By Joe Elsasser, CFP®
Over the past few months, the Biden administration has already made some significant changes and more could be on the horizon. Some of these plans could have a big impact on retirees, but there are both challenges and opportunities if you know where to look. Converting funds from a traditional retirement account into a Roth IRA could become even more beneficial considering new required minimum distributions (RMD) guidelines and potential tax law changes.
First, let’s examine two recent changes to required minimum distributions (RMDs).
The IRS released new RMD tables that become effective in 2022. Based on changes to life expectancy, the new tables back off the minimum distribution amount by roughly two years. For instance, at age 70, the lifetime table would have had 27.4 years as the distribution period, now at age 72 it has 27.4 years. As you go further out, the ages get closer and closer together, but it is a reduction in the amount that you would have to take at any given age.
The beginning date for required minimum distributions is changing from 70 1/2 to 72. The adjustment shortened the distribution period, the time over which you must take distributions, and added a couple of extra years of deferral for most people. However, it has also caused a bit of a tax problem for those who might have contributed too much to their tax-deferred retirement account.
If you’ve saved almost entirely in IRA accounts, you will eventually have minimum distributions that get taxed at a higher rate than necessary. To solve this, consider leveling out tax brackets earlier by converting to a Roth.
While the updates to RMDs have already been implemented, the suggested modifications to the current tax law are still in the preliminary stages. While we have idea of what the changes could look like since they are outlined in President Biden’s tax plan, the reality is that the plans are likely to change at least somewhat as legislation moves through the House of Representatives and the Senate. Here are a few potential changes to be aware of:
Changes to Taxation for Current Employees to Pay for Social Security
Currently you pay tax on up to $142,800 of income which is indexed each year for inflation. These are called FICA taxes and are paid by both the employee and the employer–6.2% each for a total of 12.4%. FICA taxes fund the Social Security system. There is a proposal to continue this structure, but also reinstate the tax for people who earn over $400,000 a year. High wage-earners would again begin paying 6.2%, and self-employed people would pay both halves for a total of 12.4% on income over $400,000.
Changes to the Step-Up in Basis
Let's say you buy a stock today and in 20 years that stock triples in value. You have a low basis on a high current value. Under the current law, when you die your heirs would get a step-up in basis. This means if they sold that stock on the day after you died, they would pay only the difference between the date of death value and the day they sold it. They would pay very little capital gains tax.
Eliminating the step-up in basis could look like one of two things:
1. Carryover basis–which is the possibility that they would retain the original purchase price as their new basis. They wouldn't be taxed until they actually sold the asset, but they wouldn't get that step-up in basis that would allow them to sell the asset with very low taxation.
2. Immediate taxation of the difference between the deceased’s basis and the value as of the date of death.
Changing the Estate Tax Exemption
Currently you can have $11.7 million in your estate before you face any estate taxation. The Biden tax plan proposes to bring that number back down to $3.5 million.
Increasing the Top Tax Rates
The Biden administration proposes increasing the top tax rate from a current 37% under the Tax Cuts and Jobs Act back up to 39.6%—the rate from before the Tax Cuts and Jobs Act went into effect.
Looking at the planned tax changes, now is the time to consider taking advantage of the historically low tax rates by converting to a Roth before they take effect. Roth conversions can be a fantastic tool, particularly for those in a low tax bracket. A good financial advisor can help you determine the impact these changes could have on your retirement strategy. It’s important to be aware that some versions of these proposals are likely to pass and to plan accordingly.
About the author: Joe Elsasser, CFP®
Joe Elsasser, CFP® is the founder and president of Covisum®, a financial tech company focused on creating software solutions, practice management and marketing resources to help advisors and financial institutions grow and improve lives through better retirement decisions. Covisum helps financial advisors serving mass-affluent clients in or near retirement and powers some of the nation’s largest financial planning institutions.