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.

COVID Relief Bill

COVID Relief Bill Passes

A new bi-partisan COVID Relief bill passed Congress this week and will impact almost every American in a positive way. This stimulus legislation creates additional income and tax benefits to offset the economic damage of Coronavirus. The $900 Billion bill includes another stimulus payment to most Americans, an extension of unemployment benefits, and seven tax breaks. As of this morning, President Trump has not yet signed the bill.

$600 Stimulus Payment

The CARES Act provided many families with stimulus checks this summer. Those checks were for up to $1,200 per person and $500 per child. There will be a second stimulus check now, for $600 per person. Parents will receive an additional $600 for each dependent child they have under 17. Adult dependents are not eligible for a check.

Like the first round of checks, eligibility is based on your income. Single tax payers making under $75,000 are eligible for the full amount. Married tax payers need to make under $150,000. There is a phaseout for income above these thresholds.

Payments will be distributed via direct deposit, if your bank information is on file with the IRS. If not, like before, you will be mailed a pre-paid debit card. This payment will not be counted as taxable income. Payments should start in a week and are expected to be delivered much faster than the two months it took this summer.

These $600 payments are again based on your 2019 income, but will be considered an advanced tax credit on your 2020 income. What if your 2019 income was above $75,000, but your 2020 income was below? If you qualify on your 2020 income, the IRS will provide the $600 credit on your tax return in April. If they send you the $600 based on your 2019 income and your 2020 income is higher, you do not have to repay the tax credit. This is a slightly different process than the first round of checks, and will benefit people whose income fell in 2020.

Unemployment Benefits

The CARES Act provided $600 a week in Federal Unemployment Benefits, on top of State Unemployment Benefits. This amount was set to run out on December 26. The new COVID Relief Bill provides an 11-week extension with a $300/week Federal payment. Now, unemployed workers will have access to up to 50 weeks of benefits, through March 14. Unfortunately, because of how late the legislation was passed, states may be unable to process the new money in time. So, there may be a gap of a few weeks before benefits resume.

Seven Other Tax Benefits

  1. Child Tax Credit and Earned Income Tax Credit. Under the new legislation, tax payers can choose between using their 2019 or 2020 income to select whichever provides the larger tax credit.
  2. Payroll Tax Deferral. For companies who offered a deferral in payroll taxes in Q4, the repayment of those amounts was extended from April to December 31, 2021.
  3. Charitable Donations. The CARES Act allows for a $300 above-the-line deduction for a 2020 cash charitable contribution. (Typically, you have to itemize to claim charitable deductions.) The new act extends this to 2021 and doubles the amount to $600 for married couples.
  4. Flexible Spending Accounts (FSAs). Usually, any unused amount in an FSA would expire at the end of the year. The stimulus package will allow you to rollover your unused 2020 FSA into 2021 and your 2021 FSA into 2022.
  5. Medical Expense Deduction. In the past, medical expenses had to exceed 10% of adjusted gross income to be deductible. Going forward, the threshold will be 7.5% of AGI. This will help people with very large medical bills.
  6. Student Loans. Under the CARES Act, an employer could repay up to $5,250 of your student loans and this would not be counted as taxable income for 2020. This benefit will be extended through 2025.
  7. Lifetime Learning Credit (LLC). The LLC was increased and the deduction for qualified tuition and related expenses was cancelled. This will simplify taxes for most people, rather than having to choose one.

Read more: Tax Strategies Under Biden

Summary

The new COVID Relief Bill will benefit almost everyone and will certainly help the economy continue its recovery. For many Americans, the stimulus payments and continued unemployment benefits will be a vital lifeline. Certainly 2020 has taught all of us the importance of the financial planning. Having an emergency fund, living below your means, and sticking with your investment strategy have all been incredibly helpful in 2020.

Read more: 10 Questions to Ask a Financial Advisor

If you are thinking there’s room for improvement in your finances for 2021, it might be time for us to meet. Regardless of what the government or the economy does in 2021, your choices will be the most important factor in determining your long-term success. We will inevitably have ups and downs. The question is: When we fall, are we an egg, an apple, or a rubber ball? Do we break, bruise, or bounce back? Planning creates resilience.

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.