How to Add Tax Alpha in Today’s Environment

William Reichenstein, Ph.D., CFA, is head of research at the software firms Social Security Solutions Inc. (ssanalyzer.com) and Retiree Inc. (incomesolver.com). He is professor emeritus at Baylor University, and is a frequent contributor to the Journal of Financial Planning and other leading professional journals. His latest book is Income Strategies: How to Create a Tax-Efficient Withdrawal Strategy to Generate Retirement Income.

JOIN THE DISCUSSION: Discuss this article with fellow FPA Members through FPA's Knowledge Circles​​​​. ​​​

The coronavirus pandemic has reduced many households’ 2020 incomes well below their projected levels in future years. This article discusses tax strategies that will allow some households—sometimes with the help of parents or grandparents—to make the most of this scenario.   

Maximizing a Job Loss

Consider a married couple, Joe and Nancy Smith, who lost one or both of their jobs in 2020 due to the coronavirus pandemic. Their joint income in 2020 will place them in the 12 percent tax bracket. Like most pre-retirement-age households, their tax bracket this year is also this year’s marginal tax rate (t0 is 12 percent). Moreover, they expect their marginal tax rate in retirement n years hence to exceed 12 percent, (tn > 0.12).

Due to tax rate increases already scheduled to occur in the Tax Cuts and Jobs Act (TCJA) and the strong probability of new legislation further increasing tax rates, my colleagues and I suspect the tax bracket that many pre-retirement-age households will face in their retirement years will be higher than their current tax bracket. And, due to the taxation of Social Security benefits and income-based Medicare premiums, many retirees will have marginal tax rates in their retirement years that will exceed their then-current tax brackets. The bottom line is that unless the Smiths (1) save virtually nothing for retirement in tax-deferred accounts (TDAs) like a traditional IRA or 401(k); (2) have no pension income in retirement; and (3) the higher future tax rates we anticipate do not materialize, then they will likely have a marginal tax rate in retirement that exceeds 12 percent.  

In this case, the Smiths should not waste the opportunity to convert pretax funds from tax-deferred accounts (TDAs) like a traditional IRA or 401(k), to a Roth account to at least fill the 12 percent tax bracket. If they expect their marginal tax rate to consistently be 22 percent or higher in future years, they should consider making a Roth conversion to fill the 12 percent tax bracket and at least part of the 22 percent tax bracket. [For more on making Roth IRA conversions, see “Why Your Clients Need to Do Roth IRA Conversions Before Year-End.”]

For example, suppose, if not converted this year, then these TDA funds would be withdrawn in retirement when (according to the TCJA) the Smiths will likely be in the 25 percent tax bracket. As explained in previous publications,1 due to the taxation of Social Security benefits, at the margin each $1 of TDA withdrawal could cause another $0.85 of Social Security benefits to be taxed. If the Smiths are in the 25 percent federal tax bracket, then their federal-alone marginal tax rate on these retirement-year TDA withdrawals will be 46.25 percent, [25 percent tax bracket x 1.85].

It is better to convert funds from a TDA to a Roth this year and pay a marginal tax rate of 12 percent (or 12 percent on some of this amount and 22 percent on the remainder) than to retain the funds in the TDA until retirement, if the Smiths would be taxed at a marginal tax rate of 46.25 percent. In this example, they will have 63.7 percent more [(1 – 0.12)/(1 – {0.25 x 1.85}) – 1] after-tax dollars in retirement, than if they retain the funds in the TDA until retirement. 

The Smiths should also consider shifting their 2020 contributions to Roth accounts instead of to TDAs. Per $1 pretax contribution to a TDA in 2020, they could instead contribute $1 (1 – t0) of after-tax funds to a Roth account, where both contributions would reduce this year’s spending by $1 (1 – t0). Assume the funds are invested in the same portfolio that earns r percent pretax return per year before being withdrawn and spend n years hence in retirement. The after-tax value n years hence of this year’s $1 (1 – t0) contribution to a Roth account would be $1 (1 – t0) (1 + r)n. The pretax value n years hence of this year’s $1 contribution to a TDA would be $1 (1 + r)n, while the after-tax value would be $1 (1 + r)n ( 1 – tn), where tn is the marginal tax rate in retirement n years hence.

Comparing these two after-tax amounts shows that the key factor when deciding whether to contribute funds to a TDA or a Roth account is the relative sizes of t0 and tn. If t0 is less than the marginal tax rate in retirement, tn, then each $1 (1 – t0) of after-tax contribution to a Roth account this year will allow them to buy more goods and services in retirement than each $1 of pretax contribution this year to a TDA.

Furthermore, due to the taxation of Social Security benefits and income-based Medicare premiums, many retirees will have a higher marginal tax rate in their retirement years. Based on current law, most low- and middle-income households will have marginal tax rates on a wide range of their retirement income that will be either 150 percent or 185 percent of their tax bracket. By making Roth conversions in 2020 and perhaps the next few years before tax rates rise, these households can avoid these adverse effects.

Giving Funds to Children and Grandchildren

Consider Joe and Sue Robinson. Their current plans are to have their daughter, Beth, inherit some of their funds after their deaths. They are confident they’ll have more funds than they will need to meet their retirement needs. Beth’s 2020 tax rate, which is also her marginal tax rate, is below her expected tax rate in future years.

Beth’s 2020 income is $50,000, and she needs all or most of this income to meet her spending needs. She is not planning to save anything in retirement accounts this year. She will be in the 12 percent federal tax bracket in 2020.

Her parents could give her up to $19,500 to fund a Roth 401(k) at work and up to $6,000 to fund a Roth IRA. If Beth is 25 years old, these funds could grow tax free for 40-plus years before Beth begins to spend them in retirement. Furthermore, suppose Beth eventually gets married and has a son. She outlives her husband and lives 65 more years. Her son inherits some of these funds and withdraws them 10 years after Beth’s death. In this example, some of these funds would grow tax free for 75 years. In short, helping Beth fully fund her contributions to Roth accounts is an extremely tax-efficient way for her parents to give her funds. Of course, her parents will want to be confident that Beth will not withdraw the funds in the next few years to finance a reckless lifestyle. The 10 percent penalty tax for unqualified withdrawals before age 59.5 should encourage her to view these funds as long-term investments. Assuming the child can be trusted, this gifting strategy may be the most tax-efficient way for parents to give funds to their children. 

On a similar note, suppose Beth has a SEP-IRA or traditional IRA from her prior working years. In this example, assume she has $10,000 in a SEP-IRA and her 2020 salary is $40,000. Her parents could give Beth $1,200 to pay the taxes on the conversion of these funds to a Roth IRA this year. This conversion would take advantage of Beth’s low 12 percent marginal tax rate this year. After this conversion, her $10,000 of after-tax funds in a Roth IRA is more than $10,000 of pretax funds in a SEP-IRA.

Assume the underlying investment of the Roth IRA and SEP-IRA is the same, and the cumulative value of the underlying investment increases tenfold in the 40 years before the funds are withdrawn in retirement. If Beth would pay a marginal tax rate of 25 percent on the SEP-IRA withdrawal in retirement, then the after-tax value of the Roth IRA would be 33.3 percent higher than the after-tax balance of the SEP-IRA.

The relative advantage of the $10,000 in the Roth IRA in retirement could be substantially higher. For example, if Beth would pay a marginal tax rate of 46.25 percent on these TDA withdrawals in retirement, due to the taxation of Social Security benefits, then the after-tax value of the Roth IRA would be 86 percent higher in retirement than the after-tax value of the SEP-IRA, [($100,000/($100,000 x {1 – 0.4625}) – 1]. Similarly, if Beth withdraws the SEP-IRA funds in retirement and this withdrawal causes her to pay one or more spikes in Medicare premiums, then the relative advantage of the $10,000 in the Roth IRA will substantially exceed 33.3 percent.   

Finally, Joe and Sue Robinson may want to fund a Roth IRA for their grandchildren. Suppose their 16-year-old grandson, Chase, had a summer job in 2020. Of course, Chase would not be interested in investing his earnings this year in a Roth IRA, where he would have limited access to these funds until at least age 59.5. However, his grandparents could give him an amount equal to the lesser of his earned income this year or $6,000, and these funds could effectively be used to fund his Roth IRA. As a minor, Chase does not even have to know about this Roth IRA for years. However, one day he will learn about his grandparents’ generous gift of funds into his Roth IRA that could grow tax-free for 50-plus years.

In contrast, if the grandparents gave their grandson an equal amount of money that was placed in an investment account in his name, then the unearned income on these funds would be taxed each year. The SECURE Act changed the tax rate on this unearned income to the higher of the parents’ or the child’s tax rate. The ability to fund Chase’s Roth IRA, where the funds could grow tax-free for the rest of his life, is the most tax-efficient method of gifting money to this grandchild.     

These giving strategies are highly tax-efficient in that they allow the gifted funds to grow tax exempt potentially for several decades. In addition, they take advantage of the child’s or grandchild’s relatively low current-year tax rates.   

Endnote

  1. See the 2019 book, Income Strategies: How to Create a Tax-Efficient Withdrawal Strategy to Generate Retirement Income, by William Reichenstein, and the February 2020 Journal of Financial Planning article, “Using Roth Conversions to Add Value to Higher-Income Retirees’ Financial Portfolios,” by Reichenstein and William Meyer. See also the following articles by Reichenstein and Meyer: “Understanding the Tax Torpedo and Its Implications for Various Retirees” (July 2018 Journal of Financial Planning), and “Medicare and Tax-Planning for Higher-Income Households” (summer 2019 Journal of Wealth Management).