However, because he reset the basis lower through his swap, he may have made a future bill bigger. Chances are good that others also had low enough incomes last year to avoid taxes on gains, yet unnecessarily harvested losses anyway.
Confusion About Roths
Roth conversions can be great. Incurring taxable income today can mean paying tax at a lower rate than if you delayed the income and paid at a higher rate in the future.
We saw several people get laid off and think they were temporarily dropping to a lower tax bracket, and that’s indeed when a conversion has the best chance of working. But with severance packages and unemployment benefits added in, your marginal brackets might not have dropped low enough to make a conversion attractive.
High-income clients also make mistakes when fearing higher future tax rates.
President-elect Joe Biden’s proposals have included tax increases for people making over $400,000. Even if these are enacted, though, future brackets by themselves generally aren’t the issue. The issue is future rates for particular clients.
Take a 60-year-old in her peak earning years who expects to make $600,000 in 2021 (and who made close to that for the last couple of years). She has maxed out her qualified plan contributions and saved beyond that for the last 20 years. With her recent high income, she has socked money away in a taxable account, accumulating a bit more than $4 million in total, $1.5 million of which is qualified money. While she makes good money today, the work is intense and grueling. She wants to retire in early 2022. Her retirement cash flow goal is $150,000. Unfortunately, she believes she’s in the bull’s-eye of the Biden tax plan and wants to convert her qualified plan monies to a Roth.
She makes over $400,000 now, but once she retires, her tax rate will be more a function of what she chooses to do than what the new tax law is. She will definitely pay 37% to Uncle Sam upon a conversion in 2021. But even if she takes all of her $150,000 from a qualified plan after she retires, she is unlikely to face a rate greater than 37% after that. Conversions may be attractive to her after she retires, but converting now would probably be a mistake.
Others, meanwhile, despise paying taxes so much that they won’t consider a conversion even if they’re in a low bracket. They could pay tax in 2020 at a 12% rate with a tax-deferred account distribution or on a Roth conversion, but they 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 doesn’t 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 a lot better than 22% or more.
These are all conditions ripe for mistakes—or opportunity for 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, practices in Melbourne, Fla. You can reach him at [email protected].