2020 sure was a unique year. There were many events that we will remember for a long, long time. 2020 also presented some unique financial provisions that led to mistakes unrelated to market anxiety. Some of these errors were riffs on golden oldies but some were new compositions.
The CARES Act waived the need for Required Minimum Distributions (RMD) for older taxpayers, providing an opportunity for less taxable income and lower tax bills. The thinking went, “I don’t need it and don’t have to take it, so I won’t take it and I’ll save some money on taxes.” While that makes sense, retirees should have asked, “Even though I am not required to take a distribution, should I take money out anyway?”
For many, the answer should have been “yes.” We helped more clients voluntarily take distributions or execute Roth conversions this year than in any I can remember. In many cases, the income was taxed at a low rate and gross income was low enough to avoid triggering some of the extra costs of a higher gross income like Medicare premium increases due to IRMAA.
For some clients, the lack of RMD made capital gain harvesting attractive. For several of our married couples, some of those gains were not taxed at all.
Another retiree mistake came from the many who usually find it more convenient and flexible to pay much of their tax liability through withholding payments from IRA distributions rather than making quarterly estimated payments. With the RMD waiver, such taxpayers that did not make any distributions also did not make the planned withholding payments. If the withholding from retirement account distributions covered taxes for other income or activity, the taxpayer can be subject to penalties and interest for underpayment.
Retirees aren’t the only ones with potential withholding issues. President Trump issued an executive order in the fall allowing for the deferral of payroll taxes. This gave certain workers a boost to their take home pay. However, the mistake we are seeing is that some workers are mistaking deferral for a waiver. They did not realize they would be paying the payroll taxes in 2021 in addition to the payroll taxes on their 2021 income and will soon face a reduced cash flow.
Some people servicing student loans blew an opportunity. Federal student loan payments have been on deferment with no interest accruing. For some this is helpful because they have been laid off or suffered a drop in income. However, for others, the now voluntary payment has some people choosing not to make payments at all even if their cash flow has not been affected by Covid. Most are simply not assessing their situation, but a few are banking on forgiveness legislation.
Not paying down the balance can be a mistake because today’s zero percent interest rate presents the best opportunity they may ever have to make progress paying down these loans. When the deferment ends, the typically not so great interest rates of student loans will return. Better that interest gets charged to a lower balance than a higher one.
Whenever markets sink, you hear some common pieces of advice such as it is wise to harvest tax losses. For some people this is not good advice. A client forwarded a blog post recently from a guy who harvested $20,000 in losses back in the Spring to offset $20,000 in gains he took early in 2020. He didn’t want out of the markets so to avoid the wash sale rules, he bought similar holdings. He was very proud of his swaps, maintaining his risk profile and “beating Uncle Sam.”
What he describes is something a lot of advisors recommend for their clients, and we had in fact made tax motivated swaps for our client. However, there were some notable differences.
The author bragging about their frugality, said they live comfortably on a combined income of $70,000. Hmm. If they had $70,000 in income and $20,000 in gains, his was a wasted effort. The tax code says that losses are first used to offset capital gains. After applying a standard deduction, joint filers with $70,000 of income would not pay tax on $20,000 of long-term gains. The loss harvest did nothing for his tax bill.
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].