the 22% marginal tax bracket in 2018.  With the same income in 2026, Susanna and Kevin would be in the 25% marginal tax bracket. Of course, there are several other factors that will impact their final tax bill, but most people in that situation will stare at a higher tax bill.

So what if Susanna and Kevin project that their retirement income would place them in today’s 22% bracket? Most likely that would put them in the 25% federal bracket in 2026, resulting in a possible tax increase. In fact, depending on the exact situation, a large number of Americans will see their taxes increase in 2026 as the result of the sunset of the TCJA individual tax cuts .

Consider a Roth Conversion while working

Susanna and Kevin could also take advantage of the temporary nature of the TCJA tax cuts to convert some of their traditional tax deferred retirement accounts to Roth accounts.  In so doing, they would take distributions from the Traditional account, transfer to the Roth, and pay income taxes on the conversion. This way Susanna and Kevin would create themselves a source of tax free income in retirement, that could help them stay in their tax bracket and partially insulate them from future tax increases.

Now is the time to take steps to manage your taxes

Because Roth conversions increase current taxable income, many people will find them a limited possibility as only so much funds can be converted without jumping into the next tax bracket.  However, working people can also think in terms of changing their current contributions from Traditional 401(k)s to Roth 401(k)s. That would have the similar impact of increasing current taxable income and income tax due for the benefit of creating a reserve of future tax free assets.

Consider changing from a Traditional 401(k) to a Roth 401(k)

In the case of Susanna and Kevin, they could be in the 22% marginal federal tax bracket in 2018.  If they retire in 2026, and their taxable income in retirement does not change, they may be in the 25% marginal tax bracket. For this couple, it may well be worth switching current contributions from a Traditional 401(k) to a Roth 401(k) from 2018 to 2025 , thereby increasing taxes due from 2018 to 2025, and potentially reducing taxes in retirement.

Of course, it is not always clear where Susanna’s and Kevin’s taxable income would come from in retirement.  That is because their sources of income will likely change significantly. While they would no longer earn income, they may then have social security income, pension income, and retirement plan income which are all taxed as ordinary income. They may also take income from other assets with different tax characteristics, such as savings or investments.  That might make the projection of their taxable income more difficult.

It is possible that Susanna and Kevin’s income needs will influence the tax characteristics of their income when they retire in 2026 or later; that may place them in a different tax bracket altogether. For instance Wealth Managers routinely advise clients to postpone Social Security income as late as they can, preferably until 70 in order to maximize lifetime social security income.  When that happens it is possible that income between retirement and 70 could come from other sources, such as investments. When that happens taxable income could be significantly lower as investments are usually taxed at a lower capital gains rate.

This may sound self serving, but I’ll write it anyway: the best way to know what Susanna and Kevin’s income would look like in retirement, and how it might be taxed, is for them to check in with a skilled Certified Financial Planner. Otherwise they would just be guessing.

Considering a Roth Conversion in Retirement

So what about people who are already retired?  The situation is similar. Take David and Emily, a retired couple with social security income, state pension income, and retirement plan income.  From 2018 to 2025, their $100,000 taxable income places them in the marginal 22% federal tax bracket. With the same income in 2026, they would end up in the 25% tax bracket.  Through no fault of their own David and Emily will see their income tax increase in 2026.

One of the ways that David and Emily can fight that is to convert some of their Traditional retirement accounts to Roth between 2018 and 2025, pay the income taxes on the additional income, and then use distributions from the Roth when their taxes go up in 2026 to stay within their desired tax bracket. In this way, David and Emily could potentially reduce their overall taxes over the long term.

Conclusion

The new Tax Law, aka the TCJA, reduces individual and family income federal tax rates substantially starting in 2018. However in 2026 individual federal income tax rates will go back up resulting in a significant tax increase for many American families .  Roth conversions could help many plan to avoid the pain of this planned tax increase by balancing current lower taxes against future higher taxes. To do this successfully requires careful evaluation of current and future taxable income. Planning Roth conversions from 2018 to 2025 could pay significant rewards by lowering taxes after 2026.

The key challenge for retirement contributors would be to calibrate the right amount of Roth conversion or Roth contributions so as to minimize current and overall taxes owed.

Because each situation will be different, it will pay to check with a Certified Financial Planner to estimate future income and tax rates, and to plan a strategy that will maximize your financial well being.

Check out our other posts on Retirement Accounts issues:

Rolling over your 401(k) to an IRA

7 IRA rules that could save you time and money

Doing the Solo 401k or SEP IRA Dance

Tax season dilemna: invest in a Traditional or a Roth IRA

Roth 401(k) or not Roth 401(k)

Note 1: this post makes assumptions regarding potential individual tax situations. It simplifies the many factors that enter into tax calculations. It omits many of the rules that are applicable to Roth accounts and Roth conversions. It also assumes that the TCJA will be unchanged.  None of these assumptions may be correct. Please check with the relevant professionals for your individual situation.

Note 2: Insight Financial Strategists LLC does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Insight Financial Strategists LLC cannot guarantee that the information herein is accurate, complete, or timely, and  makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

Is 2018 the Year of the Roth 401(k) or the Roth IRA?

By Chris Chen CFP | Financial Planning , Investment Planning , Retirement Planning , Tax Planning

Much of the emphasis of the Tax Cuts and Jobs Act (TCJA) passed in December 2017 affected individual income taxes. However, there are also impacts on investment strategies.

From an individual standpoint, the primary feature of the TCJA is a reduction in income tax rates.  Except for the lowest rate of 10% all other tax brackets go down starting with the top rate which drops from 39.6% to 37%.

 Table 1: 2018 Tax Rates for Married Filing Jointly and Surviving Spouses

Even then, not everyone’s income taxes will go down in 2018 . That is because some of the features of the bill, such as the limitation on State And Local Taxes (SALT) deductions,  effectively offset some of the tax rate decreases.

However, in general, it is safe to say that most people will see a reduction in their federal income taxes in 2018. Of course, this may prompt a review of many of the decisions investors make with taxes in mind.

Retirement is one area where reduced income taxes may have an impact on the decision to invest in a Traditional or a Roth 401(k) or IRA . The advantages of tax-deferred contributions to retirement accounts, such as Traditional 401(k) and IRAs, are also tied to current tax rates. In Traditional retirement accounts, eligible contributions of pre-tax income result in a reduction in current taxable income and therefore a reduction in income taxes in the year of contribution.

Most people expect to make the same or less income in retirement compared to working life, and thus assume that their retirement tax rate will be equal to or lower than their working year tax rate. For those people, contributing pre-tax income to a Traditional retirement account comes with the possibility of reducing lifetime income taxes (how much you pay the IRS over the course of your life).

Most people are pretty excited to see their taxes go down this year! However, the long-term consequences of the tax decrease should be considered.  While the TCJA was passed with the theory that it would stimulate growth such that tax revenues would grow enough to make up for the increased deficit created in the short term by tax cuts, few serious people believe that.  The most likely result is that we will experience a small boost in growth in the short term and that federal deficits and the National Debt will seriously increase thereafter.

In the opinion of the non-partisan Committee for a Responsible Federal Budget, not even the expectation of additional short-term growth is enough to temper the seemingly irresistible growth in the federal debt.

Increased deficits will make it more difficult to fund our national priorities, whether it is defense, social security, healthcare, or investment in our national infrastructure.  Therefore, I expect that we will initiate another tax discussion in a few years, most likely resulting in tax increases, in addition to the automatic tax increases that are embedded in the TCJA.

With federal income tax rates down in 2018 and our expectation that individual taxes will start increasing after 2018, now may be the time to consider a Roth instead of a Traditional account. The consideration of current and future tax rates remains the same. It just so happens that with lower tax rates in the current year, it becomes marginally more attractive to consider the Roth instead.

Consider the case of Lisa, a married pharma executive, making $225,000. This places her in the 24% federal tax bracket. In 2018, her $10,000 Traditional 401(k) contribution reduces her income taxes by $2,400. In 2017, Lisa would have been in the 28% tax bracket. Her $10,000 Traditional 401(k) contribution would have resulted in a $2,800 reduction in income taxes. Hence, Lisa’s tax savings in 2018 from contributing to his 401(k) goes down by $400 compared to 2017.

Table 2: Tax savings on a 401(k) contribution with $180,000 taxable income

From a tax standpoint, contributing to a Traditional 401(k) is still attractive, just a little less so.  To optimize her lifetime tax liabilities, Lisa may consider adding to a Roth 401(k) instead, trading her current tax savings for future tax savings. If Lisa were to direct the entire $10,000 to the Roth 401(k), her 2018 income taxes would increase by $2,400 compared with 2017. Why would Lisa do that? If she expects future income tax rates to go back up, she could save overall lifetime taxes. It may be an attractive diversification of her lifetime tax exposure.

For instance, suppose now that the national debt does grow out of hand and that a future Congress decides to increase tax rates to attempt to deal with the problem. Suppose that Lisa’s retirement income places her in a hypothetical future marginal federal tax rate of 30%. In that case, she will be glad to have invested in a Roth IRA in 2018 when she would have been taxed at a marginal rate of 24%: she would have saved on her lifetime income taxes.

Of course, if Lisa’s retirement marginal tax rate ends up being 20%, she would have been better off saving in her Traditional 401(k), saving with a 28% tax benefit in her working years and paying retirement income tax at 20%.

Note also that Lisa would not have to put the entire $10,000 in the 401(k). She could divide her annual retirement contribution between her Roth and her Traditional accounts, thus capturing some of the tax advantages of the Traditional account, reducing the tax bite in the current year, and preserving a bet on a future increase in income tax rates.

Another possible course of action to optimize one’s lifetime tax bill is to consider a Roth conversion. With a Roth conversion, you take money from a Traditional account, transfer it to a Roth account, and pay income taxes on the distribution in the current year.  As we know, future distributions from the Roth account can be tax-free, provided certain conditions are met . A distribution from a Roth IRA is tax-free and penalty free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you have reached age 59½, become disabled, you make a qualified first-time home purchase, or you die. (Note: The 5-year aging requirement also applies to assets in a Roth 401(k), although the 401(k) plan’s distribution rules differ slightly; check your plan document for details.)  Because tax rates are lower in 2018 for most individuals and households, it makes it marginally more attractive to do the conversion on at least part of your retirement funds.

Consider David, a single pharma marketing communications analyst. With $70,000 in taxable income, he is now in the 12% marginal federal income tax bracket, down from the 25% federal income tax bracket in 2017. He is working on his part-time MBA in 2019 and expects his income to jump substantially as a result. Additionally, David, a keen student of political economy expects his taxable retirement income to be higher than his current income and overall tax rates to go back up before he reaches retirement.  David now has a sizeable Traditional IRA.

For David, the opportunity is to convert some of his Traditional IRA into a Roth IRA. To do that, David would transfer some of his Traditional IRA into a Roth IRA. He would pay income taxes on the conversion amount at his federal marginal rate of 22%. David would only convert as much as he could before creeping into the next federal tax bracket of 24%. If he feels bold, David could contribute up to the 32% federal tax bracket. Effectively this means that David would stop converting when his taxable income reaches $82,500 if he wanted to stay in the 22% tax bracket, and $157,500 if he wanted to stay in the 24% tax bracket.

In this example, if David were to convert $10,000 from his Traditional IRA to his Roth IRA, he would incur $2,200 in additional federal income taxes. If David expects to be in a higher tax bracket in retirement, he would end up saving on his lifetime income taxes.

David could combine this strategy with continuing to contribute to his Traditional 401(k), thus reducing his overall taxable income, and increasing the amount that he can convert from his IRA before he hits the next tax bracket.  If he were to contribute $10,000 to his Traditional 401(k) and convert $10,000 from his Traditional IRA to a Roth IRA, you could view this as a tax neutral transaction.

Table 3: Balancing a Traditional 401(k) and a Roth Conversion

This strategy may work best for people who expect to have a reduced income in 2018. Maybe it is people who are back in graduate school, or people taking a sabbatical, or individuals who are no longer working full time while they wait to reach the age of 70 and start collecting social security at the maximum rate.

It is worth remembering that Roth accounts are not tax-free; they are merely taxed differently . That is because contributions to a Roth account are post-tax, not pre-tax as in the case of Traditional accounts. You should note that the examples in this article are simplified. They do not take into account the myriad of other financial, fiscal and other circumstances that you should consider in a tax analysis, including your State tax situation. The examples suppose future changes in taxes that may or may not happen.

If you believe, as I do, that tax rates are exceptionally low this year and will go up in the future, you should have additional incentive to analyze this situation. The decision to contribute to a Roth IRA or 401(k) works best for people who expect to be in a similar or higher tax bracket in retirement , and have at least five years before the assets are needed in order not to pay unexpected penalties. Is that you? The financial implications of whether to invest in a Roth instead of a Traditional account can be complex and significant . They should be made in consultation with your Certified Financial Planner.

Check out out other retirement posts:

Seven Year End Wealth Management Strategies

Is the new tax law an opportunity for Roth conversions

Rolling over your 401(k) to an IRA

7 IRA rules that could save you time and money

Doing the Solo 401k or SEP IRA Dance

Tax season dilemna: invest in a Traditional or a Roth IRA

Roth 401(k) or not Roth 401(k)