Leveraging financial planning strategies is a key benefit of working with Acumen Wealth Advisors. As laws change, we work with clients to leverage new opportunities. Roth conversions are one financial planning strategy Acumen is implementing for applicable clients. In 2018 a new tax law took effect allowing for a greater capacity to recognize income at lower tax rates.
A traditional IRA is a tax-deferred account which grows tax free but is taxed upon withdrawal. Based upon the new retirement plan-based legislation, The Secure Act, IRA owners who turn 70½ in 2020 are required to start taking Required Minimum Distributions (RMDs) at age 72. The RMD is an amount based upon the life expectancy and account balance on December 31st of the previous year. The issue Acumen saw arising from RMDs is, for some clients with large IRA account balances, the RMD amount was substantial enough to push them into a higher tax bracket. This income sensitivity is particularly concerning when other sources of earned income, such as pension, social security, or substantial interest income, are included.
Unlike a traditional IRA, a Roth IRA account holder pays the taxes “up front” when a contribution is made. The account then grows tax free. There are no RMDs for the account holder and withdrawals are not taxed (since taxes have already been paid) nor do the withdrawals count towards earned income.* Roth IRAs are widely utilized and recommended for individuals who anticipate their income or tax liability will be higher in the future.
A Roth conversion is accomplished by taking a portion (or all) of a traditional, tax-deferred IRA account balance and moving it into a tax-free Roth IRA. Acumen’s financial planners work with clients to assess how much needs to be converted on an annual basis to effectively reduce future tax liability while staying in the lowest current tax bracket possible. The Tax Cuts and Jobs Act of 2017 reduced the individual tax rates and effectively doubled the standard deduction, but these provisions are only temporary and will expire in 2026. Acumen believes this time frame is a window of opportunity for optimal Roth conversion implementation. Although Roth conversions will create a tax liability for the converted amount, Acumen believes it may be better to pay the taxes in today’s relatively low tax rate environment and then enjoy tax-free growth and withdrawals from a Roth IRA without having to worry about future tax rates. We feel at this point, when it comes to taxes, “The devil you know is better than the devil you don’t.”
The effect of the 2017 tax cut can be seen with the annual federal deficit growing 60.31% from September of 2017 to September of 2019. Future tax rates are unknown, but it is widely anticipated the government will have to take some spending reduction and/or revenue increasing action to combat this deficit – actions such as increasing tax rates. The current tax brackets of 10%, 12%, 22%, 24%, 32%, 35%, and 37% are set to increase to 10%, 15%, 25%, 28%, 33%, 35%, 39.6%. And, the standard deduction will effectively be halved when the current tax law sunsets in 2026.
Another reason Acumen sees value in Roth conversions is for beneficiaries of an IRA. When the owner of a traditional IRA account passes, the account is inherited by the beneficiary(ies) listed on the account. This beneficiary could be a surviving spouse who will become a single tax filer and, consequently, have a lower income threshold for higher tax rates. The RMDs from an inherited IRA can also affect children who, in many cases, find themselves in their prime income earning years. This situation can present a problem as the owner of the inherited IRA must start taking RMDs which adds to their existing income and presents the possibility of being pushed into a higher tax bracket. This issue was not as unfavorable before the passage of The Secure Act in November of 2019 since the inherited IRA owner could use their life expectancy for RMD calculations, a provision, referred to as a “Stretch IRA”, resulting in a lower annual withdrawal amount. The Secure Act has eliminated the “Stretch IRA” provision and now the entire account balance must be taken within ten years.
Once again, the Roth IRA shows its value from a tax standpoint as the owner of an Inherited Roth IRA is required to take RMDs but the withdrawals are tax free and do not count towards income.* The benefit of inheriting a Roth IRA, as opposed to a traditional IRA, is attractive for individuals who wish to leave a tax efficient legacy.
* Withdrawals are not taxable as long as the account has been opened five years or the account owner is over age 59½. First home purchase and college expense exceptions also apply.
We encourage you to reach out to our team, so we may help you plan and protect your legacy.
About the Author: Jerome You is a Financial Planner for Acumen Wealth Advisors in Chattanooga, TN. Jerome has passed the Cannon Trust School II exam (of a three-part series) to earn the Certified Trust and Financial Advisor (CTFA) designation offered by the American Bankers Association (ABA).
The opinions expressed in this commentary should not be considered as fact. Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. The information has been obtained from sources we believe to be reliable; however no guarantee is made or implied with respect to its accuracy, timeliness, or completeness. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.
Acumen Wealth Advisors, LLC® is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Acumen Wealth Advisors, LLC® and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Acumen Wealth Advisors, LLC® unless a client service agreement is in place.