Backdoor Roth Going Away

Backdoor Roth Going Away?

Under the current proposals in Washington, the Backdoor Roth is going away. If approved, investors would not be allowed to convert any after-tax money in IRAs to a Roth IRA as of January 1, 2022. This would eliminate the Backdoor Roth strategy and also kill the “Mega-Backdoor Roth” used by funding after-tax contributions to a 401(k) plan.

We have been big fans of the Backdoor Roth IRA and have used the strategy for a number of clients. We will discuss what to do if the Backdoor Roth does indeed go away. But first, here’s some background on Roth IRAs.

The Backdoor Roth Strategy

There are two ways to get money into a Roth: through making a contribution or by doing a conversion. Contributions are limited to $6,000 a year, or $7,000 if you are 50 or older. For Roth IRAs, there are also income limits on who can contribute. For 2021, you can make a full Roth contribution if your Modified Adjusted Gross Income is below $125,000 (single) or $198,000 (married).

If your income is above these levels, the Backdoor Roth may be an option. Let’s say you made too much to contribute to a Roth. You could still make an after-tax contribution to a Traditional IRA and then convert it to your Roth. You would owe taxes on any gains. But, if you put in $6,000, after-tax, and immediately converted it, there would be zero gains. And zero taxes. Yeah, it’s a loophole to get around the income restrictions. But the IRS determined that it was legal and people have been doing it for years.

This change won’t happen until January 1. So, you can still complete a Backdoor Roth now through the end of the year. I have some clients who wait until April to do their IRAs, but this year, you had better do the Backdoor by December 31. If you are eligible for the Backdoor, you should do it. Why would you not put $6,000 into an account that will grow Tax-Free for the rest of your life? Couples could do $12,000 or up to $14,000 if they’re over 50.

Instead of the Backdoor Roth…

Your 401(k) Plan may offer a Roth option. Many people are not maximizing their 401(k) contributions. You can contribute $19,500 to your 401(k), or $26,000 if over 50. Let’s say you are currently contributing $12,000 to your 401(k) and $6,000 to a Backdoor Roth. Change that to $12,000 to your Traditional 401(k) and $6,000 to your Roth 401(k). You can split up your $19,500 in contributions however you want between the Traditional and Roth buckets. I often find that with couples that there is room to increase contributions for one or both spouses.

Self-employed? Me, too. I do a Self-Employed 401(k) through TD Ameritrade. Through my plan, I can also make Traditional and Roth Contributions. And I can do Profit-Sharing contributions on top of the $19,500. It’s better than a SEP-IRA, and there is no annual fee. I can set up a Self-Employed 401(k) for you, too.

What if you have both W-2 and Self-Employment Income? In this case, you can maximize your 401(k) at your W-2 job and then contribute to a SEP for your self-employment. Contact me for details.

Health Savings Accounts. HSAs are the only account where you get both an upfront tax-deduction and the money grows tax-free for qualified expenses. And there’s no income limit on an HSA. As long as you are participating in an HSA-compatible high deductible plan, you are eligible. If you are in the plan for all 12 months, you can contribute $3,600 (individual) or $7,200 (family) to an HSA this year.

529 Plans. You want to grow investments tax-free with no income limits and very high contribution limits? Well, that sounds like a 529 College Savings Plan. If your kids, grand-kids, or even great-grand-kids will go to college, you could be growing that money tax-free. They don’t even have to be born yet, you can change the beneficiary later. We can use 529 plans like an inter-generational educational trust that also grows tax-free. And 529s will pass outside of your Estate, if you are also following the current proposals to cut the Estate Tax Exemption from $11.7 million to $5 million.

ETFs in a Taxable Account. Exchange Traded Funds (ETFs) are very tax-efficient. Hold for over a year and you could qualify for long-term capital gains treatment. Today, long-term capital gains taxes are 15%, whereas your traditional IRA or 401(k) money will be taxed as ordinary income when withdrawn, which is 22% to 37% for most of my clients. Some clients will drop to the 12% tax bracket in retirement, which means their long-term capital gains rate will be 0%. A married couple can have taxable income of up to $81,050 and pay zero long-term capital gains! (Taxable income is after deductions. If a couple is taking the standard deduction of $25,100, that means they could have gross income of up to $106,150 and be paying zero capital gains.)

Tax-Deferred Annuity. Instead of holding bonds in a taxable account and paying taxes annually, consider a Fixed Annuity. Today, I saw the rates on 5-year annuities are back to 3%. An annuity will defer the payment of interest until withdrawn. There are no RMDs on Annuities, so you could defer these gains for a long-time, potentially. And if you are in a high tax bracket now, you could hold off on taking your interest until you are in a lower bracket in retirement.

Save on Taxes

If Congress does away with the Backdoor Roth, we will let you know. There are a lot of moving parts in this 2,400 page bill and some will change. Whatever happens, my job will remain to help investors achieve their goals. We invest for growth, but we know that it is the after-tax returns that matter most. So, my job remains to help you find the most efficient and effective methods to keep more of your investment return.

Charitable Giving in 2021

Charitable Giving in 2021

For anyone who is looking at their charitable giving in 2021, there are some important things to know. In 2020 as the Coronavirus started, the government recognized the terrible impact the pandemic would have on charities. As a result, the CARES Act included several new tax benefits to encourage charitable giving in 2020.

  • If you made a cash donation in 2020, you could deduct $300 from your tax return. This was “above the line”, which means you did not have to itemize your deductions to take this $300 deduction. (If your itemized deductions exceed your standard deduction, you could deduct more than the $300.)
  • Normally, your cash donations are limited to 60% of your Adjusted Gross Income. The CARES Act increased this to 100% for 2020. (Excess donations could be carried forward for 5 years.) This means that if your income was $400,000, you could donate $400,000 and reduce your AGI to zero.

CARES Act Provisions Extended

Both of those benefits were only for 2020. But as Milton Friedman said, “there is nothing as permanent as a temporary government program.” So, the government has extended these two benefits under the Coronavirus Response and Relief Supplemental Appropriations Act of 2021.

For 2021, you can still deduct $300 for cash donations as an above the line deduction. Unlike 2020, this is per spouse, so a married couple filing jointly can deduct $600 in 2021. And the 100% of AGI limit is also extended through December 31, 2021. Note that these apply only to “cash” donations and not to donations of stocks or goods. The limit for donating stocks remains 30% of AGI.

I do have to question whether you really would want to deduct 100% of AGI and take your taxable income to zero for one year. Let’s say you have $400,000 in annual taxable income, want to donate $400,000, and are married. Consider these two simplified scenarios. I’m using the 2021 tax rates for both years (we don’t know yet the exact income levels for 2022.)

  • You donate $400,000 in year one. Your taxes are zero. The next year, your income is back to $400,000. In year 2, you would owe $84,042 in Federal Income Taxes.
  • You donate $200,000 in years one and two. In both years, your remaining taxable income is $200,000. You would owe $36,042 in each year, for a total of $72,084 over two years. So, you actually would save $12,000 in taxes by spreading out your donations over two years, rather than doing 100% in one year. That’s because with a graduated tax system, taking your taxes to zero isn’t necessary. You pay only 12% on taxes up to $81,050.

Charitable Strategies for 2021

  • If you do want to make a large donation, consider pairing it with a Roth Conversion. The donation could take your AGI to zero, and then you can choose how much of your IRA/401(k) you want to convert and pay those taxes today. Then, your Roth is growing tax-free.
  • For many individuals or couples, the $300/$600 donation fully covers their charitable giving in 2021. Make sure you keep your receipts and donation letters! Most donors do not have enough deductions to itemize.
  • You can still donate your appreciated securities and save on capital gains tax. Do this if your donations will remain under the 30% of AGI threshold. Even if you are only taking the standard deduction, at least you will avoid capital gains. If you itemize and exceed the 30% threshold, you can carry forward your donations for five years.
  • Pack your donations into one year and establish a Donor Advised Fund (DAF). You get the upfront tax deduction and can then distribute money to charities in the years ahead. This is a good strategy if you are having a year with very high income, such as from selling a business or large asset.
  • If, on the other hand, you anticipate that your tax rate will be going up, spread out your donations or hold off to future years. This could be due to your income going up, tax increases from Washington on the wealthy, or the sunset of current tax rates after 2025.
  • If you are over age 70 1/2, you can give from your IRA tax-free. If you are 72, this counts towards your RMD. While the CARES Act eliminated RMDs for 2020, they are back for 2021. You can make a Qualified Charitable Donation (QCD) of up to $100,000 a year from your IRA.

Tax Smart Giving

No one gives to charity just for the tax benefits. We have causes and organizations we want to support. Giving back is a way of showing gratitude for our success, helping others, and being a positive contributor to making the world a better place. When we have an Abundance mindset, giving with purpose is a joy. Still, if we can be smart about our charitable giving in 2021, there can be significant tax savings. That could mean not only lower taxes for you, but ultimately, more money can go to charities in the years ahead.

Since our founding in 2014, Good Life Wealth Management has donated 10% of profits to charity each year. Additionally, we offer a Matching Gift Program to our clients each fall, in which we match $200 of donations to their favorite charity.

Strategies if the Step-Up in Basis is Eliminated

Strategies if the Step-Up in Basis is Eliminated

Today, we look at strategies if the step-up is basis in eliminated for estate planning. There were two new proposals in the Senate this week which will target inherited wealth. These two Acts, if passed, would completely change Estate Planning for many families. The two Acts are called the STEP Act and the 99.5% Act.

The STEP Act

The STEP Act (Sensible Taxation and Equity Promotion Act), proposed by Senators Booker, Sanders, Warren, Whitehouse, and Van Hook would eliminate the Step-Up in Cost Basis. A Step-Up in Basis means that upon Death, an asset has its cost basis reset to the date of death. This allows the heirs to immediately sell an asset and receive the funds without owing any taxes. Or, if they choose to hold on to the asset, they will only owe tax on the capital gains from the date of death forward. Otherwise, they would owe taxes based on their parent’s cost basis (or other decedent).

The STEP Act proposes to eliminate the Step Up in Basis, retroactively to January 1, 2021. In its place, the Act would allow a one-time exclusion of up to $1 million of inherited capital gains. It also allows the tax to be paid over 15 years if it is an illiquid asset like a farm or business. Many older parents have held on to assets, such as mutual funds or real estate, specifically to get a step-up in basis for their children. Allowing for the exclusion of $1 million in capital gains at death will help most families. But include real estate, and many families will have over $1 million in unrealized capital gains. And those families will now be paying a capital gains tax.

The 99.5% Act

The 99.5% Act, proposed by Senator Sanders, will increase the Estate Tax paid by many families. Currently, the Estate Tax Exemption is $11.7 million ($23.4 million for a couple), which has effectively eliminated the Estate Tax for Middle Class Families. Previously, the Estate Tax Exemption was $1 million, as recently as 2003. My clients have welcomed the increase of the Estate Tax Exclusion over the past 17 years. The 99.5% Act includes provisions to:

  • Reduce the Estate Exemption from $11.7 million to $3.5 million.
  • Reduce the Unified Gift Exemption from $11.7 million to $1 million per lifetime.
  • Raise the Estate Tax Rate to a range of 45-65%.
  • Reduce the Annual Gift Tax Exclusion from $15,000 to $10,000 per donee, AND impose an annual limit of $20,000 per donor.
  • Reduce certain tax benefits of Trusts, Generation Skipping Trusts, etc.

While I don’t cater to the ultra-wealthy, I do have a number of Middle Class families who this will impact. Ideas in Washington often stick around until they become reality. So, if these Acts don’t get passed now, don’t think that we will never hear them again. I don’t think there will be much empathy for families who have over $1 million in unrealized capital gains. However, in some cases, children will need to sell the houses, farms, and businesses they inherit to pay for these new taxes.

How Many Taxes?

Just to be clear, the Estate Tax is in addition to any Income Tax or Capital Gains Tax. Under the two proposals, an individual who dies with $5 million, would owe a 45% Estate tax on $1.5 million (the amount above $3.5 million). That’s a $675,000 Estate Tax Bill. Then, if their cost basis was $1 million and the unrealized capital gain was $4 million, the heirs would owe another 23.8% on $3 million of capital gains. That would be another $714,000 in taxes, for a total of $1,389,000. Presently, that tax would be zero, so we are talking about a huge increase. Let’s consider eight strategies if the step-up in basis is eliminated and other changes enacted.

Ways to Reduce Taxes under STEP and 99.5% Acts

1. If the Step-Up in Basis is eliminated, you may want to pay your capital gains gradually. Aim to keep your total unrealized gains under $1 million. For example, if you have $2 million in gains, perhaps you could harvest $100,000 of gains for the next 10 years. The goal is for you to pay the gains gradually at the 15% rate and save your heirs from being taxed at the 23.8% rate.

There is a separate proposal from Biden to increase the long-term capital gains rate for taxpayers in the highest tax bracket to 39.6%. Plus you would be subject to the 3.8% Medicare Surtax and state income taxes. And then, capital gains will be taxed at 43.4% to well over 50% in many states. The government would take more than half of your gains! If that happens, it will be vitally important to harvest gains regularly to avoid pushing your heirs into the top bracket.

Roth IRAs

2. Keep your high growth investments in a Roth IRA. Beneficiaries inherit a Roth IRA income tax-free. The Roth 401(k) looks better every year, versus a tax-deferred Traditional 401(k). If higher taxes are ahead, it may be preferable to use the Roth 401(k).

3. Gradually convert your Traditional IRAs to a Roth. By pre-paying the taxes today, you can both shrink the size of your taxable estate and reduce the Income tax burden on your heirs. The current tax rates will expire after 2025. The next five years is a good window to make Roth conversions.

Plan Your Giving

4. Give away your full Annual Gift Tax Exclusion every year. Reduce your Estate. Please note that the direct payment of someone’s medical or education bills does not count towards the annual exclusion. Do not reimburse your children for those expenses – make the payment directly to the doctor, college, etc.

5. If you make charitable donations, give away your most highly appreciated securities, rather than cash. This will reduce your taxable gains. If you do want to leave money to charity, make a charity a beneficiary of your Traditional IRA. If you are over age 70 1/2, you can make charitable donations of up to $100,000 a year from your IRA as Qualified Charitable Donations, or QCDs. QCDs can reduce your taxes so you have more budget to harvest capital gains from taxable accounts. You do not have to itemize to deduct QCDs.

Other Estate Tax Savings

6. Sell your primary residence. A couple, while alive, can exclude $500,000 in capital gains on the sale of their primary residence, as long as they lived there at least 2 of the past 5 years. ($250,000 for single filers.) Let your kids inherit the house and that capital gains exclusion may be lost. Better to sell it yourself and buy another house where you don’t have the big capital gains.

7. Maximize your contributions to 529 College Savings Plans for your children or grandchildren. These will pass outside of your taxable estate and will grow tax-free for the beneficiaries. 529 Plans will not be taxable under any of these proposals, and will become a more important estate planning tool.

8. Life Insurance proceeds are not subject to income tax to the beneficiary. Additionally, If we establish your insurance policy with an Irrevocable Life Insurance Trust (ILIT) as the owner, the life insurance will pass outside of your Estate and not be subject to the Estate Tax. This didn’t matter as much when the Estate Exemption was $11.7 million. ILITs will benefit a lot more families if the Estate Exemption is reduced to $3.5 million. Include the tax benefits, and Permanent Life Insurance looks even better as an asset.

Higher Taxes Ahead?

I am proud to be an American and pay my fair share of taxes. Still, these proposals represent a massive tax increase on a lot of families. Many professional couples have the potential to have over $3.5 million before they pass away, and easily over $1 million in capital gains, too. We will keep you posted on this legislation. It seems likely that the two Acts will be merged and some compromise reached before a final version is up for a vote.

Luckily, there is a lot we can do to offset some of these proposed taxes and reduce the burden on your Estate and Heirs. Last minute strategies won’t work here, though. Families need to be thinking about their transfer of wealth years and decades ahead of time. Have questions on strategies if the step-up in basis is eliminated? Feel free to drop me an email.

Tax Strategies Under Biden

Tax Strategies Under Biden

With the Presidential election next month, investors may be wondering about what might happen to their taxes if Joe Biden were to win. Let’s take a look at his tax plan and discuss strategies which may make sense for high income investors to consider. I am sharing this now because we might consider steps to take before year end, which is a short window of time.

Let’s start with a few caveats. I am not endorsing one candidate or the other. I am not predicting Biden will win, nor am I bashing his proposals. This is not a political newsletter. Even if he is elected, it is uncertain that he will be able to enact any of these proposals and get them passed through the Senate. The discussion below is purely hypothetical at this point.

My job as a financial planner is to educate and advise my clients to navigate tax laws for their maximum legal benefit. I create value which can can save many thousands of dollars. Some of Biden’s proposals have the potential to raise taxes significantly on certain investors. If he does win, we may want to take steps before December 31, if we think his proposals could be enacted in 2021. I would do nothing now. I expect no significant changes under a continued Trump administration, but I will also be looking for tax strategies for that scenario.

Other Biden proposals will lower taxes for many people. For example, he proposes a $15,000 tax credit for first-time home buyers. I am largely ignoring the beneficial parts of his tax plan in this article, because those likely will not require advance planning.

Tax Changes Proposed by Biden

1. Tax increases on high earners. Biden proposes to increase the top tax rate from 37% back to 39.6%. He would eliminate the Qualified Business Income (QBI) Deduction, which would penalize most self-employed business owners. He would limit the value of itemized deductions to a 28% benefit. For those with incomes over $1 million, he proposes to increase the long-term capital gains and qualified dividend rate to the ordinary income rate, an increase from 20% to 39.6%, plus the 3.8% Medicare surtax. He proposes to add 12.4% in Social Security payroll taxes on income over $400,000.

Strategies:

  • Accelerate earnings, capital gains, and Roth Conversions into 2020 to take advantage of current rates.
  • Accelerate tax deductions into 2020, such as charitable donations or property taxes. Establish a Donor Advised Fund in 2020.
  • Increase use of tax-free municipal bonds, and use ETFs for lower taxable distributions. Shift dividend strategies into retirement accounts.
  • Use Annuities for tax deferral if you anticipate being in a lower bracket in retirement.

2. 26% retirement contribution benefit. Presently, your 401(k) contribution is pre-tax, so the tax benefit of a $10,000 contribution depends on your tax bracket. If you are in the 12% bracket, you would save $1,200 on your federal income taxes. If you’re in the 37% bracket, you’d save $3,700. Biden wants to replace tax deductibility with a flat 26% tax credit for everyone. On a $10,000 contribution to a 401(k), everyone would get the same $2,600 tax credit (reduction). This should incentivize lower income folks to put more into their retirement accounts, because their tax savings would go up, if they are in the 24% or lower bracket. For higher earners, however, this proposal is problematic. What if you only get a 26% benefit today, but will be in the 35% bracket in retirement? That would make a 401(k) contribution a guaranteed loss.

Strategies:

3. End the step-up in cost basis on inherited assets. Currently, when you inherit a house or a stock, the cost basis is reset to its value as of the date of death. Under Biden’s plan, the original cost basis will carry over upon inheritance.

Strategies:

  • If parents are in a lower tax bracket than their heirs, they may want to harvest long-term capital gains to prepay those taxes.
  • Life Insurance would become more valuable as death benefits are tax-free. Or Life Insurance proceeds could be used to pay the taxes that would eventually be due on an inherited business or asset. Read more: The Rate of Return of Life Insurance.

4. Cut the Estate Tax Exemption in half. Presently, the Estate/Gift Tax only applies on Estates over $11.58 million (2020). Biden wants to cut this in half to $5.79 million (per spouse).

Strategies:

  • If your Estate will be over $5.79 million, you may want to gift the maximum amount possible in 2020. Alternatively, strategies such as a Trust could be used to reduce estate taxes. (For example, the Intentionally Defective Grantor Trust (IDGT) or Grantor Retained Annuity Trust (GRAT).)
  • Be sure to use all of your annual gift tax exclusion, presently $15,000 per person.
  • Establish 529 Plans, which will be excluded from your estate.
  • Shift Life Insurance out of your Estate, using an Irrevocable Life Insurance Trust (ILIT).

While we don’t know the outcome of the election, there could be valuable tax strategies under Biden. We will continue to analyze economic proposals from both candidates to develop planning strategies for our clients. When there are significant changes in tax laws, we want to be ahead of the curve to take advantage wherever possible.

CARES Act RMD Relief

CARES Act RMD Relief for 2020

The Coronavirus Aid, Relief, and Economic Security CARES Act approved this weekend eliminates Required Minimum Distributions from retirement accounts for 2020. If you have an inherited IRA, also known as a Stretch or Beneficiary IRA, there is also no RMD for this year. We are going dive into ideas from the CARES Act RMD changes and also look at its impact on charitable giving rules.

Of course, you can still take any distribution that you want from your retirement account and pay the usual taxes. Additionally, people who take a premature distribution from their IRA this year will not have to pay a 10% penalty. And they will be able to spread that income over three years.

RMDs for 2020

Many of my clients have already begun taking their RMDs for 2020. (No one would have anticipated the RMD requirement would be waived!) Can you reverse a distribution that already occurred? Not always. However, using the 60-day rollover rule, you can put back any IRA distribution within 60 days.

If you had taxes withheld, we cannot get those back from the IRS until next year. However, you can put back the full amount of your original distribution using your cash and undo the taxable distribution. You can only do one 60-day rollover per year.

For distributions in February and March, we still have time to put those distributions back if you don’t need them. Be sure to also cancel any upcoming automatic distributions if you do not need them for 2020.

If you are in a low tax bracket this year, it may still make sense to take the distribution. Especially if you think you might be in a higher tax bracket in future years. An intriguing option this year is to do a Roth Conversion instead of the RMD. With no RMD, and stocks down in value, it seems like a ideal year to consider a Conversion. Once in the Roth, the money will grow tax-free, reducing your future RMDs from what is left in your Traditional IRA. We always prefer tax-free to tax-deferred.

Charitable Giving under the CARES Act

Congress also thought about how to help charities this year. Although RMDs are waived for 2020, you can still do Qualified Charitable Distributions (QCDs) from your IRA. And for everyone who does not itemize in 2020: You can take up to $300 as an above-the-line deduction for a charitable contribution.

Also part of the CARES Act: the 50% limit on cash contributions is suspended for 2020. This means you could donate up to 100% of your income for the year. This is a great opportunity to establish a Donor Advised Fund, if significant charitable giving is a goal.

Above the $300 amount, most people don’t have enough itemized deductions to get a tax benefit from their donations. Do a QCD. The QCD lets you make donations with pre-tax money. Of course, you could do zero charitable donations in 2020 and then resume in 2021 when the QCD will count towards your next RMD. But I’m sure your charities have great needs for 2020 and are hoping you don’t skip this year.

The Government was willing to forgo RMDs this year to help investors who are suffering large drops in their accounts. To have to sell now and take a distribution is painful. However, if you already took a distribution, you are not required to spend it. You can invest that money right back into a taxable account. In a taxable account, the future growth could receive long-term capital gains status versus ordinary income in an IRA. I’ll be reaching out to my clients this week to explain the 2020 CARES Act RMD rules. Feel free to email me if you’d like our help.