However, because he reset their basis lower through his swap, he may have made a future bill bigger. Chances are good we will see others that ended 2020 with a low enough income to avoid taxes on gains yet engaged in similar transactions, unnecessarily harvesting losses.
The change of income many experienced in 2020 has increased confusion about Roth conversions. As we know, Roth conversions can pay off because in some cases incurring taxable income today results in paying tax at a lower rate than delaying the income and paying at a higher rate in the future.
We have seen several people who after getting laid off think they are dropping to a lower bracket temporarily. That is indeed when a conversion has the best chance of working well. However, due to severance packages and unemployment benefits, their marginal bracket did not drop or drop low enough to make a conversion attractive.
The other Roth mistake we have encountered are high-income clients concerned about even higher future rates. President-elect Biden’s campaign featured proposals to raise taxes in several ways for persons making over $400,000.
Whether you believe such provisions will be enacted as proposed or not, the issue is not what the brackets will be in the future generally. The issue is what are the likely rates for a particular client likely to be in the future.
For example, a 60-year-old client in her peak earning years expects to make $600,000 in 2021. She has been making about that for the last couple of years. She has maxed out her qualified plan contributions and saved beyond that for the last 20 years. Because of the high income recently she has socked money away in a taxable account. She has accumulated a bit over $4,000,000 in total, $1.5 million of which is qualified money. While she makes good money today, the work is intense and grueling for her. She wants to retire in early 2022. Her retirement cash flow goal is $150,000. Unfortunately, she believes that because she is the bullseye of the Biden tax plan, she should convert her qualified plan monies to Roth.
She makes over $400,000 now but her tax rate once she retires will be a function of what she chooses to do more so than what tax legislation Congress ends up passing. She will definitely pay 37% to Uncle Sam upon a conversion in 2021. Even if she took all of her $150,000 from a qualified plan after she retired, she is unlikely to face a rate greater than 37% after she retires. Conversions may be attractive to her after she retires but converting now would probably be a mistake.
The opposite side of that coin is the people who despise paying taxes so much they do not consider conversion when in a low bracket. A few of our retired clients think this way. They could pay tax in 2020 at 12% via a distribution from a tax deferred account or a Roth conversion but won’t do it. For couples, this could be costly later even if Congress does nothing.
When one spouse dies, the other files as a single taxpayer in future years. For 2020, the 22% bracket for single filers starts at taxable incomes above $40,125. That is half the threshold for married couples and isn’t much. The tax cuts enacted in the first half of Donald Trump’s term are set to expire in 2026. If Congress does not act, the marginal rate at that level of income will be 25%. Whether those rates are extended or not, 12% is a very attractive rate and lot better than 22% or more.
Changes often create conditions ripe for making mistakes. They also can present opportunities to those who think things through. Financial planning rightly concerns itself with long term issues. Years like 2020 show that if one has a good plan in place, assessing short term tactical opportunities is easier too.
Dan Moisand, CFP, has been featured as one of America’s top independent financial planners by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines. He practices in Melbourne, FL. You can reach him at [email protected].