As clients prepare to meet with their financial advisors on planning strategies for the new year, this is the perfect opportunity to discuss how to potentially reduce their future tax obligations with a concept called, Strategic Roth IRA conversions. Over the past year we witnessed the National debt surpass $31 trillion dollars with record government spending and deficits. Not only has our nation’s debt gone up substantially, so have interest rates which compounds the problem. With no end in sight in reckless government spending, or a chance of a balanced budget, the tax risk your clients face will likely get worse not better. Fortunately, we can have a retirement tax escape hatch which your clients can utilize to avoid a ticking tax time bomb on their retirement accounts.
It’s no secret that, given the choice, your clients would rather have tax free growth, distribution and transfer than taxable benefits at potentially higher tax rates. Everyone wants a Roth IRA conversion, but simultaneously no one wants to pay the upfront taxes. What if you could provide your clients up to three discounts on Strategic Roth IRA conversion taxes? If structured correctly, your clients can use this strategy to enjoy tax-free income in retirement, leave a tax-free legacy to their kids and grandchildren while also minimizing their upfront Roth IRA conversion tax obligations.
The three potential discounts are the 1) tax rate discount; 2) market value discount; and, lastly, 3) tax base discount. First, let’s talk about the tax rate discount. With the Tax Cuts and Jobs Act sunsetting in 2026, we’re in a unique situation where we know that tax rates will be increasing in 2026 for most clients. The way to paint this picture is by reminding them that they are going to go to bed December 31st, 2025, on New Year’s Eve and wake up the next morning on New Year’s Day, January 1st, 2026, owing more taxes.
Not only will most of your clients face higher income tax rates in 2026, but it also means that they’re going to have a lower standard deduction. Further, the child tax credit is also being reduced as well as changes in AMT and capital gains. By converting their IRA or 401k over the next three tax years, they’re getting a discounted rate compared to if they wait until 2026 and beyond to do those same conversions.
The other big issue on top of your client’s mind is the current rampant inflation. While stubbornly high inflation has been a thorn in our sides, it does have a surprising benefit: Increased top end marginal tax brackets. In 2023, the tax brackets (not rates) are all being bumped up on a dollar basis. For example, the top end of the 24 percent tax bracket for married filing jointly is going up by about $24,000, essentially allowing your clients to convert more and still stay in the same low tax bracket.
Let’s move on to the market value discount. Unfortunately this year has not been the greatest for both stock and bond returns, and our account balances, unfortunately, have suffered. For example, if we look at the S&P 500 it’s down about 24 percent as of the end of Q3 2022. Not just the equity markets, but the U.S. Aggregate Bond Index was also down almost 15 percent over that same timeframe! Nobody likes losing money, but we can actually use this pullback in the stock market and bond market as a potential opportunity. Let’s say, for example, the balance of your client’s IRA was at $400,000 at the beginning of the year, and they lost 25 percent, bringing down their account balance to $300,000. What that means is they can convert a lower value and therefore pay lower taxes. In addition, once the stock market eventually rebounds, which historically it does, all those future gains will be tax-free. In contrast, if they wait until the market does potentially rebound, they are going to be paying taxes on a higher amount. The problem with this is that we typically don’t convert an entire account balance in one tax year as it can push your clients into higher marginal rates. The third strategy I discuss will help eliminate or reduce that potential increase altogether.
Lastly, let’s talk about the third discount, which is the tax base discount. I mentioned earlier that the potential downfall or obstacle with doing strategic Roth IRA conversions is that we don’t typically convert an entire balance in one tax year to avoid bumping a client into a higher tax bracket. Generally we convert over a period of time, typically the next three tax years prior to the 2026 Tax Cuts and Jobs Act sunset or up to a specific tax rate or income threshold. The problem is, what happens if the market rebounds over those next three years or more? Your clients would have to pay taxes on higher balances each year.
What we can do is lock in today’s tax base using a five-year point-to-point index with a lock feature. With this strategy, your client’s account value doesn’t grow until the end of the fifth year (unless locked during the five-year index segment). Normally that may not be the best strategy, but this works out perfectly for Strategic Roth IRA conversions. It allows us to lock in today’s tax base, avoid any future stock market losses and convert over time without having any increase on their account value. Once we convert all of the IRA at the end of the third or fifth year, all of the potential indexed gains would be tax-free.
Let’s say your client has a $300,000 account balance growing at a hypothetical 10 percent rate. If the market rebounds and they don’t use this discount, they would convert $100,000 today, and kick the remaining conversions into tax years 2024 and 2025 at a potentially higher account value. What this means is they would convert $100,000 in 2023, $110,000 in 2024, and $121,000 in 2025, which comes out to a total of $331,000 over the next three tax years. If the market rebounds, your clients will pay more in taxes by converting over time. However, if they use a five-year index, which doesn’t grow until the end of the fifth year (unless locked), they can convert $100,000 over the next 3 tax years with a total amount converted of $300,000. If they’re in a 24 percent tax bracket, they are saving about $7,500 in taxes using the strategy. At the end of the fifth year all the potential index gains will be tax-free.
To summarize, your clients want to pay less taxes in the future but are also looking for creative strategies to pay less taxes today. With the nation’s debt at $31 trillion and growing, the Strategic Roth IRA conversion strategy is something that we are really passionate about. This is a huge issue that is likely to affect the people who pay the majority of taxes, who are high-income-earning families. There is an incredible opportunity here to take all these three potential discounts into your clients favor and provide tax-free benefits for their future.
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