#rothira

By:  Arash Navi, CFP®, CPA, Controller & Wealth Manager

Our goal is to help our clients build and grow their wealth and tax planning plays an important role in this process. We recommend that you mark your calendar to review your finances in the first week of October, annually. Take this time to review your income for the year from employment, businesses, investments, or any other sources. This will help you project your tax liability ahead of time and allow your financial advisor or tax accountant to find strategies to reduce your tax burden. Implementing this consistently and reducing your tax burden annually will have a compounding impact over the years and increase your retirement nest egg. Here are a few tax planning strategies to keep in mind:

IRAs and Retirement Plans

Take full advantage of tax-advantaged retirement accounts. By contributing to Traditional IRAs and employer-sponsored retirement plans such as 401(k) plans, you can reduce your taxable income and lower your taxes. For 2023, you can contribute up to $22,500 to a employer-sponsored retirement plan ($30,000 if you’re age 50 or older) and up to $6,500 to a Traditional IRA ($7,500 if you’re age 50 or older).

Roth Conversions

If you are in a lower tax bracket this year and expect your income tax rate to increase in the future, you may want to consider a Roth IRA conversion. You can convert all or part of your pre-tax retirement account into a Roth IRA and pay the taxes now at a lower rate. The funds in your Roth IRA will continue to grow tax free, and you will have more income flexibility in retirement. Watch here as we make a case for Roth conversions and how they could benefit you.

Charitable Donation

If you are charitably inclined, you should plan your donations in advance to ensure you maximize the tax benefits. For those over age 70.5, you may want to consider Qualified Charitable Distribution (QCD), where you can transfer up to $100K from your IRA to a charity. This method not only reduces your Required Minimum Distribution (RMD), but the distribution is also excluded from your taxable income. Beginning in 2024, the QCD limit ($100k) will change as it will be linked to inflation. Also, with the passage of the SECURE Act 2.0, starting in 2023 taxpayers may take advantage of a one-time gift up to $50k (adjusted annually for inflation) to fund a Charitable Remainder Unitrust, Charitable Remainder Annuity Trust, or a Charitable Gift Annuity. This is an expansion of the type of charity, or charities, that can receive a QCD.

Tax Bracket Management

The IRS uses a progressive tax system which means as your income grows, it is subject to a higher tax rate. Therefore, it is important to know which of the seven federal tax brackets you will fall into. In your high-income years, you may want to reduce your tax liability by increasing your retirement contribution or utilize a tax-loss harvesting strategy. On the other hand, in low-income years, you may want to consider Roth IRA conversions, accelerate income recognition, or postpone deductible expenses.

Tax planning should be part of every individual investor’s financial and retirement plan. There are many strategies available for individuals and business owners, but it requires proper planning throughout the year. If you’d like to learn more about tax planning strategies unique to your personal circumstances, feel free to Talk With Us!

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

The tax filing deadline is fast approaching, which means time is running out to fund an IRA for 2022. If you had earned income last year, you may be able to contribute up to $6,000 for 2022 ($7,000 for those age 50 or older by December 31, 2022) up until your tax return due date, excluding extensions. For most people, that date is Tuesday, April 18, 2023. The IRS has postponed the deadline to file federal income tax returns and make tax payments for certain New York storm victims until May 15, 2023, and to July 31, 2023, for certain Mississippi storm victims. The deadline has been postponed for disaster-area taxpayers in most of California and parts of Alabama and Georgia until October 16, 2023 (there is no need to file for an extension). This means certain New York storm victims have until May 15, 2023, to make contributions to an IRA for 2022; certain Mississippi storm victims have until July 31, 2023; and disaster-area taxpayers in most of California and parts of Alabama and Georgia have until October 16, 2023. The current list of eligible localities and other details for each disaster are always available on the Tax Relief in Disaster Situations page on irs.gov.

You can contribute to a traditional IRA, a Roth IRA, or both. Total contributions cannot exceed the annual limit or 100% of your taxable compensation, whichever is less. You may also be able to contribute to an IRA for your spouse for 2022, even if your spouse didn’t have earned income. You can find retirement plan contribution limits for 2022 and 2023 here.

Traditional IRA Contributions may be Deductible

If you and your spouse were not covered by a work-based retirement plan in 2022, your traditional IRA contributions are fully tax deductible. If you were covered by a work-based plan, you can take a full deduction if you’re single and had a 2022 modified adjusted gross income (MAGI) of $68,000 or less, or married filing jointly, with a 2022 MAGI of $109,000 or less. You may be able to take a partial deduction if your MAGI fell within the following limits.

If you were not covered by a work-based plan but your spouse was, you can take a full deduction if your joint MAGI was $204,000 or less, a partial deduction if your MAGI fell between $204,000 and $214,000, and no deduction if your MAGI was $214,000 or more.

Consider Roth IRAs as an Alternative

If you can’t make a deductible traditional IRA contribution, a Roth IRA may be a more appropriate alternative. Although Roth IRA contributions are not tax-deductible, qualified distributions are tax-free. You can make a full Roth IRA contribution for 2022 if you’re single and your MAGI was $129,000 or less, or married filing jointly, with a 2022 MAGI of $204,000 or less. Partial contributions may be allowed if your MAGI fell within the following limits.

Tip: If you can’t make an annual contribution to a Roth IRA because of the income limits, there is a workaround. You can make a nondeductible contribution to a traditional IRA and then immediately convert that traditional IRA to a Roth IRA (this is sometimes called a backdoor Roth conversion). Keep in mind, however, that you’ll need to aggregate all traditional IRAs and SEP/SIMPLE IRAs you own — other than IRAs you’ve inherited — when you calculate the taxable portion of your conversion.

A qualified distribution from a Roth IRA is one made after the account is held for at least five years and the account owner reaches age 59½, becomes disabled, or dies. If you make a contribution — no matter how small — to a Roth IRA for 2022 by your tax return due date, and it is your first Roth IRA contribution, your five-year holding period starts on January 1, 2022.

Prepared by Broadridge. Edited by BFSG. Copyright 2023.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

The federal income tax filing deadline for individuals is generally Tuesday, April 18, 2023.

The IRS has postponed the deadline to file federal income tax returns and make tax payments for certain New York storm victims until May 15, 2023, and to July 31, 2023, for certain Mississippi storm victims. The deadline has been postponed for disaster-area taxpayers in most of California and parts of Alabama and Georgia until October 16, 2023 (there is no need to file for an extension). The current list of eligible localities and other details for each disaster are always available on the Tax Relief in Disaster Situations page on irs.gov.

Need more time?

If you’re not able to file your federal income tax return by the April (or May or July) due date, you can file for an extension by the April (or May or July) due date using IRS Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return. Filing this extension gives you until October 16, 2023, to file your federal income tax return. You can also file for an automatic extension electronically (but only if filed by the original April due date) (details on how to do so can be found in the Form 4868 instructions). There may be penalties for failing to file or for filing late.

Note: Special rules apply if you’re living outside the country, or serving in the military outside the country, on the regular due date of your federal income tax return.

Pay what you owe

One of the biggest mistakes you can make is not filing your return because you owe money. If the bottom line on your return shows that you owe tax, file and pay the amount due in full by the due date if at all possible. If you absolutely cannot pay what you owe, file the return and pay as much as you can afford. You’ll owe interest and possibly penalties on the unpaid tax, but you will limit the penalties assessed by filing your return on time, and you may be able to work with the IRS to pay the unpaid balance (options available may include the ability to enter into an installment agreement).

It’s important to understand that filing for an automatic extension to file your return does not provide any additional time to pay your tax. When you file for an extension, you have to estimate the amount of tax you will owe; you should pay this amount by the April (or May or July) filing due date.  If you don’t, you will owe interest, and you may owe penalties as well. If the IRS believes that your estimate of taxes was not reasonable, it may void your extension.

Tax refunds

The IRS encourages taxpayers seeking tax refunds to file their tax returns as soon as possible. The IRS anticipates most tax refunds being issued within 21 days of the IRS receiving a tax return if the return is filed electronically, the tax refund is delivered through direct deposit, and there are no issues with the tax return. To avoid delays in processing, the IRS encourages people to avoid paper tax returns whenever possible.

IRA contributions

Contributions to an individual retirement account (IRA) for 2022 can be made up to the April due date (without regard to extensions) for filing the 2022 federal income tax return.  Certain New York storm victims have until May 15, 2023, to make contributions to an IRA for 2022; certain Mississippi storm victims have until July 31, 2023; and disaster-area taxpayers in most of California and parts of Alabama and Georgia have until October 16, 2023.

Prepared by Broadridge. Edited by BFSG. Copyright 2023.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

By:  Henry VanBuskirk, CFP®, Wealth Manager

“Who can it be knocking at my door?” It’s the Men at Work and Women at Work in Congress(¹) with new retirement legislation, SECURE Act 2.0. While this new legislation has many positive changes, many of those changes come with added complexity to how the Traditional IRA and Roth IRA contribution limits and catch-up contribution amounts are calculated. For example, the $1,000 catch-up contribution amount for persons aged 50 and older will now be indexed for inflation starting in the 2024 tax year. Further, persons aged 60-63 have an even higher catch-up contribution amount, and then persons aged 64 and older revert back to the $1,000 catch-up contribution amount indexed for inflation rule. The exact wording in the SECURE 2.0 Act is in Sections 108-109 and reads as follows:

Those familiar with the Medicare prescription drug coverage gap usually referred to as the “Medicare Part D donut hole”, know that coverage starts out good, then not so good, and then goes back to being good again. The new catch-up contribution rules in SECURE Act 2.0 for persons aged 50 and older give us a “Reverse Donut Hole”, where catch-up contributions to your Traditional IRA or Roth IRA start off okay, then really good, then go back to being okay. As I’m writing this and thinking through it, a reverse donut hole doesn’t make much sense, so I’m just going to call this catch-up contribution phenomenon created by Congress a donut with no hole. A wise man once said that “…A donut with no hole is a Danish”(²⁾.

Whether you are Danish American, Asian American, African American, or prefer not to specify, chances are you probably want to maximize the potential of your Traditional IRA and/or Roth IRA accounts throughout your lifetime. You also most likely want to also take advantage of the new contribution limits applied by Congress.

The advice that’s generally given is that lower-income earners should contribute to a Roth IRA and higher-income earners should contribute to a Traditional IRA regardless of whether or not that Traditional IRA contribution is deductible or not. However, there is no catch-all solution to this catch-up contribution question for higher-income earners. Our team of CFP® professionals at BFSG can help answer that question for you through a customized financial plan.

If you are a high-income earner that cannot take a deduction on a Traditional IRA contribution and cannot contribute to a Roth IRA (read here for current phaseouts), it may be worth considering a Backdoor Roth IRA strategy. I will illustrate how this strategy works through a case study.

Case Study

Ray Barone (age 40) is a sportswriter for a local Long Island paper making $80,000 per year and is married to Debra Barone (age 40), a homemaker that takes care of their three children. Ray has a Traditional 401(k) at work that he contributes to and does not contribute to any other retirement accounts. Debra does not have any retirement accounts that she contributes to and believes that she is not eligible to contribute to a Traditional IRA or Roth IRA since she doesn’t have any earned income. Ray gets an unexpected call from Sports Illustrated saying that they loved reading his article on the career of retired New York Mets baseball player, Art Shamsky, and offered Ray a job as their Editor in Chief. His salary at Sports Illustrated would be $400,000 per year and full benefits, including a 401(k) plan. Ray almost fell out of his chair when he heard this news since he knew it would mean a significant increase in pay. Ray then asked if he could take time to discuss this job offer with his family and call them back in the morning.

Ray then proceeds to tell Debra, cynical brother Robert, and doting parents Frank and Marie the news and asks what they all think. They have the following conversation:

Debra: “I think this is a great opportunity, go for it, Ray!”

Frank: “Congratulations son, I say take the job.”

Marie: “This is great, Ray! I always knew that one of my sons would be successful!”

Robert: [With a long sigh] “Everybody Loves Raymond.”(³)

Marie: “Robert! Don’t be jealous of Ray’s talent.”

Robert: [Nefariously] “Sorry Ray, I’m happy for you. I really am. Just remember, the higher up the corporate ladder you climb, the further down you have to fall.”

Frank: “Robert, don’t be a jerk to Ray! Maybe I should climb up that corporate ladder and knock some sense into that big head of yours.”

Robert: “Please forgive me, King Ray. I didn’t mean to upset your loyal subjects.”

Ray: “Stop it, everyone! I’ll call Sports Illustrated in the morning and accept their job offer.”

Ray accepts the new job offer but is nervous about making sure his wife and kids have a prosperous future. After Ray starts his new job, Ray and Debra then decide to meet with their advisor, Phil Rosenthal, to have him run a financial plan for them. Ray and Debra’s main goal is to have the greatest possible account value in their retirement accounts so that they can pass on a legacy to their kids. They also know that they need to make sure that Ray continues to contribute to his 401(k) at work.

The Meeting

The first thing Phil recommends is for Ray to maximize his 401(k) contributions at work, which was not a surprise to hear from Ray and Debra. Phil then recommends that Debra start to contribute to a Traditional IRA and make the maximum contribution each year that Ray has earned income. This confuses Debra since she believes that since she has no earned income of her own, she cannot contribute to a Traditional IRA or a Roth IRA. Phil then exclaims, “A non-earning spouse can contribute to a Traditional IRA or Roth IRA as long as the other spouse has earned income.”(⁴⁾ Debra thinks to herself that this is great since with the extra money that Ray is earning, they will be able to afford to contribute to a Traditional IRA for her and Debra asks Phil to run an analysis of what the account could be at her age 100 assuming that she only takes the Required Minimum Distributions (RMDs) in her account and that because of SECURE Act 2.0, her starting age to take RMDs will be age 75. Ray wants to retire at 65 and Ray and Debra want to see the analysis run until their age 100. Phil then proceeds to run the analysis with the following assumptions:

Here is a summary of the results of that analysis based on the assumptions above:

• Total RMDs throughout Debra’s lifetime: $1,087,987.46
• Total Tax on RMDs: $335,644.13

While Phil was running the analysis, Debra reads on the IRS website that they would not be able to take a tax deduction for the contributed amount to her Traditional IRA because Ray makes too much money and also is covered by a 401(k) plan at his work. This leads to the following conversation:

Debra: “Why would anyone contribute to a Traditional IRA now, not be able to deduct the contributed amount, and then pay taxes on their RMDs later in life? I don’t understand the purpose of a nondeductible Traditional IRA.”

Phil: “That’s a great point, Debra. I do recommend contributing to a tax-advantaged account like a Traditional IRA or Roth IRA since the assets in the account will grow tax-deferred. Assets in nonqualified accounts do not grow tax-deferred and taxes could be owed on any dividends, interest, or capital gains earned in the account. The main difference between the Traditional IRA and how you would be able to fund a Roth IRA, you either pay the taxes later in the case of a Traditional IRA or pay taxes now, in the case of a Backdoor Roth IRA strategy. For you and Ray, a Backdoor Roth IRA strategy would be more beneficial to you both in the long run.”

Ray: “What is this Backdoor Roth IRA strategy?”

Phil: “The strategy would be that Debra would contribute to a nondeductible Traditional IRA. She would then immediately convert any amount into a Roth IRA and would repeat this process each year until you retire at 65.”

Ray: “What do you mean by, convert to a Roth IRA?”

Phil: “You establish a Roth IRA and transfer funds from the Traditional IRA. Any funds that are transferred from the Traditional IRA to the Roth IRA are taxable to you as ordinary income. After the funds are in the Roth IRA, they will grow tax-free, and distributions are tax-free as long as the account has been established for 5 years and you are at least age 59.5. A Roth IRA also does not have Required Minimum Distributions.”

Debra: “According to the IRS website, Ray also makes too much money to contribute to a Roth IRA. We can’t do what you are suggesting, Phil.”

Phil: “You are right in that you cannot contribute to a Roth IRA. However, the IRS does allow you to convert existing assets in a Traditional IRA to a Roth IRA. This is referred to as a Backdoor Roth IRA since you have to go through this extra hoop to fund a Roth IRA account because you are above the Roth IRA contribution limit.”

Phil: “What is going on mechanically is you are making after-tax contributions. Instead of receiving a tax deduction for the contribution, your adjusted gross income will stay the same as if you were to never take a tax deduction on the converted amount. You aren’t paying taxes on that nondeductible contribution itself. For example, if a married couple is in the 35% tax bracket with an AGI of $500,000 and decides to make a nondeductible contribution of $5,000 their AGI would still be $5,000. If they could receive a deduction, their AGI could be reduced to $495,000 and their tax bill would be reduced by $1,750. The “tax due from the backdoor Roth” would be this $1,750.”

Debra: “Can you show us the same analysis, but with this Backdoor Roth Strategy?”

Phil: “I’d be happy to.”

Phil then proceeds to run the analysis on the Backdoor Roth Strategy and uses the following assumptions:

The analysis using the assumptions above concluded that the total tax on Roth conversions would be $88,560.43.

Here are a couple of conclusions that we can draw from this analysis:

1. Since Debra would not be subjected to RMDs in a Roth IRA, she would not need to pay taxes on those distributions. That difference in tax savings over their lifetimes is $247,083.70. This is the difference between the total taxes for the Traditional IRA of $335,644.13 and the total taxes for the Backdoor Roth Strategy of $88,560.43.
2. If Ray and Debra decide not to do the Backdoor Roth strategy and did not need the funds from the RMD to live on, they could always reinvest those proceeds in a nonqualified investment account. The nonqualified investment account could grow, and taxes could be owed on any dividends, interest, or capital gains earned on that account. If they needed the funds from the RMDs to live on, they would still owe taxes regardless because they are required to take RMDs on a Traditional IRA.
3. With the Roth IRA strategy, they are able to keep it in a tax-free bucket and not be subjected to RMDs. If they need cash from the Roth IRA to live on in retirement, distributions would be tax-free.
4. Another key factor to consider is that any amount still in the Traditional IRA or Roth IRA at Ray and Debra’s passing would go to their children. Their children would be subjected to the inherited IRA and inherited Roth IRA rules, which declare as of SECURE Act 2.0’s passing, that inherited IRA and inherited Roth IRA accounts are subjected to RMDs on the beneficiary’s life and that the inherited IRA or inherited Roth IRA account must be depleted within 10 years of the original depositor’s death. Inherited IRA distributions are taxable at ordinary income and inherited Roth IRA distributions are tax-free. Not only do Ray and Debra get to enjoy tax-free growth and distributions with a Roth IRA in retirement, but their kids would as well.

Debra and Ray are delighted by the analysis and eager to start the Backdoor Roth Strategy. They proceed to thank Phil for his work and proceed to end the meeting. The next day at work, Ray then thinks about his own 401(k) and if there are additional long-term planning opportunities that they can do. He believes that his plan at work will start to offer employer-matching Roth contributions and not require RMDs from Roth 401(k)s because of the new SECURE Act 2.0 legislation. His thinking comes from the following two sections in the SECURE Act 2.0:

Ray then proceeds to call Phil and ask about this. Phil states, “There might be a financial planning opportunity for you and Debra with a Mega Backdoor Roth strategy. A Mega Backdoor Roth Strategy works similarly to the regular Backdoor Roth Strategy. I am happy to run the numbers for you.” Ray declines since he believes it’s too premature to run the numbers since his company has yet to amend its current 401(k) plan and may not offer matching Roth contributions⁽⁵). Ray feels content for now with Phil’s answer and believes that his financial plan is solid.

Pro-Rata Rule

You may be asking yourself, what if I want to implement a Backdoor Roth strategy or Mega Backdoor Roth Strategy and my existing IRA has some deductible contributions and some nondeductible contributions? In that case, we would need to account for the pro-rata rule. To illustrate the pro-rata rule for an IRA and for a 401(k), we have the following two examples.

IRA: Tom has an IRA worth $100,000 with $30,000 from nondeductible contributions and $70,000 from deductible contributions. If Tom wants to implement a Backdoor Roth Strategy and convert $10,000 from his IRA to a Roth IRA, $3,000 of that converted amount is from nondeductible contributions and $7,000 would be from deductible contributions. Tom would then need to pay tax at ordinary income rates on $7,000 of the $10,000 total converted amount.

This rule is in place so that people implementing Backdoor Roth or Mega Backdoor Roth Strategies aren’t able to pick and choose what converted amounts get taxed and what converted amounts don’t. You will need to make sure to track any nondeductible contributions with the IRS Form 8606 and we strongly recommend working with a trusted tax professional when implementing a Backdoor Roth or Mega Backdoor Roth Strategy.

Conclusion

After reading through this article, you may be thinking why Congress adjusted the catch-up contributions the way they did, why they increased the RMD age to 73 for persons that will be 73 before 01/01/2033 and age 75 for persons that will be 75 after 01/01/2033, or why they had Roth 401(k) RMDs before but now they are getting rid of them. If you are upset about these changes that Congress made, you are free to fill in the following blanks to blame Politician _______ from the ________ Political Party who has Machiavellian intentions to do _________. We aren’t here to judge why Congress does what they do. We just work with the facts that we’re given and plan accordingly. What we do know is that even after the new SECURE Act 2.0, the Backdoor Roth strategy is still available. It may be more beneficial now than ever to consider a Backdoor Roth strategy if your situation is similar to what was described in this article.

Our team of Certified Financial Planners work with you to craft your comprehensive financial plan to understand whether or not a Backdoor Roth strategy is right for you. Please feel free to reach out to us at financialplanning@bfsg.com or 714-282-1566 and let us know how we can be of help. Thank you.

Footnotes:

1. From the ‘80s band, Men at Work, and their song, “Who can it be now?”
2. That great philosopher was Chevy Chase in the movie Caddyshack: https://www.imdb.com/title/tt0080487/.
3. The characters in the case study are from the sitcom, “Everybody Loves Raymond”: https://www.imdb.com/title/tt0115167/.
4. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
5. If you are interested in learning more about a Mega Backdoor Roth strategy and how it impacts your financial plan, our team of CFP® professionals are happy to analyze how this strategy affects your long-term financial goals.

References:

1. https://www.finance.senate.gov/imo/media/doc/Secure%202.0_Section%20by%20Section%20Summary%2012-19-22%20FINAL.pdf
2. https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2023
3. https://www.irs.gov/retirement-plans/2023-ira-deduction-limits-effect-of-modified-agi-on-deduction-if-you-are-covered-by-a-retirement-plan-at-work
4. https://www.medicare.gov/drug-coverage-part-d/costs-for-medicare-drug-coverage/costs-in-the-coverage-gap

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

Please Note: The above projections are based upon historical data and should not be construed or relied upon as an absolute probability that a different result (positive or negative) cannot or will not occur. To the contrary, different results could occur at any specific point in time or over any specific time period. The purpose of the projections is to provide a guideline to help determine which scenario best meets the client’s current and/or current anticipated financial situation and investment objectives, with the understanding that either is subject to change, in which event the client should immediately notify BFSG so that the above analysis can be repeated.

(This is the third article in a four-part series. Click here to read Part 1 and Part 2.)

By:  Henry VanBuskirk, CFP®, Wealth Manager

Mr. Hill arrived in Texas and is eager to talk to his parents about the Roth Conversion idea that he overheard his boss talking about at work last week. Mr. Hill does not know his parents’ finances and just believes that a Roth Conversion will be a good idea for them and for anyone else their age. This is important to understand that while the recommendations that we give are not gospel, there are very few universal financial planning recommendations that can be given. We will show throughout this article why it is important to go through the financial planning discovery process to understand the household’s unique needs, what assets they have to work with, and how realistic their financial goals are before making a Roth Conversion recommendation.

As Mr. Hill heard over the phone, a Roth Conversion is when someone takes funds from an IRA, pays taxes on the distributed amount, and transfers the distributed amount into a Roth IRA. As long as the person is over age 59.5 and waits 5 years before taking money from the Roth IRA, distributions are tax-free. Mr. Hill knows that his parents do not have an advisor and do all of their financial planning work themselves on their financial planning software. Mr. Hill then proceeds to call his parents and they decide to run the numbers. Here is a summary of their financial plan (which we will call the Base Case):

• Hank and Peggy are 68, live in Texas, and are projected to live to age 100.
• Hank and Peggy are retired, but Hank still works part-time at Strickland Propane earning $5,000 per year. Hank plans to work part-time until age 70.
• Peggy earns a pension of $25,000 per year that grows at 2% per year and will pay out throughout both of their lives¹.
• Hank will receive $46,000 per year in Social Security benefits starting at age 70. Peggy does not receive any Social Security benefits.
• They have $25,000 in cash earning 1.55% per year.
• Hank has an IRA worth $102,000 earning 4.66% per year.
• Peggy has an IRA worth $87,000 earning 4.66% per year.
• Their home is worth $480,000 and there is no debt on the property.  The home value is expected to appreciate by 2.5% per year.
• $3,000 per year for Alamo Beer, indexed to inflation at 2.5%
• $30,000 every 10 years to buy a new truck starting in 2025, indexed to inflation at 2.5%

Hank and Peggy want to see the effect of converting both of their IRAs to Roth IRAs. They run the numbers and get the following result:

Hank and Peggy are pleased to see that their total assets are $229,889 greater ($865,087 vs. $635,198) at age 100 by doing the Roth Conversion this year.  Hank and Peggy understand that by doing a Roth Conversion, they would be treating any amount that they convert from their IRA as ordinary income in the year of the conversion.  Therefore, they run the scenario in their tax planning software and get the following result:

Hank and Peggy like what they see and understand that they can pay $32,126 in taxes this year to have an additional $229,889 at the end of their financial plan since they will not be required to take any RMDs (Required Minimum Distributions) during their lifetimes. Hank and Peggy decide to meet with a local advisor, Mr. Handshake that checks their work and commends them for their plan. Mr. Handshake mentions that they have no problem with their planning. The advisor thanks Hank and Peggy for their time and the meeting concludes. Hank has an uneasy feeling about Mr. Handshake since his handshake was not firm. Hank mentions this uneasy feeling to Peggy about Mr. Handshake’s handshake and says he can’t trust a person who doesn’t have a firm handshake. Peggy rolls her eyes and then obliges Hank’s concern and decides to schedule a meeting with another advisor, Mr. Rock, to get a second opinion.

Mr. Rock meets with Hank and Peggy to review their financial plan and their Roth Conversion scenario. He mentions that while their assumptions are correct, there are a couple of items that he wants to make sure that they are aware of. Hank has been listening intently the entire meeting since Mr. Rock’s handshake at the onset of the meeting was very firm. They have the following conversation:

Mr. Rock: “Hank, Peggy, your plan for a Roth Conversion does help out your financial plan in the long run, but it looks like you missed projections for the Medicare Part B and Part D increase when doing a Roth Conversion. I took the liberty of adding a couple of line items to your report:

Mr. Rock: “If you are going to do the Roth Conversion, you are going to need to pay in 2025 an additional $66 per month in Medicare Part B premiums and $12 in Medicare Part D premiums. This threshold that you passed is called IRMAA and was created to help fund the Medicare program². What if I showed you a financial plan that would allow you to convert your IRAs to Roth IRAs over a 5-year period, increase your ending portfolio value by $36,136, and not have to worry about any increase in Medicare Part B or Part D premiums?

Hank and Peggy: “We’re listening.”

Mr. Rock: “First off, here is your updated plan with the new strategy for converting your IRAs to Roth IRAs over a 5-year period.

“As you can see, instead of a portfolio ending value of $865,087 from converting everything in 2023, you can instead have a portfolio ending value of $901,223 from the 5-year Roth Conversion strategy.”

Peggy: “Mr. Rock, hold on. I’m reviewing your tax planning projections for the 5-year Roth Conversion strategy and our plan to Roth convert everything in a 5-year period (for those interested in the calculations and assumptions used, please see the Appendix at the end of this article). Just so we understand correctly if we follow the 5-year Roth Conversion plan we would pay the following taxes:

• $4,059 in 2023
• $4,161 in 2024
• $8,971 in 2025
• $8,507 in 2026
• $9,511 in 2027

For a total tax of $35,209

and if we were to instead Roth convert everything in 2023, we would pay the following taxes if we were to Roth convert everything in 2023:

• $32,126 in 2023
• $0 in 2024
• $1,483 in 2025
• $572 in 2026
• $642 in 2027

For a total tax of $34,823

Why would we do the 5-year Roth Conversion plan if we would be projected to pay more in taxes?”

Mr. Rock: “You are right that you would pay more in taxes to the IRS over the next 5 years if you decided to do a Roth Conversion over the next 5 years instead of Roth convert everything in 2023, but you would also avoid any increase in Medicare Part B and Part D premiums by doing the Roth Conversion over a 5-year period. If you did Roth convert everything at once, you would owe an additional $936 in Medicare Part B and Part D premiums, which is the IRMAA discussion that I had with you earlier. You actually would owe less out of pocket over your lifetimes over the 5-year Roth Conversion plan and since you would be spreading that tax liability over a 5-year period, there is less strain on your portfolio and won’t need to withdraw as much in 2023, which leads to a higher ending portfolio value doing the 5-year Roth Conversion plan.”

Hank: “Can you explain that again?”

Mr. Rock: “Think of IRMAA as a tax, just one that is administered by the Social Security Administration, not the IRS. A tax in my book is any money that you need to pay from your earnings to a government entity to receive services from that government entity. Paying additional money each month for Medicare services whether or not you actually use those services is still money out of your pocket. Breaking down Peggy’s numbers from earlier, your total tax bill looks like this:

• 5-year Roth Conversion plan:
  • $4,059 in 2023
  • $4,161 in 2024
  • $8,971 in 2025
  • $8,507 in 2026
  • $9,511 in 2027

For a total tax of $35,209

• Roth convert everything plan:
  • $32,126 in 2023 + $936 IRMAA increase due in 2025 = $33,062
  • $0 in 2024
  • $1,483 in 2025
  • $572 in 2026
  • $642 in 2027

For a total tax of $35,759

You save $550 over this 5-year period by avoiding any Medicare Part B and Part D increases, increase your ending portfolio value by $36,136, and avoid RMDs during your lifetimes since all of your IRA assets would be in Roth IRAs by the time you reach your RMD age of 73.” 

Hank: “That sounds great to me. What do you think Peggy?”

Peggy: “Sounds great to me. Thank you, Mr. Rock.”

Hank: “Thank you, Mr. Rock.”

Mr. Rock: “You’re welcome. Have a good day.”

Hank and Peggy decide to follow Mr. Rock’s advice and decide to have Mr. Rock manage their finances. There’s only one additional mistake that Hank and Peggy made. They didn’t ask how Mr. Rock was compensated. Luckily, Mr. Rock is a fee-only advisor, and his full title is Mr. Dwayne Rock, CFP®. A CFP® professional has a fiduciary duty, meaning that they strive to put their client’s interest ahead of their own at all times. Further, to be called a fee-only advisor, the advisor must adhere to the following rules (by the CFP Board’s definition)³: (a) the CFP® professional and the CFP® professional’s firm receive no sales-related compensation; and (b) related parties receive no sales-related compensation in connection with any professional services the CFP® professional or the CFP® professional’s firm provides to the client. It is important to note that just because an advisor can earn commissions, doesn’t make them nefarious. However, it is important to know how an advisor gets paid to understand whether or not they actually do have your best interest in their heart at all times when making a recommendation⁴. Tune in next week to see what potential issues can arise if you work with an advisor that puts their bank account ahead of your needs.

Footnotes:

1. This pension benefit was awarded to her for winning “Substitute Teacher of the Year” three years in a row.
2. You can find the IRMAA brackets here https://www.medicareadvantage.com/costs/medicare-irmaa
3. https://www.cfp.net/-/media/files/cfp-board/standards-and-ethics/compliance-resources/cfp-board-guidance-for-fee-only-advisors.pdf
4. BFSG is a fee-only Registered Investment Advisor.

Appendix:

Assumptions used in the tax calculations in the 5-year Roth Conversion plan:

• The pension income increases by 2% compounded interest each year
• The assumed values of the IRA values and the Roth Conversion amounts assume that Hank and Peggy’s IRA balances total $189,000 and increase by 4.66% per year.  The Roth Conversion amount increases by 2.5% per year until the final year has the full remaining balance of $48,627.15 in Traditional IRAs be converted into their Roth IRAs.  Here is the balance in a spreadsheet:

• Hank’s wages increase by 2.5% per year and stop at 2025
• Taxable interest increases by 1.55% per year
• Social Security starts in 2025 and increases by 1.5% per year
• The standard deduction does not sunset back to the proposed 2017 values (adjusted for inflation)

Assumptions used in the ‘Roth convert everything’ plan:

• The pension income increases by 2% compounded interest each year
• The entire combined IRA balance of $189,000 is converted into Roth IRAs in 2023
• Hank’s wages increase by 2.5% per year and stop at 2025
• Taxable interest increases by 1.55% per year
• Social Security starts in 2025 and increases by 1.5% per year
• The standard deduction does not sunset back to the proposed 2017 values (adjusted for inflation)

Disclosures:

Past performance is no guarantee of future results.  Different types of investments involve varying degrees of risk.  Therefore, there can be no assurance that the future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Benefit Financial Services Group [“BFSG”]), or any consulting services, will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  BFSG is neither a law firm, nor a certified public accounting firm, and no portion of its services should be construed as legal or accounting advice. Moreover, you should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from BFSG. A copy of our current written disclosure Brochure discussing our advisory services and fees is available upon request or at www.bfsg.com. The scope of the services to be provided depends upon the needs and requests of the client and the terms of the engagement. Please see important disclosure information here.

Please Note: The above projections are based upon historical data and should not be construed or relied upon as an absolute probability that a different result (positive or negative) cannot or will not occur. To the contrary, different results could occur at any specific point in time or over any specific time period. The purpose of the projections is to provide a guideline to help determine which scenario best meets the client’s current and/or current anticipated financial situation and investment objectives, with the understanding that either is subject to change, in which event the client should immediately notify BFSG so that the above analysis can be repeated.