Tag: Taxes

You’ve probably been told that the best way to save for retirement is with your employer’s 401(k), or similar retirement plan. The reasoning, you usually receive some sort of matching contribution from your employer and you receive an immediate “tax break” for the amount you contributed.

In general, this is good advice. However, putting all of your long-term savings into a tax-deferred account can be a serious mistake that doesn’t come to fruition until retirement.

That is because when the account is tapped for income, the withdrawals are subject to the highest possible tax rates, and IRS mandated distributions makes the problem even worse by causing taxation of income you may not even need until later in retirement.

The Time Bomb

Take for example a 70-year-old who has been living on $50,000 per year during their retirement. They have been receiving Social Security benefits of $24,000 per year so they were only taking around $26,000 per year from their investment portfolio to supplement.

They did a great job saving during their working years and have a balance of tax-deferred assets of around $1.5 million. Unfortunately for them, they turn 70 1/2 this year and the IRS has required they begin taking minimum distributions from the account. Based on the IRS’s Required Minimum Distribution worksheet, this person will need to take out nearly $55,000 from their assets this year alone! To compound the problem, the required minimum distribution gets larger the older you get. 

These excess distributions will cause their adjusted gross income to increase, which can lead to their Medicare premiums to rise and a larger portion of their Social Security benefits being taxed. Not to mention their overall tax liability increases!

So how do you mitigate this tax time bomb? The same way we manage most risks in finance…diversification.

Tax Diversification Basics

When you boil down the dozen or so ways you can own assets, there are only three basic ways your assets are treated for taxes: Taxable, Tax-Deferred, and Tax-Free.

“Taxable” accounts are simply individual, joint, and trust investment accounts in which you pay taxes on the income and capital gains generated each year. You receive preferential tax treatment on assets that you hold longer than one year in these types of accounts.

“Tax Deferred” accounts include traditional IRAs, 401(k) plans, SEP-IRAs, profit-sharing plans, 403(b) plans and similar accounts. Contributions to these accounts are often tax deductible, but not always. Withdrawals are taxed at your highest marginal income tax rates and the accounts are subject to mandatory distributions beginning at age 70 ½.

“Tax Free” accounts include Roth IRAs and Roth 401(k) plans, as well as Health Savings Accounts (HSA). Roth contributions are made after-tax, while HSA contributions are tax deductible. Withdrawals are tax free and are not subject to required distributions.

The ideal ratios are to have one-third of your assets in each of the three tax types as you enter retirement. But this is not easy to achieve because the default path for most investors is excess tax-deferred holdings due to:

1. The default election is for contributions to go into a tax-deferred 401(k) plan.
2. A tax-free Roth 401(k) plan might not be available. 
3. Employer contributions are made into a tax-deferred profit sharing plan.
4. If your income is too high, you can’t directly contribute to a tax-free Roth IRA.
5. Saving to a taxable account takes being proactive.

Extra attention has to be put into building tax-free and taxable accounts since the default accumulation path is having the majority of assets in tax-deferred accounts. 

Strategies To Achieve Diversification

The following strategies can be used to aid in tax diversification. Many of them can be used in conjunction with one another, but be aware that they become increasingly complex as you move through the list.

1. If you are eligible for a Health Savings Account (HSA), fund it to the maximum every year and invest it. Don’t make withdrawals for current health expenses. An HSA is the best tax account type in the U.S. (tax deductible, tax-deferred, and tax-free). You’ll have plenty of health expenses in retirement to begin using the account after years of tax-free accumulations.
2. If your 401(k) plan has a Roth option, use it. There are no income limits on a Roth 401(k), so even high-income earners can accumulate tax-free assets here.
3. Fund a Roth IRA each year if you are eligible.
4. Begin funding of a taxable individual, joint, or trust account.
5. If you have maxed out your 401(k) plan and are not eligible for a Roth IRA, contribute the maximum ($5,500/$6,500) to a non-deductible IRA. By carefully coordinating your IRA and 401(k) plan balances and eligibility requirements, you can convert these IRA contributions to a Roth IRA at a later date with minimal tax liability. This is often referred to as a “backdoor” Roth IRA.
6. If you have a particularly flexible 401(k) plan — or are a business owner/partner with the ability to control the features of your 401(k) plan — you can make after-tax non-Roth contributions to your plan, which can be subsequently converted to a Roth IRA with minimal tax liability. This would be the “mega backdoor” Roth IRA.
7. If you are nearing or entering retirement and feel behind on achieving tax diversification, there are some additional techniques you can use to enhance your tax diversification. This can be accomplished with partial Roth IRA conversions in concert with Social Security timing and other income and deduction timing strategies. If properly planned, your tax bracket can be pushed to very low levels for a single year, allowing a low-cost partial Roth conversion to occur. And it may be possible to repeat the technique every few years.

By implementing any number of the above strategies, most people can achieve reasonable tax diversification as they build wealth. Just make sure you are re-examining your current and projected tax diversification each year to make adjustments as needed.

The Benefits of Diversification

It is unlikely you will achieve perfect equalization between the three asset types, but aiming for tax diversification will help:

• minimize tax rates
• prevent the double taxation of Social Security benefits
• avoid higher Medicare premiums
• allow for tax-free payment of health care expenses and long-term care insurance premiums
• facilitate conversion of asset from tax-deferred to tax-free with nominal taxation
• pass wealth tax-free to heirs
• aximize tax deductions and standard exemptions and credits every year
• preserve ability to balance and time income sources
• add to your after-tax income and total lifetime wealth

You will find plenty of opinions claiming one asset type is better than another, but these are always based on certain assumptions that may not come true.

The bottom line is that no one can predict the future, especially decades in advance.  That’s why it’s wise to have assets spread across different asset types. 

The Tax Cut and Jobs Act (TCJA) introduced some significant changes to the rules concerning itemized deductions. In fact, many of the deductions on Schedule A — the itemized deductions — were repealed or modified in a way that limits their use.

Couple this with the (almost) doubling of the standard deduction and it’s not surprising that many taxpayers are simply taking the standard deduction.

With fewer taxpayers itemizing, certain deductible expenses — in particular, charitable contributions — are no longer providing any federal tax benefit.

Rather than giving up on charitable giving, taxpayers can use a strategy known as “bunching” to maintain some tax benefit for those gifts.

Bunching essentially means lumping multiple years’ worth of charitable contributions in a single year in order to take an itemized deduction in year one and the standard deduction in the following years.

How bunching produces Tax benefits

To help illustrate the tax benefit of bunching charitable gifts let’s look at an example assuming:

• A couple is married filing jointly, ages 60 & 58
• Total income reported from various sources is $160,000
• Line 7 of Schedule A (State and Local taxes) usually totals around $10,500
• Line 10 of Schedule A (home mortgage interest) is zero, they have no mortgage
• Line 14 of Schedule A (gifts to charity) is $10,000 per year
• Taxable income in 2019 is 135,600 (assuming they use the standard deduction of $24,400)
• Federal tax liability in 2019 is $19,764 based on the IRS tax chart
• This couple will be taking the standard deduction rather than itemizing, meaning the $10,000 annual gift to charity is no longer tax-deductible
• These underlying numbers will remain unchanged for each of the years

Running a series of multi-year tax projections produces the following tax outcomes.

In this case, lumping charitable contributions provides a total tax savings of $3,476 over three years, with the potential for additional tax savings through capital gains avoidance if appreciated stock is gifted.

bunching QUick guide

How do you know if the strategy makes sense? Hopefully, this decision tree will help you determine if you can benefit from bunching your charitable gifts.

Keep in mind that other tax strategies — like qualified charitable distributions and Roth conversions — can also be deployed when bunching charitable gifts that can produce additional tax savings!

Ultimately, if it looks like you would benefit from bunching your deductions, I suggest discussing it with your tax advisor. They’ll be able to help you navigate the timing of the gifts and the optimal amount, as well as the other strategies that are applicable to you.

Beginning in 2018, there were significant changes to the allowable itemized deductions that could be taken on Schedule A and the standard deduction was increased substantially.

As a result, many taxpayers are no longer be able to itemize deductions which means they don’t receive a tax benefit for making charitable gifts.

However, there still remains a very appealing tax-planning option for folks who are age 70.5 and older called a Qualified Charitable Distribution (QCD).

What is a Qualified Charitable distribution?

A Qualified Charitable Distribution is a direct gift from an IRA (including traditional, rollover, inherited, SEP, and SIMPLE) to a qualified charity.

These distributions have the benefit of satisfying the annual Required Minimum Distribution (RMD) rules while also avoiding income taxes on the distribution — RMDs are taxed as ordinary income.

In fact, QCDs are not included in your adjusted gross income (AGI) at all. Depending on how much you give, this can lower the odds that you’ll be affected by various unfavorable AGI-based rules such as those that can cause more of your Social Security benefits to be taxed and Medicare premiums to increase.

Should i use one?

How do you know if making Qualified Charitable Distributions makes sense for you and your financial situation?

This flowchart will help you get the conversations started with your financial or tax advisor.

things to consider

If you think this strategy is a fit for you, there are some things you’ll want to consider before jumping in head first.

1. Decide early in the year if you want to use a Qualified Charitable Distribution to satisfy your Required Minimum Distribution. The first dollars out of an IRA are considered to be the RMD. If you satisfy your RMD in February but want to do a QCD in November, that income can be excluded, but it won’t offset the income from the RMD taken earlier in the year.
2. Each person can donate up to $100,000 annually using the QCD rule. If you’re married filing jointly, and each of you has an IRA, you can both QCD up to $100,000 per year. Keep in mind that that extra distribution can’t be carried over—i.e., used to meet the required minimum distributions for future years. This contrasts with other strategies, such as a donation of cash and appreciated securities, where a large donation can be made in one year and the tax benefits can be carried forward.
3. Work with your IRA custodian to make sure the QCD is completed correctly. The funds will need to be made payable directly from your IRA to the charity, which means they can’t send you a personal check and you turn around and give it to charity.
4. Make sure your tax preparer knows that you completed the QCD. Your IRA custodian will send you a 1099-R showing the amount withdrawn from your IRA but the QCD may not be clearly identified. If the QCD isn’t properly listed on your tax return, you won’t get the tax benefits of doing it.
5. You can make QCDs to multiple charities, just keep meticulous records for your tax preparer.
6. Verify that the organizations you are giving to qualify. The organization must be a 501(c)(c) and you can’t be receiving a benefit for giving (raffle, sporting event seats, etc.).

As a financial advisor, I help clients navigate rolling over old 401(k)s to IRAs all the time. But what about people who don’t have a financial expert to rely on? They’ll most likely look to the internet for advice. 

I noticed something recently though. The articles and blogs online only give guidance on the first step of a rollover, which is how to initiate one.

I couldn’t find an article that explained what happens after the rollover takes place, which is when some of the most important work actually begins.

That’s because rolling over a retirement plan to another retirement plan is considered a tax-free event. However, if you don’t report the rollover properly, you could be surprised with a tax deficiency letter from the IRS and possibly many hours spent resolving the issue.

Fear not! This is your complete rollover guide — from start to finish — so you’ll never miss a step in the process. 

Before Starting a Rollover

Before actually beginning the rollover process, you’ll need to decide where you want your money to go. 

If you have an old employer retirement plan — like a 401(k), 403(b), etc. — there aren’t very many reasons you’d want to leave it there.

Having multiple accounts at different custodians (the financial institution that holds your money) makes it really difficult to keep track of your finances. By simply rolling over an old retirement plan to another one you will greatly simplify your account structure.

Does your new employer retirement plan accept rollovers? If so, are you comfortable with putting your money there? If you already have an Individual Retirement Account (IRA), would you rather put it there?

Here is a nifty guidethe IRS provides that can help you choose which type of retirement plan you can roll in to. 

Rollover Initiated

Once you’ve decided where the money will be going, you’re going to begin the actual rollover process.

There are a few ways I usually see rollovers initiated:

• With a rollover form that the old custodian will give you
• With a phone call to the old custodian
• With transfer paperwork from your new custodian

It’s at this point that your first major decision takes place because you’ll have two ways the money can be delivered.

Option 1. Have the money sent directly to your new custodian. This is the simplest type of rollover since the money goes from one account to the other, with no involvement or responsibility on your part. This is known as a direct rollover, or trustee-to-trustee transfer.

Option 2. Have the money sent to you and then you forward that money to the new custodian. This is known as an indirect rollover. 

With an indirect rollover, the day you take possession of the money you have 60 days to turn around and put that money into another retirement account. Even if you’re one day late, the entire distribution will become subject to income taxes and the 10% early withdrawal penalty if you’re under the age of 59 1/2.

Outside of some advanced planning strategies, I would generally avoid indirect rollover at all costs because they can be difficult to manage.

After the Rollover Occurs

Okay, the money is in your retirement account but you’re not done yet!

Even though you aren’t required to pay tax on this type of activity, you still must report it to the Internal Revenue Service.

At the end of the year — or early the following year — that your rollover took place, you will receive a Form 1099-R from the custodian who sent the money. The IRS will also be receiving one. That’s because your rollover is reported as a distribution, even when it’s rolled into another eligible retirement account. 

It’s up to you to properly report the rollover on your tax return to avoid paying taxes. To do this, you’ll need to write in the amount shown on the 1099-R on line 4a and a zero on the taxable amount on line 4b. Write “rollover” or “R/O” in the blank space beside it. This will explain to the IRS why the distribution amount shown on line 4a is more than the taxable amount shown on line 4b.

And thats it! After your taxes are filed and the rollover has been reported, you are finally done!

Incorrect Reporting

Keep in mind that when a rollover isn’t reported properly, you’ll receive Notice CP2000 from the IRS asking for the taxes you owe them. I know because it’s happened to me!

If the rollover went into your IRA, you’ll receive Form 5498 from your custodian that can be used to substantiate your case. Make sure you keep these in your tax file.

If the money is sent to an employer retirement plan (401k, 403b, etc.) you won’t receive Form 5498 and it will require a little more work on your end to show the IRS that it was, in fact, a rollover.