In this episode Dave and Steve discuss a topic that is near and dear to all of us; how can we (legally) minimize the taxes we pay. First they explain the analysis behind the decision to convert to a Roth IRA (8:23). Next they discuss how it might make sense to realize capital gains now rather than in the future when capital gains taxes might rise (23:03). Lastly, they discuss the use of life insurance and how it can be structured as a very tax efficient asset (24:42).
Steve: All right. Welcome to Plan For Life Now, episode number 86. Dave, if we had have been thinking ahead, we could have done this in person together. You know that.
Dave: I thought about, there’s a lot of things. Today’s podcast theme is Hmm, Things We Could Have Already Done. Right?
Dave: We could have already done this in person. Before we started, I was telling you I could have worn my EarPods to do these instead of having the phone next to my ear for 80 episodes or whatever episode we’re on.
Steve: Wow. We haven’t done all 80 of them remotely. We were doing them.
Dave: That’s true, that’s true. But you know what I mean? So now I’m so much more comfortable wearing these EarPods, which I should have done a long time ago doing these podcasts. So we could have done that before and then which you’ll get to, the topic itself, we probably couldn’t have done before.
Steve: Yeah. So here we are in early December, and as we were thinking about topics to discuss, I was thinking, “Gosh, I’m positive. We’ve done one of these on Roth conversions already because in all of our review meetings with clients, we’ve been talking about Roth conversions.
So when you talk about something five times a week, or however many review meetings we do each week, I feel like we’ve talked about this so many times we must have done a podcast. But I went back and I looked over the last year and certainly not in the last year, and I doubt we did one in the last two years or so. And really more broadly than just Roth conversions, what I wanted to talk about today is how to prepare for the prospect of rising taxes.
And this is sort of an ambiguous idea that’s out there. You know, even if you step back from the current Biden goals or aims as far as any legislation before the end of the year or anytime soon, and you just step back and you say, “The government spends a lot of money, we have a big national debt.” And by the way, it doesn’t matter which party is in power, both are spending a lot of money, big deficit spending. We have a big national debt. And at some point we’re going to have to pay for all of this.
And that could have been a discussion you had before coronavirus. Then you throw in all of the stimulus, which for the most part, a lot of that was necessary. But you throw in all of the stimulus and all of the government spending over the last year and a half, two years. This idea that taxes are going to be higher in the future. I don’t think you’re really going out on a limb saying that.
Dave: Right, and as we’ve discussed this, I think a bunch of things are converging to make planning for higher taxes and figuring out how you’re going to deal with it even more important. And that would be the higher taxes themselves, which for retirees takes money out of your pocket and your retirement savings, inflation, which we’ve already talked about which makes everything cost more as you’re having more money taken out of your pocket with taxes, and things cost more. And then of course there’s no guarantee, which seems weird to say, since we’re in the greatest bull market of all time, but if we go back to the textbook of how these things are supposed to work, it does appear tapering occurring with the Fed.
And it does appear like interest rates will start to go up, you might have a stock market that’s flat or down for an extended period that we’re not used to, which puts less money in your retirement assets also.
So the convergence of these three things makes when we have a podcast about tax planning and doing the best we can, I think it magnifies that need.
Steve: Absolutely. And I think as investors, we’ve all been so conditioned with this idea that it’s good to pay taxes later. We all just kind of inherently have this idea, “Oh, I don’t want to pay taxes now, I want to pay taxes later.”
And yeah, I’d always prefer to pay things later versus paying them now, but you’ve got to bring into the discussion, “Well, what will the tax rates be later versus now?” And you know, as we talk about this, I want to talk about three kind of main strategies that regular people can use.
I’m not talking about offshore banking or Opportunity Zone investing or things that are really only-
Dave: You could have made that up and I’m going to guess that 99.9%, what was that called? What?
Steve: Opportunity zone investing.
Dave: Opportunity zone to me, in this time of year with my team just waiting would have something to do with the Washington football team and not finance.
Steve: That’s the thing on the NFL network, or the Red Zone Channel. This is the Opportunity Zone.
Dave: We’re not going to explain it. We’re not going to go down the tangent rabbit hole.
Steve: Oh, come on.
Dave: Sorry, go ahead.
Steve: Come on. I’ve got to explain this just a little bit here. Okay, so remember President Trump’s tax cut bill? 2017 Tax Cuts and Jobs Act, blah, blah, blah. This is going down a little bit of a rabbit hole here.
Do you remember the guy, Sean Parker? Sean Parker was one of the founders of Napster. I mean, this is probably for a lot of our listeners, they don’t remember what Napster was, but this was right in my college days when you could share music files with people. And then he was also one of, I think he was the first president of Facebook. So he kind of got in on the ground floor there at Facebook.
So Sean Parker made this whole effort to lobby for these Opportunity Zones to be included in The Tax Cuts and Jobs Act, which basically says, “Let’s identify these areas of the country that are run down and blighted and, basically have, have had years of decay. And if people invest money in there, you could defer taxes or possibly even avoid capital gains taxes.”
So it’s a longer story than that even. But he got that included in The Tax Cuts and Jobs Act.
Dave: But, the bottom line is if you have a pothole near your house in McLean, that doesn’t count.
Steve: No, no, I think if you want to head up to Baltimore, you can find some Opportunity Zones a lot of stuff in Ohio, stuff like that. All right. Well that was a big tangent there.
So basically what I was saying is we’re not going to talk about that. We’re going to talk more about how do we minimize taxes or plan for the future of rising taxes and we’re not billionaires, or you don’t even have to be a billionaire for that, but you know, big money type of things, regular people.
So I really like this idea. You know, when we talk about these tax strategies here, I really like this idea of this term of tax diversification, because I think most people generally feel very good about the term diversification. It has a real positive connotation to it. You know, you say, “Ah, diversification. Yes. I like being diversified. I don’t want to have all my eggs in one basket. I want to spread things out there.”
But unfortunately what you see with a lot of people, and I mean, this is not inherently a bad thing, but you see a lot of people who have saved and they’ve put money away and they’ve got $1.2 million in a traditional IRA and maybe $100,000 in a brokerage account. That is not very tax diversified because that $1.2 million in a traditional IRA, that’s all subject to ordinary income taxes when it comes out.
So this idea of tax diversifying is saying, “Okay, we’ve got money that’s in traditional IRAs. We would like to have some money in a Roth IRA. We would like to have some money in some after tax investments, like brokerage accounts and things like that.”
So some of these strategies are attempting to accomplish that ideal.
Dave: And I also wanted to remind people, this is for our more novice listeners, your money’s in a 401k, it’s in an IRA format.
Steve: Good point.
Dave: If you’ve rolled over a 401k into something and those mutual funds, they’re in an IRA format, if you just, that’s most likely.
Steve: Yeah, and I would say that it is not uncommon for us to hear the comment from people, “Wait a second, I’ve got to pay taxes on this money when it comes out?” You know, I mean, it’s not most investors. Most people know that. But it’s not uncommon to hear that a couple times a year from people where they go, “Whoa, I thought I had a million dollars in my 401k or my TSP.”
“Well no, Uncle Sam hasn’t-”
Dave: It’s not uncommon to hear, “My money’s not in an IRA, it’s in a mutual fund.” Let alone that. So that’s A, why we have a job, and B it’s why you have to be very aware of these things. And as we always say in the middle of this, some of you for sure, are our clients, but others are just listening to this. This is why it helps to have a financial advisor.
Steve: Okay. So let’s tackle number one, the Roth conversion. And I had this discussion with somebody the other day. And like I said, we’ve been having this discussion a lot with clients, because I think it’s a good one to have. And like I referenced at the beginning, obviously President Biden is trying to get through this reconciliation bill, which if you can get the Democrats on board would raise taxes on certain segments of people. And there have been a lot of different proposals, but if that were to happen, this could have a more immediate impact.
So here’s the decision points and the discussions that we often have around, “Should I convert money from a traditional IRA to a Roth IRA.” It’s a married couple filing jointly and they’re taking a look at their income and they’re saying, “Okay, well between our social security and our pensions, et cetera, our taxable income is only going to be about $50,000.”
Well, if I take a look at the income tax bracket, the 12% tax bracket for Mary filing jointly goes up to $81,000. So for this couple, I would say, “Hey, let’s go ahead and convert $31,000 because you’re only going to be paying taxes at that 12% tax rate.”
And in my mind, I’ve said this many times in meetings, I don’t think there should be any hesitation at all about paying taxes at 12%. I don’t think you’re ever in the future going to say, “Man, I really regret paying taxes at 12%. You know, that was way too high.”
Dave: No, it’s a safe prediction.
Steve: Right now that same calculation could come into play for a couple making 150,000. And now if we look at the 22% tax bracket, that goes up to 172, so they could say, “You know what, I could convert roughly another $22,000.”
So when we talk about converting real simply what you’re doing is taking that money that you’re converting and saying, “I agree to go ahead and pay taxes on that this year.” So in my 12% example, if you’re going to convert $30,000, you’re going to pay $3,600 in federal taxes, plus whatever state taxes you might have to consider in there. So you’ve got to make a plan for how am I going to pay those taxes now?
I should probably put a disclaimer, Dave, on this podcast, just so people know at the beginning that I’m going to go into little bit more detail than usual. Just a heads up, I’ll be going into that. I went into that Sean Parker story about the Opportunity Zone, a little bit of detail here. So-
Dave: It’s more of a tutorial today.
Dave: The podcast, but that’s okay. One of the reasons people listen to this is to learn.
Steve: So let’s say that you were going to go ahead and convert that $30,000 and I’ll just stick with the federal taxes right now. So you’ve got this $3,600 tax bill essentially, extra amount that you’ve got to pay there. You’ve got a couple of options on how to pay that. The best way to do it is to say, “I’m going to pay that $3,600 out of other assets. You know, I’ve got the money in my checking account, I’ve got it in the savings. I’ve got it in a brokerage account, whatever.” That’s going to be the way to maximize your conversion there.
But let’s say you don’t have those funds liquid. You still could have those taxes withheld from the conversion. So now you’ll be converting 30,000, but they would subtract out that 3,600. So you’re only going to have that 26,400 there in the raw.
So one way is optimal. It’s going to come out better in the long run. You know, the other way still is going to make sense, but it’s just not going to benefit you quite as much there.
Now I want to go and just touch on a couple of other considerations, a couple things to keep in mind here when we’re talking about converting. So one that I’ll often bring up with people is the idea that when you convert money, so when you’re doing this conversion, that all counts as ordinary income. And that can have an impact on your Medicare premiums.
So most people who are over 65 and have Medicare, you guys out there, you know that your Medicare premiums can be impacted by your income. So, and I’m talking about Medicare Part B here, and then any supplemental Medicare that you might have. So your base Medicare premium say in 2020, and I know this is going up next year, but your base premium is at $148 a month, but let’s say that this is a single person. You made $87,000. Your premium’s $148. If you make $89,000, you’re going to pay $60 a month more. So it’s a big deal to make sure that you don’t go over that threshold.
Dave: Because it could look like the conversion makes sense. But then when you get into that nuance, now it didn’t make sense to do it.
Steve: Exactly. So you’ve got to be laser focused on some of those details there. Another impact, and this one I’m not going to go into all the details on it, but it also can impact how much of your social security is subject to taxation. So social security, if you make less than a certain threshold is only 50% taxable, but it can be up to 85% taxable.
So I was just going through a calculation with some clients where, by converting an extra $20,000, they also made an extra, I think it was $13,000 taxable from their social security. So it resulted in even more taxes there. But the long term considerations, if you’re converting money I would say even at 22 or 24% you look out there long term and if tax rates are 28 or 30 or 32%, you’re going to feel pretty good about paying taxes at those lower rates there.
All right. My last point on the Roth IRA conversion, and I think this is something that sort of gets overlooked by a lot of people, but I don’t think it should. It’s this idea that by converting, it’s not just the idea of paying taxes at a lower rate now versus later, it’s also this idea of reducing your required minimum distributions later on.
So a lot of time when we’re doing retirement projections for people, and let’s say they’re 62 years old and they’re looking out and they say, “I was just curious, what are my RMDs going to be at 72?” Right? Because remember that’s the new age for RMDs, 72. And we’ll look at that and it’ll say, “Well, Bob, your RMDs are going to be $150,000 a year. And Sally, what are you two years younger than Bob? Okay. Let’s look at 72 for you. Oh yeah. Yours are going to be another $150,000 a year.”
I mean, that’s not terribly uncommon to see people who have two, three, $400,000 of RMDs.
Dave: People are shocked when they see that.
Steve: Yeah. So you know, what this is doing is not only try to take advantage of the tax differential there, but remember there are no RMDs on Roth IRAs.
Dave: And then going further. So once we are dead, being a couple or the individual, in a Roth, so now you’re inheriting money that’s going to, I’m assuming be tax free out of the Roth.
Steve: Yeah. Absolutely. Now that’s getting into a whole different level where I have had people try to get into this calculation of saying, “Well, I could convert this money and pay at this rate, but my son who’s going to inherit the money in 30 years. He doesn’t work and doesn’t do anything. So he’s in a lower tax rate. Ah that’s too many moving parts there to try to put back in.”
Dave: That’s too much to go. But if I can interject for a second, this now gets to this whole… This is why and it’s self-serving when you say maybe you should seek a financial advisor as you get older to do everything.
So in other words, if you listen to this and said, “Yeah, no kidding. Oh, of course, Steve. Yes. I’ve already done all that.” Oh, no, like you’re saying to yourself, “This is so simple.”
Well then you are the financial planning version of the guy who extended his garage and goes underneath his car to change the transmission and do stuff on the [rollie 00:20:17] thing. There are very few of those, although my neighbor two doors down did exactly that.
He’s extended his garage because he’s into cars. And I saw one time, I saw a rollie thing when I was walking by, he had the garage open when I was walking my dog. I’m not saying it doesn’t exist. I’m just saying this is super complicated stuff, but it means a lot in the grand scheme.
And it’s only one part of a plan like you mentioned or alluded to. All of this has to be done within the grand scope at looking at your entire picture. Not on the individual basis.
It’s like we’ve had people back when we did in-person seminars and we’d even mention an annuity. People would badger us like it was Best Buy. Should I get this annuity? Which one’s cheaper? This annuity? It’s like, you’ve lost the point. You might not even need an annuity. And you’re not looking at things from the grand scheme of things.
And this whole topic is the same thing. That the most efficient way to deal with this is unless you’re an expert with a financial advisor and also looking at the grand scope of your plan, and how this may or may not fit in. That’s what the danger of these topics is.
Dave: And I know a lot of you already know that, but I thought I’d point that out.
Steve: Yep. Okay. So let me shift gears. So we talked about Roth conversions and I do think that’s probably for most people going to be, not only just the easiest way, but kind of most direct way to play this increasing tax possibility.
You know, the second thing, and I think this one’s a little bit harder to do with any certainty, but it’s this idea of realizing capital gains now versus realizing capital gains later. And it’s been floated around out there, the idea of increasing the capital gains tax. You know, if you’re not aware right now, capital gains tax for most people is 15%.
So there’s been talk about increasing that to 28%. So if it were to come to pass and they didn’t put a retroactive deadline on it, which they’ve talked about, one strategy could be, “Go ahead and sell some of those highly appreciated assets now. Realize the capital gains at 15%, because later on, maybe it’ll be higher.”
You know, maybe it’ll be 20, maybe be 25, who really knows? To me, there’s too much uncertainty there to do anything definitive, but it might be something where if you’re on the fence or you were considering getting rid of an asset anyway. You wanted to get out say, of a concentrated stock position.
Once again, I don’t think you’re going to look back and say, “Man, I really regret paying taxes at 15%.” I think long run, you’re going to feel pretty good about a 15% capital gains tax.
All right. This last idea here. I wanted to throw this in. And this is something Dave that I had mentioned to you and I’ve gone to a couple of these talks and listened to people describe some of these strategies. How do we diversify for taxes? You know, what are the best strategies? And one of the ideas that I found somewhat compelling in the right circumstance is using life insurance.
Now this is a cash value life insurance policy as a way to save, essentially if it’s done correctly, to save tax free in the long run. Now, as with any of these things, you always have to say that there’s always legislative risk.
You know, legislative risk is simply the idea that the tax rates and the laws as they stand right now are subject to change. So some things can change, but I will say that the taxation of life insurance is one of those things that has been very stable. And if you look over the long run, they have not come under fire in the same way that if you remember back in the ’80s, there were limited partnerships that had great tax benefits and those all got repealed. And obviously capital gains tax rates have changed all over the place.
So I feel like in my mind, there is less legislative risk to something like life insurance, but that’s obviously open for debate. So here’s the idea of using life insurance as a way to minimize taxes or possibly get tax free growth.
Let’s start with the basic idea that when you buy a life insurance policy and you die, your heirs inherit that money tax free, right?
That has been a fundamental tenant of life insurance for as long as there’s been taxation in this country. So if you inherit money from a life insurance policy, it’s not like you have to go pay income taxes on those assets there.
Now that’s fine for your heirs. Doesn’t really do you as much good because obviously in that case, you are dead. So it really doesn’t do you any good there. So the idea with using life insurance as a savings vehicle is, you take a permanent life insurance policy and you try to cram as much money as you can into it over a limited period of time.
Now, the IRS has set certain guidelines, certain rules, that basically say, I can’t just go out and I can’t get favorable tax treatment if I just took half a million dollars and dumped it into a life insurance policy, right. I can do that. I can technically do that, but I’m not going to get favorable tax treatment if I do that.
So what I can do though, is put money in over a period of years. Most of the time, this is somewhere in a five to seven year time period, where I say, “Okay, I’m going to take 50,000, $70,000 as a year.” Let’s just use 50,000 over a five year time period. So I’m going to put $250,000 into an investment like this.
Now, what I told you in the very beginning is that death benefits go on tax free, right? Your heirs don’t have to pay any taxes on death benefits. So what a policy like this will allow you to do while you’re still alive is, borrow money out of the policy, which of course, reduces the death benefit, but borrow money out of the policy and not pay taxes on it. So the net effect of something like this-
Dave: And most people who do this don’t care about the death benefit anyway so, it’s not the purpose of doing it.
Steve: Yeah. It’s kind of a secondary concern. So you design the policy to have the least amount of death benefit that you can get away with. And there are, of course, rules on that as well.
The net effect of something like this is if you can get an investment in this policy, say you could get six or 7%, but you’re getting it tax free versus an investment in an after tax investment vehicle. “You know, maybe I could do better get eight, nine, 10%, but I’ve got to pay taxes on it.” That’s pretty attractive.
So like I said at the beginning of this, I don’t think this particular case applies to everyone but I do think that this could be a strategy where some of the higher net worth people, it’s got to be the right fit. I mean, to make it work, you have to be healthy enough to qualify for the life insurance in the first place. And you’ve got to have the liquid assets to basically stick with this for 10 years or so.
Dave: Right. Not for everybody, but still fits into the general theme of what we’re trying to discuss today, which is with the way things look, what’s in our toolbox to do the best we can, based on your situation with this whole rising tax thing?
And that’s why we threw it out. A little technical today, but that’s okay actually, because people should have an idea of what we can do, even if it is a little complicated. At the end of the day, if I have a complicated… I’m going back to the car analogy, just into the car thing.
If I have a complicated problem with my car and it can be fixed by a mechanic, I’m not going to say, “Well, it’s complicated. So I don’t want to get my car fixed.” Makes no sense. So it’s the same kind of deal. So, as far as what we do, and we should say, if you listen to this and you’re especially one of our clients, a lot our clients are listening to it. And some of these things have intrigued you, or you just listen to the podcast and you’re interested, you could always contact us. You can always go to the website and we can dig into it a little bit and discuss it.
Steve: Absolutely. All right. Thanks for checking in with us. Hope everybody has happy and safe holidays, Hanukkah, Christmas, Happy New Year. And we’ll talk to you guys all again soon.