We spent much of 2021 watching the news, wringing our hands, and waiting for the politicians in Washington to make dramatic changes to our tax code system. Thus far, we have not seen any of the tax law changes proposed by the Democrats make their way into law. With the current “Build Back Better” bill passed by the House on 11/19/2021, there are not significant changes to capital gains or ordinary income tax rates unless your income exceeds $10 million or your IRA account balance exceeds $10 million. Of course, new factors could be added onto the bill before it becomes law. We may yet see new taxes.
This reminds us of the importance of taxes with regard to your portfolio. At Bragg, we like our clients to have choices when it comes to sources of retirement income. Specifically, we like the idea of having different money types or accounts from which to draw after retirement. Different account types give you more control over your retirement distribution strategies. Different money types include pre-tax accounts like traditional IRAs and retirement plans, after-tax accounts, Roth IRAs, 529 Plan savings accounts, and even health savings accounts (HSAs).
We may not be able to predict what tax law will look like by the end of 2022, and we certainly can’t predict what rates might be beyond 2022. But we can own various types of accounts that are treated differently from a tax perspective. Some might be taxed as ordinary income, some at capital gain rates, and others never taxed at all; some grow tax-deferred and others grow tax-free. To illustrate, here are the various account types and how they are treated from a tax perspective. Following the chart is a more detailed explanation of the various types of accounts and the tax treatment for each:
|Account Type||Are contributions tax‑deductible?||Does the account grow tax‑deferred?||How are distributions taxed?|
|Traditional IRA||Yes, if income is below certain level||Yes||Ordinary income*|
|Traditional 401(k)||Yes||Yes||Ordinary income*|
|Roth IRA||No||Yes||No tax*|
|Roth 401(k)||No||Yes||No tax*|
|Taxable Account||No||No; you will pay tax on dividends, interest, and realized capital gains along the way||You continue to pay tax on dividends, interest, and realized capital gains each year|
|529 Plan Account||No**||Yes||Tax-free if distributions are qualified 529 education expenses|
|HSA Account||Yes***||Yes||Tax-free if distributions are qualified medical expenses|
|* Distribution rules apply to all retirement accounts; this article does not cover these rules.
** Certain states allow deductibility of 529 Plan contributions to a certain level.
***Contributions to HSAs are only allowed if you are participating in a high-deductible health plan.
If you have earned income, you can contribute to an IRA or 401(k). You receive the benefit of reduced income tax in the year you make contributions to the 401(k). For contributions to an IRA to be deductible, your income must be below a certain level. Your IRA/401(k) contributions grow tax-deferred until you start to withdraw the funds. Once you meet qualifications for withdrawing from your IRA, every dollar withdrawn from these accounts is a dollar of taxable income, taxed at ordinary income tax rates. If all of your retirement savings is in a traditional IRA or 401(k) when you retire, then the only source available to fund your draw is from these accounts. If you need to draw $120,000 a year to support your retirement living expenses, then your ordinary income will be $120,000 from this source. Upon reaching age 72, you are also required to distribute a certain amount from these accounts annually; this required withdrawal amount is an RMD (required minimum distribution), which is treated as ordinary income. You don’t necessarily have to spend this amount, but you will pay tax on it. A very large IRA balance will mean significant income, beginning at age 72, whether you need the funds or not. In addition to paying more tax on a higher level of ordinary income, hitting certain thresholds can trigger other ancillary taxes such as an increased capital gain tax rate, unearned income Medicare contribution tax (NIIT), or an increase in Medicare Part B premium rates (IRMAA).
The current version of the Build Back Better bill Includes limiting contributions to IRA accounts once they have reached a balance of $10 million, and accelerating the required minimum distributions in this case.
If your employer offers a Roth 401(k), it makes sense to consider contributing a portion of your retirement savings to this plan. If you have earned income and your AGI (adjusted gross income) is below a certain amount, you can also contribute to a Roth IRA. While you don’t receive an income tax break in the year you make contributions to a Roth, your contributions grow tax-deferred. Once you meet qualifications for withdrawing from your Roth IRA, you also are not taxed on any of the distribution amount. If you need to draw $120,000 a year to support your retirement living expenses, then your ordinary income will be $0 if all is drawn from the Roth. Another plus to Roth accounts: Required Minimum Distributions are not required at age 72 as they are in the traditional retirement accounts above. This means you can leave the funds growing tax-free if you don’t need to draw from this source to support your expenses. If you haven’t guessed, we are big fans of Roth IRAs.
There are currently three other ways to build Roth IRA balances: Roth conversions, backdoor Roth Conversions, and Mega backdoor Roth contributions. The latter two options are on the chopping block in the BBB bill, so stay tuned to see if these are available beyond the passing of new legislation. We recommend making any backdoor Roth conversions as early as possible in 2022, in case this change is enacted on the date of legislation passing. Roth conversions may be a good option if you don’t already have a large traditional IRA balance, and if you find yourself in a year where your income might be lower than usual.
Read more about Roth IRAs, conversions, and the Mega backdoor Roth here.
In addition to saving to your traditional or Roth IRA or 401(k), we encourage saving to an investment account in your name, or held jointly with your spouse, or in the name of your Revocable Trust. There is not a tax benefit in the year funds are added to this type of account. When assets are sold, you are taxed at capital gain rates on the difference between the price of the security when sold and the price when you purchased it (cost basis). Under current law, capital gain rates are less than ordinary income rates (in most cases). If you have saved $1 million to an account such as this, you will own a variety of stocks, mutual funds, bonds, and cash, according to your investment allocation and preferences. When it comes time to fund a draw of $120,000 in retirement, your Portfolio Manager will raise these funds as part of the rebalancing process. There will be holdings your Portfolio Manager might hope to trim with various levels of cost basis and gain. For example, if equities have drifted above your target allocation to equity, some stocks might be trimmed. If everything is up from a decade of growth in the market (as we found ourselves at the end of 2021), almost everything will trigger a gain upon selling. But, instead of this full $120,000 being counted as ordinary taxable income, only the portion that is realized gain will be taxed at capital gain rates. So, perhaps you pay capital gain tax on a realized gain of $25,000 when you draw $120,000 from this type of account.
Included in some of the tax proposals from the fall of 2021 was the elimination of the step-up in basis at death. The step-up in basis refers to the current rule that when you die owning an asset, your beneficiary’s basis changes to the fair market value on your date of death (or the value six months later, as determined by your executor). This applies to assets held outside of a retirement account. Without the step-up in basis, your beneficiary inherits your original cost basis.
YIKES! How does one prepare for that? If the step-up in basis goes away at death, we will likely need to speak with each client about their situation and the best way to proceed. Factors guiding our recommendation will include your age and capital gain tax bracket, your future beneficiaries’ ages and tax brackets, diversification needs of the portfolio, and size of your taxable estate.
If you have relatives for whom you would like to provide funds to attend college or private K–grade 12, a 529 Plan can be a great option. You don’t receive a tax benefit when the funds are added to a 529 Plan, but the funds grow tax-deferred and are withdrawn tax-free, as long as they are used for qualifying education expenses. If your heirs will need funds for school, then this is a great way to diversify the tax treatment of your savings while also ear-marking these funds for the gift of education. Note gifting rules apply, so a gift tax return is required if you add more than $16,000 per year to a plan for each beneficiary; there is also a way to fund five years of annual exclusions at one time.
Read more about 529 Plans here.
If you are enrolled in a qualified high deductible health plan (HDHP), you can contribute a certain amount to a health savings account (HSA). Since healthcare expenses are part of any retiree’s budget, it makes sense to have this type of account. We often refer to it as triple-tax free. Money goes in pre-tax, accumulates tax-deferred, and comes out tax-free when use for qualified medical expenses. Because of this unique and advantageous tax treatment, consider letting these funds grow for the future if you have adequate cash flow during your working years to cover medical expenses from your checking account.
Read more about health savings accounts here.
Income is often the determining factor for getting on the IRS radar. Individuals with high income such as that from IRA withdrawals are usually on the radar. Meanwhile, those with negligible IRA balances may be able to avoid the radar by owning municipal bonds and by owning an after-tax portfolio that is managed tax efficiently.
We don’t know what the tax environment will look like down the road but we think it makes sense to put ourselves in a position to be ready for whatever comes. Owning different account types is a hedge against tax rate changes. Different account types provide control by giving you choices. We suggest reviewing your account types and savings options to help you prepare for retirement by having a choice about which bucket to tap. We are happy to help you think through this at Bragg when you are ready.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.