Experts have been talking about income tax rates rising dramatically in the coming years as the federal deficit rises to worrisome levels and current tax rates are scheduled to sunset in 2026. Now, with the new Covid-19 related stimulus package and CARES Act aid passed to help Americans and businesses in distress, our federal government is looking at adding another $1.76 trillion over the coming decade to our already bloated deficit, according to the Congressional Budget Office. And, forecasters expect falling gross domestic product as businesses close and people shelter at home – likely requiring an additional injection of aid to prop up the economy. It is likely that income tax rates will have nowhere to go but up. What can you do to protect yourself? Here are strategies that you should consider implementing now while we have the tax window of opportunity and the market is down.
- Switch to a Roth 401(k) or 403(b). If you have been contributing to a regular 401(k) or 403(b) at work, switch your future contributions to the Roth option if it is available. Yes, you sacrifice the deduction on your income this year, but that amount is allowed to grow completely tax free, and that contribution and all of the growth on that contribution will no longer be subject to income tax in the future when you take it out. If income taxes are higher then, you will be glad to have paid the tax today. Also, all the growth is yours completely tax free. An analysis of the comparison often reflects a huge savings for the investor.
- Contribute to a Roth IRA if you have earned income this year. Move some of your money to the Roth IRA if you are income eligible to do so (for the full contribution, a married couple may not have more than $196k in MAGI and a single must have less than $124k in MAGI). You can contribute up to $7,000 per tax year to a Roth IRA if you are 50 or older, and up to $6,000 per year if you are younger than 50. You must have earned at least the sum you are contributing to the Roth IRA and your income must be below the IRS thresholds to be eligible. If you have money sitting around in a regular bank account that is more than what is needed for emergencies, start by moving that money. Then, consider setting up monthly contributions for the next tax year. Yes, you can contribute to a Roth IRA even if you are contributing to an employer plan. Why a Roth IRA? Because contributions grow completely tax free and are all yours when you take the money out later, which could be when tax rates are much higher.
- Convert your IRA to Roth. A Roth Conversion is the term used when you volunteer to have any portion of your existing IRA account taxed now rather than when you take a withdrawal. This strategy is advantageous when you believe that tax rates now are lower than what they will be in the future. Also, with the market decline lowering the value of your account, you are being assessed taxes on a much lower amount, which translates in less tax owed on the same securities – without having to actually sell the securities at a loss. The portion you are “converting” is moved in kind to a Roth Conversion account where it then grows completely tax free and is not subject to any future tax increases nor RMD’s. There are some time restrictions on when you can remove that money, so make sure you will not need this money until then. Also, be sure you have the money available to pay the taxes that will come due now. And, even though the tax money is not officially due until tax time, you may want to send in the estimated payment now rather than later to avoid a potential tax penalty. Ask your CFP® advisor to help you with the amount and the positions to convert.
- Set up an HSA. If you are contributing to a high deductible medical insurance plan, open a Health Savings Account. An HSA is the only triple tax free account in existence if you follow all the rules. Your contribution goes in tax free, the money inside the account grows tax free, and when you tax it out for qualified medical expenses, there is no tax due on the withdrawal. Qualified medical expenses include long term care insurance premiums up to the IRS limits for your age. You can also keep this account with you, even if you leave your current employer. For 2020, you can contribute up to $3,550 if you have coverage for yourself only and up to $7,100 if your insurance covers your family.
- Take advantage of no RMD this year. Since the government has waived RMD’s in 2020, the opportunity for a Roth Conversion is enhanced. Your taxable income is less without the RMD adding to it this year, so there is more room for a Roth Conversion, if you have the money to pay the taxes that will come due. Not to worry, you will not need to sell anything at a loss if you are concerned about the market decline, because you can do the conversion “in kind” to the new account. Once the money is “re-titled” to a Roth Conversion account, the market investments can rebound inside the safety of a tax-free account. It is best to execute the Roth Conversion strategy with professional help from your CFP®
- QCD’s for charity. If you take the standard deduction on your tax return, are over 70 ½ in age, and you would like to get a tax benefit for a donation to your favorite charity, you can have the donation count as a Qualified Charitable Contribution, up to $100,000. Your taxable income is lowered by the same amount as the donation – if you follow the rules for a QCD. The rules require that the QCD is executed before taking a withdrawal from your IRA. Also, you must pay the charity directly from your IRA, receive a written acknowledgement from the organization, and the charity must be a qualified charity in order to get the tax advantage.
- Leverage your IRA. If your IRA balances are over $1 million, you are in good health, and you would like to ensure that your money is tax favored for your children who will likely be suffering from high income tax rates in the future, consider taking withdrawals each year from your IRA, paying the tax due at historically low tax rates, and then use the money to fund a life insurance policy that names your children as the beneficiaries. Upon your death, your children will receive a tax-free death benefit from the life insurance which is much more than the sum of what you paid into the policy. Also, with the new rules in place from the SECURE Act, your children will not have to worry about the new 10-year rule that requires them to empty any IRA accounts that you leave them within 10 years after your death, suffering the taxation that follows. Also this strategy may work to supply some tax advantaged money to you in your retirement, using the cash value accumulation.
If you need help with any of these strategies and are wondering which are applicable to your situation, please let us know and we are happy to help.
–Michelle Gessner, CFP®