By Nicole Gopoian Wirick, JD
Roth conversions are a hot topic given President Biden’s proposed tax reform and the possibility of higher tax rates. This is for good reason since prudent financial planning warrants accelerating income in lower tax years and decelerating income in higher tax years. This speed up/slow down strategy appeals to our rationality and a Roth conversion can be a great way to accelerate income.
However, in practice I’ve found that the act of raising your hand to volunteer for a larger tax bill is difficult for most taxpayers. In fact, it’s enough to deter many from a Roth conversion even though it might be in their best interest from both a personal finance and legacy planning perspective.
Given the amount of conversation surrounding Roth conversions today, it’s prudent to review potential changes to the tax law, identifying the possible impact through various tax lenses – not just ordinary income tax – and then consider a strategy that may pair well with a Roth conversion to better manage taxes in the year(s) of conversion and reduce or eliminate the dreaded check to Uncle Sam.
First, let’s review a few components of tax reform as it relates to personal finance. Please note, Congress must pass these changes before they are enacted into law. The possibility of this happening is beyond the scope of this article as I’m not a political expert and I simply can’t prognosticate the future.
With that said, it’s time to start thinking about potential changes now so you don’t get caught flat-footed later in the year. Good planning takes time and collaboration with a qualified team of professionals.
Three Tax Considerations
Income Tax: The president indicated his desire to increase taxes for people earning over $400,000. The top tax bracket would increase from 37% to 39.6%. There’s not clarity on where the top tax rate would begin and how marginal tax brackets between the top rate and $400,000 of income will be adjusted, if at all. This could create a sizable gap between the next highest marginal tax bracket of 32% and the new top bracket of 39.6%, amplifying the need for good tax planning and creating opportunity for financial planners and clients alike.
Capital Gains Tax: Under the president’s proposal, capital gains would be taxed at ordinary income tax rates for those earning over $1,000,000 of income. That means that the capital gains tax would almost double for those impacted by this change. Strategies to accelerate income and harvest gains in 2021 (assuming the tax law is effective in 2022) may be paramount for taxpayers in this category.
Estate Tax: Although the president has not indicated if a lower estate tax exemption (the amount you pass estate-tax-free to your non-spousal heirs at the end of your lifetime) will be introduced, he has indicated a desire to eliminate the step-up in cost basis, providing an exemption of $1,000,000 per individual ($2,000,000 for a married couple) plus $250,000 on a primary resident ($500,0000 for a married couple). This could dramatically impact the way assets are transferred to the next generation.
Roth conversions may have benefits far beyond that of reduced ordinary income tax during the IRA owner’s lifetime by eliminating required minimum distributions (RMDs). A lower estate tax exemption, coupled with the possibility of the elimination of cost basis step-up, might create a paradigm shift related to the identification and transfer of tax-optimized assets. An elimination of the step-up in cost basis might make Roth conversions even more popular since heirs will receive tax-free growth and distributions from inherited Roth IRAs for ten years after the death of the IRA owner. This is especially significant if the IRA owner pays the tax from a taxable investment account, therefore reducing the taxable bucket of assets that might be subject to capital gains taxes upon the account owner’s death.
The downside is that IRA owners will incur ordinary income tax in the year(s) they convert IRA assets to Roth assets. We already noted that prudent planning dictates accelerating income into lower tax years, which may likely be 2021 for those impacted by the proposed tax reform. But a Roth conversion is still a great opportunity for taxpayers in lower marginal brackets, too. The tax reduction under the Tax Cuts and Jobs Act sunsets at the end of 2025, and tax rates will increase for most taxpayers in 2026. That provides an opportunity for those with taxable income under $400,000 to accelerate income from 2021 – 2025.
After discussing this strategy with clients, the conversation is often quite similar. No one wants to pay voluntary tax to Uncle Sam, but many do want to help meaningful organizations, causes, and communities in their lives. The decision often boils down to paying Uncle Sam or supporting a charitable organization. The conversation then turns to offsetting the ordinary income tax paid on the conversion while helping those causes.
Those with charitable intentions might consider coupling a Roth conversion with a bunched charitable gift into a donor advised fund (DAF) to offset the prospective tax burden from a Roth Conversion (or any accelerated income for that matter). A transfer to a donor advised fund is tax deductible (bonus tax savings if you transfer highly appreciated assets) and removes assets from the donor’s estate because the transfer is irrevocable. A DAF provides benefits via the three tax lenses we reviewed earlier: ordinary income tax, capital gains tax and estate tax.
Let’s look at an example: Mary gives $20,000 per year to the Alzheimer’s Association as her mother was impacted by the devastating disease. Instead of giving $20,000 annually, Mary decides to bunch five years of gifting ($20,000 x 5 = $100,000) to a donor advised fund. Once in the DAF, Mary can recommend grants to any qualified 501(c)(3) organization in any fashion that she sees fit. She has flexibility on how the funds are distributed to charity.
First Benefit – Income Tax: Mary is able to take the entire deduction in the year she makes the donation to the donor advised fund, which is generally limited to 30% of AGI for non-cash donations (see the second benefit below).
If Mary’s AGI is not high enough to allow the full deduction, it will be carried forward for five years or until the deduction is completely utilized, whichever comes first. If the DAF is coupled with a Roth conversion, the Roth conversion will increase income by the amount of the conversion. The bunching of charitable gifts into multiple years is likely to create a scenario where the taxpayer is able to itemize their deductions on their Schedule A as opposed to taking the standard deduction.
Second Benefit – Capital Gains Tax: Let’s say Mary has low basis stock she’s held in her revocable living trust account for several decades. If she bought the stock for $10 in 1980 and today it’s worth $100, Mary would realize $90 of capital gains when she sells the stock and then writes a check to the Alzheimer’s Association.
If Mary donates the stock directly to the DAF, she gets the full $100 deduction and does not realize any capital gains. Assuming Mary’s in the highest tax bracket, this saves her $18 in tax ($100 - $10 = $90 x 20% LTCG gains tax rate) and provides the full $100 to the Alzheimer’s Association versus the $82 she would give after tax. Mary gets a higher deduction and the charity gets a larger donation.
Under the president’s proposed plan, the capital gains tax savings could almost double if Mary earns more than $1 million of income per year. Note, the 3.8% Medicare surtax would be added in both illustrations but is excluded for simplicity.
Third Benefit – Estate Tax: Mary has reduced the value of her estate by $100,000 since the transfer to the DAF is irrevocable. Should the estate tax exemption be reduced as part of the president’s tax reform, a DAF provides a planning tool to get assets out of an individual’s estate. Assets outside an individuals’ estate are not subject to the estate exclusion or tax. The irrevocable nature of the gift also means that once the asset is in the DAF, Mary cannot take it back or use the funds for a non-charitable purpose.
As you can see a Roth conversion and DAF pairing may be a fantastic strategy to offset higher income for those who prefer to support meaningful causes in their life rather than writing a check to Uncle Sam.
About the author: Nicole Gopoian Wirick, JD, CFP®
Nicole Gopoian Wirick, JD, CFP® is the founder and president of Prosperity Wealth Strategies in Birmingham, Michigan. Nicole is a fee-only financial planner who believes a successful advisory relationship involves compassionate conversations and planning tenacity.
Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
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