Why you might not want to rollover that old 401k
*The rollover strategies discussed also apply to 403b, 457b, 401a and other employer sponsored qualified retirement plans
For many high wage earners, making contributions up to annual Roth IRA limits (6k/$7k over 50; 2020) via the backdoor Roth IRA strategy is an appealing way to generate income tax free growth and income for future years. The backdoor Roth strategy entails making a non-deductible IRA contribution and immediately converting that contribution to a Roth IRA account. If you have no other rollover tax deferred IRA accounts when you execute this strategy, then you have simply moved money from a taxable account into a tax-free account.
What If I have existing Rollover IRA and/or Traditional IRA Assets?
When executing the backdoor Roth strategy, if you have any tax-deferred Rollover or Traditional IRA Assets, i.e. you haven’t paid income taxes on them yet, the Roth conversion will result in at least some of those funds being taxed in the year of the conversion.
For example, let’s say you have a Traditional IRA or Rollover IRA worth $60,000 and make a non-deductible contribution of $6,000 to this IRA in accordance with your backdoor Roth IRA strategy. When you convert the same $6,000 from your Traditional or Rollover IRA to Roth IRA assets, you’ll actually be taxed on ~91% of the conversion, which creates extra taxable income of $5,460 for the tax year.
This overlooked tax trap results from IRS rules which mandate, for tax calculations, your tax-deferred contributions and gains and non-deductible contributions from all IRA accounts (Rollover, Traditional & Roth) are combined into a theoretical IRA pot. From this theoretical pot, the IRS requires you to calculate the ratio of tax-deferred dollars to non-deductible dollars; the percentage of tax-deferred dollars in your theoretical account is the percentage of your Roth IRA conversion that will be taxed.
In this example your non-deductible $6,000 contribution to your Traditional IRA or Rollover IRA is divided by the total account value of $66,000—just roughly 9% is not subject to income taxes at the time of conversion.
The aggregation rules are one of the few reasons you should carefully think about not rolling over an old 401k or other employer plan. If the funds remain in a 401k, 401a, 403b, 457b etc. they are not subject to the aggregation rules.
While there’s no avoiding taxation of previously deducted personal Traditional IRA contribution assets during a backdoor Roth IRA strategy execution or other Roth conversion, there are sometimes opportunities to clean up existing Rollover IRA accounts to avoid this unpleasant tax consequence.
The Difference Between a Rollover IRA and a Traditional IRA
Though they’re nearly identical, there is a subtle, but significant, difference. You can roll over a 401k to a Traditional IRA or Rollover IRA. If you choose to roll funds into a Rollover IRA, rather than a Traditional IRA, you maintain the ability to roll those funds into another current or future 401k plan, if the plan documents allow.
Why Does That Matter?
There are 401k plans that allow IRA roll-in contributions, but they must come from a Rollover IRA, not a Traditional IRA. If your company has such a plan, you can roll your existing Rollover IRA account into your 401k plan which eliminates the tax-deferred IRA portion of your aggregate portfolio, allowing a high earner to execute the backdoor strategy completely tax-free. Without this keen planning taxes would be paid at high income brackets on the conversion, which is counterproductive to high earner’s overall tax strategy.
Don’t Commingle Rollover IRA and Traditional IRA Assets
If you commingle “regular” Traditional IRA funds and Rollover IRA funds you lose the ability to roll-in former Rollover IRA assets. It’s important to keep the Rollover IRA and Traditional IRA accounts separate. Consider opening a stand-alone Traditional IRA for annual personal IRA contributions and a separate Rollover IRA for rollover assets.
As always, things are rarely as simple as they seem. You should work with a competent Financial Planner to determine the best advice on your personal tax planning strategy.
Questions about tax minimization strategies regarding your 401k rollover or rollover IRA? Click here to setup a no cost discussion with us today!
How High Earners Can Diversify the Taxability of Their Retirement Assets
Our fee only financial advisors often recommend executing a backdoor Roth IRA contribution strategy for high earning clients who max out their tax-deferred and/or after-tax employer sponsored plans and are seeking additional tax favorable approaches to save and grow assets.
These clients often accumulate large levels of tax-deferred dollars in their 401k, 403b, or other employer sponsored plan(s). These tax-deferred contributions help save tax dollars in high brackets now and withdrawals in retirement can be structured for tax savings in the future as well.
On the other end, if we can add in Roth IRA assets to our clients’ portfolios which can be withdrawn in retirement tax-free, we add another tool in the tax-planning belt.
What are Backdoor Roth IRA Contributions
For most wage earners, if you contribute to a Traditional IRA you receive a dollar-for-dollar tax deduction. Here’s an overly simplified look at the tax reduction provided by the combined maximum family deductible Traditional IRA contributions of $12,000 for a married couple in 2020:
Unfortunately, if you earn over a certain level of income and/or have access to an employer sponsored retirement plan (401k, 403b, 457b, etc., whether you use it or not) you lose the deductibility of your Traditional IRA contributions.
**IMPORTANT: Even if you can’t deduct IRA contributions, you can still make them.**
New clients are often surprised when we tell them they’ve been missing out on these tax favorable IRA contributions. Many investors assume they can’t make IRA contributions because they make too much money or already participate and max out an employer 401k or 403b plan. In each case, you can make IRA contributions, you just can’t deduct them.
Unlike Traditional IRAs, when you make contributions to a Roth IRA you pay the taxes now-- or have already paid taxes on the contributions via payroll and will simply not receive a tax deduction for the contribution. The magic of a Roth IRA is that once the assets are in the account and the account has been open for 5 years—all withdrawals of principal AND earnings are tax-free. And tax-free > tax-deferred.
But high earners are not allowed to make direct Roth IRA contributions, because Roth IRAs have their own income level eligibility qualifications:
So-- if you’re single making more than $139,000 AGI or married and earn over $206,000 AGI you can’t make direct Roth IRA contributions AND you don’t get Traditional IRA contributions deducted.
However, if you have little or no Traditional IRA assets to start with, we recommend executing a backdoor Roth contribution strategy. High earners can make non tax-deductible contributions to their Traditional IRAs, receiving no tax deduction for the contributions. Then they can immediately convert that contribution to their tax-free Roth IRA.
Why would you want your investments growing tax-deferred when they could be growing tax-free? Not simple to do, but a no brainer…slam dunk.
How are Backdoor Roth IRA Contributions Taxed?
A key factor that must not be overlooked is the amount of previously tax-deferred Traditional IRA assets a high earner has while executing this strategy. It’s important because Roth conversions are taxed at the ratio of tax-deferred assets to after-tax, or non tax-deferred assets.
For example, let’s say you’re a married high earner and want to start this backdoor Roth IRA strategy. You make the max Traditional IRA contributions of $12,000 ($6,000 each) for you and your spouse for 2020 and plan to immediately convert that to your Roth IRA to facilitate the lifetime tax-free growth mentioned above.
At the same time, you already had $12,000 (again $6,000 each) of tax-deferred contributions from previous years where you qualified for the deduction. Or you could have rolled over tax-deferred assets from an old 401k into your Traditional IRA. Either way, half the assets in the Traditional IRAs were tax-deferred in prior years, and half are non-deductible from 2020’s contribution.
If you convert the $12,000 of non-deferred contributions you made in 2020, it wouldn’t be a tax-free conversion— it would be taxed according to the Roth IRA pro-rata rule. This states you have to use the tax-deferred to non-tax-deferred ratio for taxing of the conversion assets. In this case the ratio is 50:50 ($12k tax-deferred to $12k tax-free), so half, or $6,000 of the $12,000 Roth IRA conversion would be taxed at your normal income tax rates for 2020.
This is important-- because if you’re a high earner, you may want to avoid paying 32%+ Federal taxes this year on that $6,000 taxable portion of the Roth IRA conversion. It may be better to wait until retirement when you’ll likely be in a lower tax bracket, especially if you do some of the tax planning we mention in this article.
The Roth IRA pro-rata rule should give pause to rolling over tax-deferred dollars from 401ks or 403bs into a Traditional/Rollover IRA when a backdoor Roth IRA strategy is recommended. The more assets added to your personal Traditional/Rollover IRA, the higher the taxable percentage of Roth IRA conversions. For these reasons, our financial advisors may recommend clients keep tax-deferred dollars in an old employer plan-- even if those plans have slightly elevated fees or lack diversified, cost-efficient investment offerings. We believe the tax-free savings of Roth IRA assets for a young high earner provide unmatched advantages in terms of investment returns and future tax planning strategies. Getting assets in a high earner’s Roth IRA early while avoiding unnecessary taxes at their currently high tax brackets provides great value to our clients.
On the other hand, some clients prefer to fill up their brackets with Roth conversions to eventually get rid of all Traditional IRA tax-deferred assets, never having to worry about Roth conversion taxes again. Regardless—your taxable income level and tax bracket management must be thoroughly analyzed to make the right decision.
Why Should I Build Roth IRA Assets?
Saving on Pre-Medicare Health Insurance Premiums
For example, let’s say a couple retires at age 60, with 5 years before Medicare eligibility. Our fee only advisors use taxable investment accounts and tax-free Roth IRA assets to strategically qualify millionaires for Premium Tax Credits under the Affordable Care Act that can offset some of the cost of healthcare insurance. Monthly private marketplace insurance premiums at age 60 are likely to be $1,000 per person—meaning if you and your spouse plan to retire at age 60, every year until age 65 you’ll fork over $24,000 alone on healthcare insurance premiums before you step foot in a doctor’s office. That can put a damper on early retirement plans.
Our fiduciary advisors can situationally use taxable and Roth IRA assets to qualify even our most wealthy clients for Premium Tax Credits, which cover a portion or all of a family’s health insurance expenses. In the above example, that’s a potential savings of up to $120,000 in premiums from retirement at age 60 to Medicare eligibility at age 65—and a glaring reason everyone should invest in a financial plan.
Recently, we’ve heard several current and prospective clients mention they’re going to beat high healthcare insurance costs during pre-Medicare retirement years with some sort of too-good-to-be-true Medi-Share plan. Please reconsider. These plans are not actually health insurance and leave your family’s wealth and health in jeopardy. One un-insured serious hospitalization could put your entire financial future needlessly at risk.
Long Term Capital Gains Rates Saving
We also use taxable and tax-free assets to manage tax brackets via favorable capital gains rates, and in some cases, help our clients pay 0% on capital gains through complex tax planning strategies. For those high earners today, as tax laws are, as is, we’d be able to structure their taxable income so they can optimize favorable capital gains rates while ensuring their assets at 12% Federally. That’s a Federal tax savings of $22,000+ for every $100,000 in their IRA. Not a bad deal for someone being taxed at 24% or 34%+ today and may even pay the 3.8% Medicare investment income surcharge.
Other Uses for Roth IRA Assets
Tax-free income can help manage tax brackets/income in retirement and can lead to enormous tax savings if planned correctly. If you max out your employer retirement plans and are looking for even more tax diversification of your assets, a backdoor Roth IRA strategy is a good choice. There are many factors to analyze to ensure you realize the tax savings these strategies provide.
If you could use help determining the most appropriate course of action to take with your excess savings give us a call and get started with a financial plan today.
This is being written as the bill is still in progress. Edits may be required as more information becomes available. Please check back for updates and be sure to consult a financial professional before implementing any of the strategies suggested in this post.
The Senate has passed an emergency relief bill that is expected to pass the House later this week. The package is over $2 trillion in scope, $6 trillion if you include loan provisions, and is the largest relief bill in the history of the United States.
Relief Payments Made Directly to Taxpayers
Let’s start with the direct payment checks you have probably heard about. In general, individuals will receive payments of $1,200 and joint filers $2,400, plus $500 for each qualifying child. The definition of a qualifying child is already in the current Child Tax Credit Guidelines i.e. if you claim someone as a dependent child on your tax return in 2020 then they’ll qualify for the additional $500 per child payment.
High income taxpayers will see these amount reduced as income exceeds $150,000 for joint filers, $112,500 for head of household, and $75,000 for single filers. For every $100 over those limits the payment is reduced by $5 until you reach zero. That means joint filers earning $198,000 or more, heads of households earning $136,500 or more and single filers earning $99,000 or more will receive nothing.
The payments will be based on the most recent tax return filed. So, if you have already filed for 2019 you are stuck with those earnings. If you have not filed for 2019, then your payment will be based on 2018 return information. If your income is higher in 2019 than 2018 DO NOT FILE YOUR TAXES UNTIL LATER. On the other hand, if your 2019 income is lower than 2018 IT IS IMPORTANT TO FILE YOUR TAXES NOW.
The payments will be direct deposited for taxpayers who elected to have direct deposit on their income tax forms. This could be a problem if the direct deposit instructions you provided in 2018 are to an account that has since been closed, or if you have divorced or separated since your 2018 tax filing. Within 15 days of the money being released, the IRS will send a letter informing you of the amount and where it was sent. If there is an issue with your payment, like it never arrived or went to a divorced spouse, the letter will include a phone number where you can call to resolve the issue, but unfortunately, the IRS is difficult to communicate with in general.
Required Minimum Distributions from IRA Accounts Suspended
For the tax year 2020, there are no required minimum distributions (RMDS) from IRA accounts. If you have already withdrawn your RMDs for 2020, you cannot undo that. If you haven't taken your RMD yet, consider how delaying or withdrawing your RMD will affect your income tax brackets. For inherited IRA accounts required withdrawals are also eliminated for the 2020 tax year.
Corona Virus Distributions from Qualified Retirement Plans
Distributions of up to $100,000 from any IRA, 401k, 403b, or other qualified plan will not be subject to the usual 10% early withdrawal penalty for those who are infected with the COVID virus, have a family member infected by the virus, or were laid off or lost wages due to the virus. The distribution is still taxable, but the income, by default, will be spread over a 3-year period. This can help you access funds without bumping yourself into a much higher income tax bracket. It could potentially be used to advance fund Roth IRA conversions. More on that as we have time to digest all the ins and outs of the legislation.
The law also allows for repayment of any qualified plan distributions over a 3-year period as a qualified rollover contribution. So, if you need the funds now and are re-employed later, you will be able to replace the funds, offsetting any potential tax bracket increase in the future.
Allowable loans from qualified plans, such as a 401ks, are also increased to $100,000 or 100% of the vested account balance, whichever is lower. Repayment of any loan taken in 2020 can be delayed for up to one year.
Charitable Contribution Deduction
After the recent Tax Cuts and Jobs Act (TCJA), many taxpayers found themselves using the increased standard deduction and no longer itemizing on their income tax return. That eliminated the charitable contribution deduction. One of the permanent changes the relief bill provides is a new above the line deduction for up to $300 of cash contributions to a qualified charity. This does not include contributions to donor advised funds.
*Again, this is a preliminary look at the relief bill, we will provide updates and corrections as new information becomes available
What's the Problem?
IRAs that will be inherited by anyone except a spouse, minor children, beneficiaries with disabilities, and anyone who is ten years or less younger than the IRA owner, are now to be completely distributed over 10 years, rather than the lifetime of the heir.
Why is this a Problem?
With a shortened time span to distribute inherited IRAs, taxable income generated from an inherited IRA, in addition to one’s normal earned income, can cause uncharacteristically high tax bills if appropriate tax planning is not executed. In larger inherited IRAs, tens of thousands of tax dollars are at stake.
What are some Solutions to the SECURE Act?
Tax Planning for the SECURE Act
With the passage of the SECURE Act, stretch IRAs became a thing of the past. Rather than allowing beneficiaries to withdraw funds based on their life expectancy, the Act requires IRA beneficiaries to make a total distribution of all funds from the IRA within 10 years, with limited exceptions for spouses, minor children, beneficiaries with disabilities, and anyone who is ten years or less younger than the IRA owner.
Congress passed the Act knowing the net effect would be higher income taxes to most IRA beneficiaries. According to the Congressional Research Service, the elimination of the stretch IRA alone has the potential to generate about $15.7 billion in tax revenue over the next decade. For many beneficiaries, the inherited IRA will come during their peak earnings years when their income tax rate could be at a maximum. The effect of high earnings and additional taxable distributions from a Beneficiary IRA could cause the net value of the IRA to be reduced by 30% or more. To minimize to tax bite of an IRA inheritance, both the original IRA owner and the beneficiary will need to do diligent tax planning.
How IRA Owners can Minimize Taxes from the SECURE Act
Roth IRA Conversions
Now, more than ever, converting Traditional IRAs to Roth IRAs should be examined. We strongly believe almost everyone should convert enough funds from a Traditional IRA to a Roth IRA to fill the 12% income tax bracket each year. 12% is a fair tax rate for most taxpayers and it’s much easier to implement effective tax planning for inherited Roth IRAs than for inherited Traditional IRAs.
Having assets in a Roth IRA has advantages for the original IRA owner as well. It will reduce the amount of required minimum distributions (RMDs) when you reach age 72 (up from 70 ½, a positive from the SECURE Act), as well as provide more flexibility in managing your income-tax rate in retirement. For a free Roth conversion flow chart that will help you understand how a Roth conversion can work for you click here.
While we usually don’t recommend going beyond the 12% bracket for Roth conversions, there could be certain circumstances where that might be appropriate. For example, if you don’t need the assets in your Traditional IRA for your retirement lifestyle and all of your heirs are high wage earners, it might be better for you to pay a 22% tax rate now rather than leaving the IRA to an heir who may be taxed 32-40% on those same assets.
Naming Grandchildren as Partial IRA Beneficiaries
If you have grandchildren, including them as partial beneficiaries of your IRA can potentially increase the net value of an inherited IRA. For example, suppose you have a $500,000 IRA, two children, and four minor grandchildren.
Both children and their spouses work and earn $150,000 per year in combined taxable income, so under current income tax law that puts them in the 22% marginal Federal income tax bracket. With a Beneficiary IRA of $250,000 each, if they take equal distributions from their Beneficiary IRA of $25,000 per year for 10 years, they will be pushed into the 24% bracket and thus nearly every dollar distributed from the Beneficiary IRA is taxed at the 24% level. Or worse, say they wait to take the full $250,000 distributions in year 10 or another single year—they would jump into the 32% Federal tax bracket.
To steer some IRA assets away from being taxed at those higher tax brackets you could earmark a portion of the IRA to go to each grandchild. Under current rules, any minor can have $1,100/year of unearned income with no income tax liability. This kiddie tax rate applies to children under the age of 19 and college students under the age of 24.
Every year $1,100 is distributed from your grandchild’s inherited IRA tax-free, resulting in a savings of $242 each year the child qualifies. If the child has earned income during their teen years, the distributions can be increased to fund a Traditional IRA or Roth IRA for the child’s benefit. Smart tax-planning could combine Traditional and Roth IRA contributions to eliminate all taxes on the child’s earnings. Once the child reaches the age of majority, the ten-year rule begins. It is unlikely the grandchild’s earnings will place them in a top bracket fresh out of school, so the strategy of offsetting distributions with tax-deferred savings could allow your grandchild to build a nice retirement nest egg without much loss to income taxes.
To accomplish this, you must be sure to name a custodian for the minor grandchildren since minors cannot make financial decisions for themselves. The custodian could be a parent, but one must be named. Another important factor in determining the dollar amount that should be allocated to a grandchild is the age of the grandchild when they receive the Beneficiary IRA.
Most IRA owners will name a spouse as a primary beneficiary and that is perfectly fine. Spouses are exempt from the ten-year distribution rules. Children are generally named as contingent beneficiaries, in some equitable percentage of the account value. Most custodians only allow for simple percentage distributions to be named beneficiaries and that could create some problems. For complex beneficiary strategies, using a pass-through trust might be a better solution.
Using Pass-Through Trusts Correctly
If you’ve already established a trust as the beneficiary of your IRA, it is imperative that you review and update that trust. Most trusts have language that instructs the trustee to pay out the required minimum distribution (RMD) to the beneficiary each year. Under the SECURE Act, there are no annual RMDs until the end of the 10-year term, then the required distribution is 100% of the account value. This is a tax time bomb just waiting to explode.
At a minimum, you must rewrite the trust to allow flexibility for distributions, which also provide flexibility for income tax planning for the beneficiary(ies) of your IRA. Realizing a $500,000 Beneficiary IRA distribution through a trust in one single year will likely subject the distribution to the maximum income tax rate of 37%, plus a 3.8% Medicare surtax on some of the recipient’s income. This is just for the Federal level taxes; add in state income taxes and the beneficiary may only end up with 50% of the original account value-- certainly not what you had in mind when you drew up the trust.
Most IRA custodians do not allow for complex IRA beneficiary schemes, so the ability of pass-through trusts to manage distributions to multiple generations becomes much more important. Through a trust you can establish custodians for minor beneficiaries, name an investment and income tax counselor, and provide for flexibility in the timing of distributions during the 10-year window allowed under the SECURE Act, or even longer in the case of minor children. Although establishing the trust incurs more expense and investment of time and thought, the result can certainly provide enough benefit to owners of substantial IRA assets and their families to make it worthwhile.
How Beneficiaries Can Reduce Taxes from an Inherited IRA
Off-Setting Distributions with Tax-Deductible Savings
For many Beneficiary IRA owners, the biggest tax planning opportunity will be to simply manage the distributions over the 10-year period. One strategy would be to offset the taxable Beneficiary IRA distributions with additional tax-deferred savings. To do this, simply increase savings to an employer’s retirement plan such as a 401k, 403b, or other tax-deferred plan, or establish and contribute to a separate deductible Traditional IRA or self-employed retirement plan of your own. Any form of tax-deductible contribution will reduce the impact on income realized from one’s Beneficiary IRA dollar-for-dollar.
Let’s go back to our previous example with the $500,000 IRA. If the IRA owner’s children in this illustration are like most investors, they only contribute about 5% of their salaries to an employee retirement plan in order to maximize the company matching formula-- a.k.a get the free money. This means the parents are likely contributing much less than the $19,500 maximum salary deferral allowed by the IRS.
Let’s assume the decedent’s children can defer an additional $15,000 for each spouse in their employer 401k plans. If they defer the additional $30,000 in one year, they can distribute another $30,000 from their Beneficiary IRA(s). This results in a wash for $30,000 of distributions from the Beneficiary IRA as it would swap funds from one tax-deferred account to another and fulfill the original IRA owner’s estate planning intent.
Inherited Roth IRAs
While inherited Roth IRAs are easier to manage from an income tax perspective, you should put some thought into the options. The most obvious option is to do nothing until the final day of the ten-year withdrawal period and then take a distribution of the entire account. This maximizes the tax-free growth of the inherited Roth IRA and because the distribution is tax free, has no effect on the recipient’s tax rate.
If the beneficiary is not making maximum retirement plan contributions when they inherit the Roth IRA, taking distributions along the way and using those funds to fund their own Roth IRA, or even better-- make contributions to a Roth 401k-- could mean you really do get to stretch the inherited Roth IRA over your lifetime. Non-deductible 401k contributions, up to the annual $19,500 limit, will work as well. When you retire, the non-deductible contributions, but not the earnings, can be rolled over into your own Roth IRA. Taking money from one pocket and moving it to the other pocket, that has no hole in it, (i.e. tax-free) makes a lot of sense.
The Role of Your Financial Planner
The SECURE Act makes working with a financial planner more important than ever before. Earning an 8% or even 10% return on your investments pales in comparison to shielding 30% or more of your assets from the ravages of our income tax system. To get started on a plan to preserve your IRA assets, click HERE.
With the end of the year approaching, now is the time to look for opportunities to save on income taxes. Here are some items you should look for:
In Charleston and Myrtle Beach, clients and potential clients often assume the Affordable Care Act (ACA) only helps low earning individuals and families. This is far from the case. When using proper financial planning strategies, some families can make up to $239,000 and still qualify for the healthcare subsidy.
Over 10 million Americans utilized Affordable Care Act (ACA) healthcare insurance in 2018, 87% of which received some sort of subsidy to help them pay for that insurance. Many receiving that subsidy don’t understand the how and why of the program; and many who aren’t receiving the subsidy don’t realize just how close they may be to pocketing thousands in tax relief via the Premium Tax Credit. We’re going to walk you through a broad overview, without getting into too much detail, so you may determine if you can qualify for the Premium Tax Credit and what strategies you can implement to help you qualify.
Who qualifies for tax relief from the Affordable Care Act in 2020?
How do you determine your Modified Gros Income (MAGI)?
Start with Gross Income which, for simplicity, is any income you receive throughout the year.
Next, you’ll need to determine your Adjusted Gross Income (AGI). You’ll do this by subtracting:
Finally, to determine your MAGI, add-back to your AGI:
We see that for most people, the only way to lower your MAGI number is to increase the deductions that calculate your AGI, such as 401k (or any qualified employer plan), IRA (SEP, SIMPLE, Traditional) and HSA contributions—therefore we use these deductions in our general example below. Theoretically, the following gross compensations can be earned with corresponding contributions reducing overall MAGI:
Often families cannot afford to, or choose not to, dedicate the maximum amounts to these accounts. We recommend establishing a strategy each year for qualifying for the Premium Tax Credit that matches your personal and financial goals.
Keep in mind, this is a general overview. There are many other rules that can change these calculations, such as non-working Spousal IRA contributions which phase out at certain income levels and the catch-up provisions afforded to anyone over the age of 50 for IRAs and 55 for HSAs; The goal of this article is to give a broad overview so you may pinpoint exactly where your family sits in reference to the Premium Tax Credit eligibility.
If you’d like a CERTIFIED FINANCIAL PLANNER™ to help create and manage a tax strategy that will aims to qualify your family for the Premium Tax Credit click here.
Many investors love the Federally tax-free income they receive from municipal bonds. Municipal bonds are debt securities issued by state and local governments to fund operations or special projects. Because the income an investor receives is not taxed, the after-tax return of municipal debt is often higher than the after-tax income provided by corporate bonds and bank CDs.
For example, the yield on the iShares Core US Aggregate Bond ETF (AGG) currently stands at about 2.73%. For a taxpayer subject to a 22% marginal income tax rate, the after-tax return drops to just 2.1% and is even lower as you climb into higher marginal tax brackets. Compare this to the Vanguard Tax-Exempt Bond Index Fund ETF (VTEB) which yields 2.28% federally income tax free.
An often-underappreciated item in the US income tax code deals with qualified dividends. A qualified dividend is a dividend from a common stock or a preferred stock that the filer owns for a specified minimum time period. The beauty of qualified dividends is that they are taxed at the filer's long-term capital gains rate rather than as ordinary income. The following table compares ordinary income rates and long-term capital gains rates for married filing jointly returns.
Capital gains rates are not perfectly aligned with the marginal tax rates due to the Tax Cut and Jobs Act of 2017, but except for a small slice of taxable income between $78,751 and $78,950 (2019), the tax rate on long term capital gains is lower that the tax rates on other forms of taxable income.
Which brings us to the value of qualified dividend income (QDI). QDI extends to income received from preferred securities. Preferred stocks are debt-like securities issued by corporations that rank below the bond holders-- but above the stockholders-- in the event of a liquidation. The term preferred is used because the dividends on these shares must be paid in preference to dividends paid to common stock shareholders. To learn more about preferred stocks you can view the Wikipedia entry here.
The importance of this is the after-tax returns of many preferred securities held long enough to receive QDI tax treatment, are higher than rates generally available in the municipal bond market. Take the Goldman Sachs preferred A shares (GSPRA) for example. This security has a current dividend yield of 4.7%, even at the highest capital gain rate of 20% the after-tax net on this income is 3.7% or 60% more than the tax-free rate of 2.3% from VTEB.
There are some details to keep in mind; to qualify for QDI status, the security must be held for 91 days out of the 181-day period, beginning 90 days before the ex-dividend date. Because most preferred securities pay quarterly dividends, you would generally need to make your purchase the day of the preferred trade’s ex-dividend to ensure you receive favorable tax treatment.
Also, preferred issues are highly concentrated in the financial and utility sectors of the market which could lead to poor diversification. You could use exchange traded funds (ETFs) like the iShares Preferred and Income Securities ETF (PFF) or an open-end mutual fund like the Nuveen Preferred Securities and Income Fund; but be aware that not all the distributions from funds like these are considered Qualified Dividend Income. Only 62% of the distributions from PFF were eligible for QDI treatment in 2018 and usually about 60% of the Nuveen funds distributions were QDI eligible.
Still, for investors concerned with building a tax-efficient portfolio, preferred securities are certainly worth consideration.
Okay-- you just completed your income tax return for last year. You want to file it away and not worry about taxes until next year, but before you do-- take a look at your completed return to identify ways you can save tax dollars next year.
Income tax planning can add to your future net worth and your future income streams. Here is a line by line view of some of the things that good income tax planning can do to improve your financial life.
Line 10 on your new 1040 return shows your taxable income after all deductions. Knowing your marginal income tax rate is the first step to efficient income tax planning. Lowering your income taxes in the current tax year is not always the best long-term strategy, lowering your lifetime income tax liability is often much more important.
For 2019, the federal income tax brackets for individuals are:
Your marginal income tax rate is the amount you would pay on your last dollar. For example, a single person with taxable income of $84,201 would pay a 24% rate on only one dollar of income, not their total taxable income. They would in fact pay 10% on their first $9,700 of taxable income, then 12% on the next $29,775, then 22% on the next $44,725, and finally 24% on the last dollar of taxable income.
It is important to remember that the current income tax rates for individuals are scheduled to revert to the pre Tax Cuts and Jobs Act rates in 2025. Barring tax changes passed by Congress in the interim, you have six years to utilize the current brackets to your benefit.
Managing Your Income Tax Bracket
Depending on your income level, managing the income tax bracket you fall in may mean realizing extra income to take advantage of a favorable rate; or you may want to lower your taxable income to qualify for a lower tax bracket or other income tax benefits (such as Obamacare).
In my opinion the 12% bracket is extremely valuable. Married couples can have up to $78,950 of taxable income and pay no more than 12% in federal income taxes. Less than 25% of American households have taxable income above this level and I believe the odds of their marginal income tax rate falling is quite small.
If you are among the many that fall into the 12% rate, you should look for ways to pay taxes on as much income as you can without moving into the 22% bracket. Some of the things you should consider are:
Contribute to a Roth IRA or Roth 401k rather than a Traditional IRA or standard 401k account
Convert existing Traditional IRA funds to a Roth IRA
Higher marginal income tax payers will want to take the opposite approach. They’ll want to defer more income unless they anticipate being in an even higher bracket in future years. High bracket individuals will want to:
The absolute worst taxable income numbers are $200,000 for single filers and $250,000 for joint filers; along with $157,500 for single filers and $315,000 for joint filers who own their own business.
The first range, $200,000 single and $250,000 joint subjects a taxpayer to the 3.8% net investment income tax.
The second range for self employed filers of $157,500 for single and $315,000 for joint are the cutoff for the pass-through business income deduction.
Taxpayers at those levels should take aggressive steps to lower their taxable income.
Moving back up your return, line 2 and line 3 deal with investment income.
Note that these lines have been subdivided into an A and B column. The column on the left is better than the column on the right for income tax purposes.
On the left you have tax-exempt interest, which is income generated from municipal and state government entities. Municipal bond interest is generally income-tax free, although there are some taxable municipal bonds, and some municipal bond interest is subject to the Alternative Minimum Tax.
Tax-exempt interest is also added to your Adjusted Gross Income (AGI) for purposes of calculating how much of your Social Security benefits are taxed. The higher your marginal income-tax rate, the more valuable tax-exempt interest is. To determine the taxable equivalent yield of a tax-exempt security, you divide the tax-exempt yield by 1 less your marginal income tax rate.
For an investor in the 12% marginal income tax bracket, a municipal bond yielding 2.5% gives them the same after-tax return as a taxable security that yields 2.8% (.025/ (1-.12)). For an investor in the 32% tax bracket the same 2.5% yield from a municipal bond equates to a 3.6% taxable yield.
Again, the column on the left is more valuable than the column on the right. A qualified dividend is a dividend from a company that: a) trades publicly on a US exchange and b) is incorporated in a US possession or c) is eligible for the benefits of a comprehensive income-tax treaty with the US. The advantage to generating qualified dividend income is that these payments are taxed at your capital gains rate, which is generally much lower than the rate on your ordinary income
Dividends from REITs, MLPs, employee stock options, tax-exempt organizations, money market accounts, and shares used for hedging are not eligible for qualified dividend status.
Make sure to also consider the treatment of preferred stock dividends. Although ranked below bondholders in the event of financial difficulty, preferred stock pay yields that are similar to long-term bonds. All taxpayers should consider these securities against table bond holdings for the tax advantages alone.
IRAs, Pensions, and Annuities
Income received from pensions and some annuities are absolute, in that you receive the income and you pay the taxes; however, income from an IRA and certain types of annuities are somewhat discretionary. You can plan the timing and the amount you withdraw to achieve the best income-tax outcome for your personal needs. If you are over 70 ½, you are required to take some distributions from your traditional IRA accounts (required minimum distributions/RMDs), but even then you can take advantage of the Qualified Charitable Distribution rules to lower the amount that is reported to the IRS.
Income derived from variable annuities can be problematic for some. All income from variable annuities is considered ordinary income until you have spent down those assets to your cost basis. At that point, the withdrawals are deemed to be return of principal and are no longer subject to income taxes.
Although we prefer to use IRA to Roth IRA conversions to manage income tax brackets for those in the 12% marginal tax bracket, you can certainly use variable annuities in a similar fashion. If you are in a higher marginal tax bracket, you can also consider exchanging your variable annuity for an immediate annuity. Doing this will change the deemed ordinary income rule to a pro-rata distribution rule, where some of your distribution is considered ordinary income and some of it is considered a return of principal.
You probably will pay taxes on some of your Social Security benefits. If your total income is more than $25,000 but less than $34,000 for individuals; or $32,000 but less than $44,000 for joint filers, you will pay income tax on 50% of your Social Security benefit. If you are above those ranges, you’ll pay income tax on 85% of your Social Security benefit.
Sadly, I have to say I have seen cases where an individual is less than 70 years old, in a 30%+ marginal income-tax bracket, saving money, and still insists on claiming their Social Security benefit. It would be a simple fix to suspend Social Security benefits, reduce their taxable income, and accrue delayed filing credits to their future social security income. Yet some will still continue those benefits because they feel they have paid in all their life and want to see some return on their money. Yes, you could die, but throwing away money paying needless taxes is hard to understand.
Additional Income and Adjustments
In trying to make the form 1040 look simpler, the IRS added this line. It refers to a Schedule 1 and is attached to your 1040.
Under the old tax rules, alimony was deductible to the payer and taxable to the payee. No more--Congress has managed to shift the income tax burden for alimony payments to what is likely the higher earner with the higher marginal income tax rate. If you are divorcing it is important that the income tax liability of alimony payments be considered in developing an equitable settlement.
This has become a much more important item than in years past, as owners of any business that uses a pass-through entity can receive a 20% reduction to taxable income generated through that business. Assuring you maximize this important benefit is essential. See our previous post ‘Big Savings for Self-Employed and Business Owners’.
Capital Gains and Losses
For all taxpayers, it is important to use tax-efficient strategies for taxable investment accounts. High yield stocks and bonds are more efficient being owned in tax advantaged accounts (401ks, IRAs, Roth IRAs etc), while investments that mostly appreciate in value are a better fit for taxable accounts. Still, capital gains rates are attractive relative to the tax rates on ordinary income.
You can use capital losses to offset any capital gains you receive, plus $3,000 of ordinary income. Capital losses are never a good thing, but at the end of each year you should review your investments to look for opportunities to offset gains.
Rental Real Estate, Royalties, Partnerships, S-Corps, trusts, etc.
If you own rental properties you know how helpful depreciation can be for your income tax liability. Yes, some of the depreciation will be needed to maintain the property, but some of it will also reduce your taxable income, and if you sell, will result in more income being taxed as capital gains at currently favorable rates. If you own a property that has been fully depreciated you might consider using a tax-free exchange to like property to increase your basis and start the depreciation process all over again.
Adjustments to Income
Health Savings Accounts
Many American’s are now covered by high-deductible health insurance plans either through their employer or purchased directly from insurers through the Affordable Care Act Marketplace. Contributing to an HSA will reduce your current income tax liability, and if the funds are used to pay for qualified medical expenses the distributions are tax-free as well. See our post on ‘Hacking Your Health Savings Account’.
Self Employed SEP, SIMPLE, and Qualified Plans
An easy way to reduce your current year income tax liability is to contribute to a retirement plan. IRA contributions are reported on line 32, but if you’re self-employed you can defer taxes on even more money. You can establish a SIMPLE retirement plan before October 31 of the current tax year and defer up to $13,000 ($16,000 if you are over age 50) annually.
A SEP retirement plan allows an even bigger tax deferred contribution of up to $56,000, plus a catch-up contribution of $6,000 if you are over age 50. Another useful benefit is you have until your income tax filing deadline, plus any extension, to establish and fund a SEP for the previous tax year. If you’re a business owner who still needs to reduce your previous years taxable income-- this is your chance!
Self Employed Health Insurance Deduction
If you’re self-employed, this is where you get to reduce some of your taxable income for health insurance expenses. If you’re not self-employed and are not covered by an employer health insurance plan, this is motivation for starting a side gig.
For example, the mechanic that works on cars after hours, or maybe the carpenter that does an occasional job on the side. Formalize your business to take advantage of this deduction.
While this is far from an exhaustive list of ways to reduce your income tax liability both now and in the future, you can see there are opportunities for almost everyone to benefit from income tax planning. Take some additional time to review the tax forms you just filed or see a financial planning professional-- there is a lot at stake.
A health savings account is a tax-deductible savings plan for individuals covered by a qualified High-Deductible Health Plan (HDHP). This program allows for tax deductible contributions to a special account that allows you to pay for expenses your insurance plan does not cover with pretax and tax-free dollars.
A high deductible plan for 2019 requires a minimum deductible of $1,350 for individuals and/or $2,700 for a family. These plans must have a maximum out-of-pocket expense of at least $6,750 for an individual and $13,500 for a family.
If you’re covered by a spouse’s workplace policy, Tricare, the Veterans Administration, or Medicare you are not eligible. If you are a dependent on someone else’s tax return or covered by a Flexible spending account or Health reimbursement account, you are not eligible.
How an HSA Works
The beauty of an HSA is you make contributions that are deducted from your taxable income, yet when you spend the money for qualified expenses, the distribution is tax-free as well. Any growth within the HSA account is also tax-free. So, the contributions are deductible like a Traditional IRA, but earnings and distributions are tax-free, like a Roth IRA – you get the best of both worlds!
Contributions to an HSA are deductible from your taxable income in the years you contribute, and like a Traditional IRA, you can make contributions until April the 15th or your normal tax filing deadline of the following year. For 2019, the maximum HSA contribution is $3,500 for and individual and $7,000 for a family, with an additional $1,000 per year “catch-up” contribution for those over age 55. It is important to know that for married couples the $1,000 catch-up provision applies to each spouse. If you and your spouse are each over 55 your HSA contribution limit for 2019 would be $9,000.
If you contribute to an HSA plan through your employer, your annual contributions are reduced dollar-for-dollar by any contributions your employer makes on your behalf. For example, if you and your spouse are under age 55 and your employer makes a $1,200 annual contribution on your behalf, you would only be allowed to contribute and deduct from your taxable income $5,800 for 2019 ($7,000 contribution limit minus $1,200 employer contribution).
If you drop out of a high deductible plan before the end of any calendar year, say you become eligible for Medicare, or you change employers and the new coverage does not qualify as a high deductible plan, your contributions for that year are simply pro-rated. Meaning if you participate for three months then changed to a plan that is not eligible for HSA contributions, you would be eligible for a 3/12ths deduction in that calendar year.
On the other hand, if you become eligible for HSA contributions during a calendar year, you can make contributions as if you were covered by a high-deductible plan for the full year. So, if you moved from an employer plan that was not HSA compliant to another employer plan that was HSA eligible in October you would be allowed to contribute as if you were eligible for the entire year. This is known as the last month rule.
The contribution rules for HSA accounts also allow others to contribute to the account on your behalf. For example, if you have a working child who is covered by an HSA compliant insurance policy, you can contribute directly to the account for them. The contribution is considered a gift so you will not receive an income tax deduction, but it may be an important step to helping your child become financially stable.
Qualified HSA Funding Distribution
An important funding technique is the ability to make a trustee to trustee transfer from an IRA into your HSA account. Each taxpayer may only do one qualified transfer in their lifetime and the amount of your HSA contribution will be reduced dollar-for-dollar in the year you make a conversion. This is an outstanding opportunity to convert dollars that are potentially taxable in the future to dollars that can be tax-free. If you are young and make a conversion, the potential for tax free growth can’t be beat. Even if you’re just shy of Medicare eligibility, the income tax savings of this strategy make it worthy of consideration.
An important note for couples is that only one person can own an HSA account. To maximize the Qualified HSA funding distribution benefit, one spouse will open a family HSA for a calendar year and use their qualified funding distribution. In the following year the other spouse will open a separate HSA account and use their own once in a lifetime qualified funding distribution to fund that account. This would allow a couple to convert up to $18,000 from IRAs where distributions are likely to be taxable--into HSA accounts that compound tax-free and provide tax-free future benefits.
You are allowed to rollover funds, via a trustee-to-trustee transfer, from one HSA account to another without triggering a taxable event. This means if you leave an employer’s plan and wish to establish an HSA account through a different provider, you can consolidate your account with the new provider and simplify your finances. Or if you wish you can change HSA account custodians anytime.
If you name your spouse as the beneficiary of your HSA account, the account will be treated as the spouse’s HSA upon your death. For other beneficiaries, the fair market value becomes a taxable distribution to the beneficiary.
Funds from your HSA account can be used for qualified medical expenses for you and your family. The IRS is a bit liberal in their definition of family. Anyone who qualifies as a dependent on your income tax return can have medical expenses paid from your HSA account. You, your spouse, your children under age 19 or under age 24 if a full-time student, grandchildren, parents, and foster children are all included.
Medically necessary expenses not covered by insurance can be paid from your HSA account without taxation. Even things like drug and alcohol rehab, home modifications for disabilities, acupuncture, dental and vision care, and over the counter drugs prescribed by your doctor, are all allowed expenses.
Although your current insurance premiums cannot be paid from you HSA account, you can use those funds to pay for Long-Term Care insurance and Medicare Part B and Part D premiums.
For a complete listing of eligible expenses see IRS publication 502.
Look Back Provision
If you have an HSA account open during any tax year and do not have enough money contributed to cover all the allowed reimbursements, you can use future years contributions to pay yourself back. For example; In 2018 you had an HSA balance of $4,000 but in December you had a large unexpected $5,000 medical expense. You would be able to make 2019 contributions and then reimburse yourself for the extra $1,000 expense you incurred in 2018.
Like IRA accounts, there are certain transactions that are prohibited inside your HSA account. You cannot have any self-dealing transactions such as sale leasing or exchange of property between yourself and your HSA account, you cannot charge your HSA account for services you provide, and you cannot use your HSA account as collateral for any loans. A violation of these rules will trigger a deemed distribution from your HSA account and subject all the funds to taxation in the year the violation occurs. For more information on prohibited transactions see section 4975 of the tax code.
For the full IRS guidance on Health Savings Accounts see Publication 969.
If you're age 70 ½ or older you probably know you must begin taking distributions from your IRA -whether you want to or not. The IRS life expectancy tables determine your required minimum distribution (RMD) based on the previous years ending balance for your IRA and your attained age for the tax year.
The qualified charitable distribution rules provide those subject to RMDs an option that can help them reduce their income tax liability by having certain charitable contributions made directly to a qualified charity. Given the changes to itemized deductions and the standard deduction in the 2017 tax law update, the qualified charitable distribution rules for your IRA account becomes even more important.
If you make charitable contributions throughout the year, it would be wise to consider making those contributions directly from your IRA. Up to $100,000 of charitable distributions from each IRA owner's accounts can be excluded from your taxable income each year.
Say you plan to give $10,000 to your church or another qualified charity and you are receiving taxable distributions from your IRA. If you make the contribution to the charity directly from your IRA, your $10.000 gift will not be reported as income on your income tax return.
If you instead receive these funds as income from your IRA distribution and then send the same $10,000 to the charity it is included in your taxable income and could result in higher Medicare premiums and a higher percentage of your social security income being taxable. If you do not have itemized deductions that exceed the new $24,000 per couple or $12,000 per individual standard deduction, you could lose all the tax benefits of your generosity.
By having the distributions sent directly to the qualified charity from your IRA, you will exclude the amount from your taxable income, potentially lowering your Medicare premiums, the taxable portion of your social security benefits, and your overall income tax rate at both the federal and state level.
If you follow this strategy, be sure to let your income tax preparer know. There is no indicator on the 1099R you receive at the end of the year that shows that part of your distribution is non-taxable, so there is a chance many people using this strategy are over-paying their income taxes each year.