Many of today’s planners and accountants are poorly prepared to help their clients through changes in IRA tax and retirement rules, said IRA and tax expert Ed Slott.
That’s because until recent years, long-standing conventional wisdom in tax planning has been to delay taking taxable income or distributions for as long as possible, Slott, president of Ed Slott & Co., said in late June at Financial Advisor’s Next Chapter—ReThinking Retirement virtual conference. Today’s retirement rules and proposed changes in tax laws create greater incentive to take income and pay taxes sooner than later, he said.
“We were trained from the first days of college, hard-wired from our first accounting class, to always defer income, put it off, defer, defer, defer—that was the game,” said Slott. “But when the Roth came out, I became a recovering accountant. I believe in paying taxes at the lowest possible rate. That is how you always end up with more.”
Most people should consider paying income taxes now on assets in their tax-deferred accounts, like traditional IRAs, to convert those assets to a Roth IRA, since taxes are likely to go up in the future, Slott said.
However, others have argued that there is an opportunity cost to taking money out of a tax-deferred retirement account for expenses or to convert it to a Roth IRA, he said.
“But there isn’t, and it can be proven mathematically,” said Slott. “If the effective tax rate now and the effective tax rate later are the same, then the cost is exactly the same. If rates go up, the Roth IRA benefit takes off: It pays to pay some tax now to have more money later, whether you rip the Band-Aid off and do it all or do it partially each year.”
The exception, according to Slott, is if someone will be taxed at a lower rate in the future than they are now. But even if that ends up being the case, clients win a “consolation prize” of being able to take distributions tax-free from their Roth accounts.
Slott urged advisors not to frame Roth IRA conversions in terms of market performance, encouraging conversions after a decline in market performance.
“You can’t time a Roth conversion,” he said. “It’s a long-term proposition, and that’s how advisors have to look at them—a long-term planning vehicle for retirement or even for beyond, for estate planning.”
For married couples, there is even more value in Roth IRA conversions, as any surviving spouse will be faced with the prospect of paying income taxes as a single filer in the future, Slott added.
Converting money out of traditional IRAs has become even more important as a strategy since 2019’s SECURE Act ended most use-cases for the “stretch IRA” estate planning strategy, greatly reducing the value of traditional IRAs as wealth transfer vehicles. Under the stretch IRA strategy, the calculations for required minimum distributions from an inherited IRA could be stretched across a beneficiary’s life expectancy, leading to a lower annual income tax bill.
“The SECURE Act was passed in 2019, took effect in 2020, but look at everything that happened in 2020,” said Slott. “People forgot about the SECURE Act because it was overshadowed.”
The SECURE Act mandates that for most designated beneficiaries, all IRA assets be withdrawn before the end of the 10th year after the death of the original account owner, said Slott. After some confusion, recent clarification from the IRS confirms that annual required minimum distributions are no longer required from most inherited IRAs.
Slott identified three types of IRA beneficiaries: non-designated beneficiaries,eligible designated beneficiaries and non-eligible designated beneficiaries.
Non-designated beneficiaries are non-human beneficiaries like estates and charity trusts that will likely be subject to a five-year withdrawal rule mandating that all of the IRA’s assets are distributed before the end of the fifth year after the death of the former account owner.
Eligible designated beneficiaries still get the stretch IRA. There are five different classes of eligible designated beneficiaries: surviving spouses, minor children until the age of majority, a disabled person, a chronically ill person or someone not more than 10 years younger than the original IRA owner.
Non-eligible designated beneficiaries encompass any other living human being indicated by an IRA’s beneficiary form, said Slott, and they are bound by the 10-year rule.
“Then there is this other class of beneficiaries advisors have to keep track of: beneficiaries who inherited their IRA before the SECURE Act took effect in 2020,” said Slott. “They’re grandfathered in. So a two-year-old grandchild who inherited on 12/31/2019 gets to go out the 80 years of their life expectancy, but if that child inherited just one day later, they would be bound by the 10-year rule. So it depends if people inherited before 2020 or after 2019, and you’ll only need to know about these two different systems for about 80 years.”
Most advisors’ clients today probably inherited IRAs under the pre-SECURE Act rules, said Slott, but advisors need to be prepared for an influx of IRA beneficiaries who will be bound by the new, more complex rules system.
For those bound by the new rules, there is greater incentive to convert to a Roth account or to take down the asset in traditional IRAs at low rates today and put them into a life insurance policy, he said.
While advisors and tax planners will need time to adjust to the new IRA tax rules, Slott said that the changes make sense.
“Congress didn’t want the IRA to be an estate planning vehicle,” he said. “This has incentivized us to do better planning the planning we should have been doing all along.”