Who can resist a good sale? When prices are slashed, there's usually a great financial opportunity.
This carries over to financial planning, too. Essentially, right now taxes are on sale. Smart investors should take note of tax cuts implemented by the Trump administration and use them to their advantage.
Under the 2017 Tax Cuts and Jobs Act, our tax brackets have been reduced. For example, the 15% tax bracket went to 12%. The 25% tax bracket went to 22% . Under the taxes-on-sale concept, we have approximately seven years before they are scheduled to sunset in 2025.
So what to do?
IRAs and 401(k)s Come with Future Tax Bills
For the majority of retirees, their largest assets are mostly in pre-tax dollars, either through a traditional IRA or a 401(k) plan through their work. We tell people, "Hey, it's great that you have a million bucks in an IRA, but think about what you're really carrying here.''
As you enter retirement, your biggest debt probably isn't a mortgage. It's actually the debt to Uncle Sam. That million-dollar 401(k) you own absolutely looks great, but know that about $150,000 to $300,000 of that sum will actually be owed to the government.
Now let's tie everything together. The amount of that debt is controlled by the tax brackets. Smart investors will know that and will find a way to pay off and buy out that debt at the lowest possible cost. In light of the tax-bracket adjustments, we obviously want to employ that strategy for all of our clients, because it should add up to big savings in the long run.
How can we make it work? For the sake of an example, let's say you're married and your income is $120,000. Currently, the 22% tax bracket goes up to $165,000 for married joint filers , so that leaves about $45,000 worth of wiggle room for money that can be taken out of your IRA or 401(k).
We're not going to spend that money, mind you. We're going to convert it.
3 After-Tax Strategies
There are three main strategies to leverage what will now become the after-tax dollars:
This is probably the most popular option. When we take the $45,000 and convert it into Roth IRA assets, that money becomes completely tax-free forever -- to you, your wife, your kids, to everyone, forever and ever under the current law.
There's a bit of bad news, though. You do have to pay taxes on that transaction. That might mean the $45,000 becomes $35,000 after taxes. But if you have cash on the side to settle the $10,000 tax bill, you can convert the whole $45,000. There's also a five-year window to consider during which you can't take out any of the gains without a tax obligation.
You shift the $45,000 from your IRA or 401(k) into an after-tax account, paying the taxes necessary for the transaction. After-tax accounts are technically considered non-qualified, meaning they do not qualify for tax deferral. Most people refer to these types of accounts as "brokerage accounts." Let's say your IRA is invested in Acme stock, and after paying taxes on the $45,000 transaction you are left with $35,000 in after-tax dollars in Acme stock. This means that Uncle Sam's claim (taxes) to the stock has been bought out, and you are free to buy, hold or sell the stock at any time for any purpose. For example, you may hold onto the stock for years and then leave it to your children, or you may sell the stock to pay for a trip around the world. It is your choice.
Now, remember, there are IRA rules and penalties that makes this strategy more difficult for people younger than 59½; however, this strategy does maximize your flexibility. Unlike the Roth conversion, these funds are fully flexible. You don't have to worry about a five-year look-back period before you can start taking withdrawals. On the negative side, to create flexibility, you do lose some of the tax benefits, such as the tax-free nature of Roth accounts, and you'll be subject to capital gains and dividend interest (if any). But it becomes a question of what's more important for the individual -- the flexibility or the taxes?
Maybe your biggest concern is the next generation or long-term care. In that case, you should consider leveraging the surplus IRA withdrawal into a life insurance policy. That would create a tax-free benefit for the kids. But if you use a hybrid life insurance program, it could provide a long-term care benefit to you. Maybe you convert $45,000 a year for seven years to create a large death benefit for a loved one. Again, under a hybrid program, that same death benefit could become a long-term care benefit in your lifetime, should you need a nursing home or home health care. Keep in mind, if you're younger than 59½ then taxes and penalties can apply for withdrawing money from your IRA.
Every financial plan has five key elements -- income, investment, health care, legacy/estate planning and tax planning.
Why is tax planning on this list? Look, I could be the best financial adviser in the world. My insight could make you an extra 2% in the market, and that's great. But if I'm not talking to you about taxes, then I'm losing you money and certainly not providing a comprehensive plan.
It's not just about having a budget, sticking to a budget or diversifying a portfolio. It's about tax diversification and making sure you and your adviser are applying the current tax brackets to your ultimate advantage.
Here's another reason taxes should command your attention -- they literally require an act of Congress to change. When it comes to things like tariffs and trade wars, who's to say what will happen? I can give you an educated hypothesis. Really, though, I have no clue ... and no else knows, either. But on taxes, I do know. So do you.
It's the old Donald Rumsfeld line: Taxes are "known knowns." Everything else is an unknown. But taxes are a known known that doesn't require speculation.
Taxes are on sale. It's time to take advantage.
Joey Johnston contributed to this article.
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