Most people understand the value of contributing to retirement accounts during their productive years of gainful employment and then living off the accumulated nest egg after they retire. Certainly, the government’s tax policies today encourage deferring earned income until retirement. There is a good reason for this: for most Americans, Social Security is only designed to replace about 40% of pre-retirement earnings, according to the Social Security Administration.1 For the rest, there are myriad qualified and non-qualified plans in place to ensure comfortable living during the golden years for those able to save.
At its core, the current taxation system’s appeal is based on the assumption that our contributions into qualified plans will not only grow tax-free until withdrawn, but we will also pay less tax on the retirement income when we start taking it out than we would have paid when we earned it. That holds true in most cases for traditional IRAs and 401Ks. There are, however, other (if more subtle) planning techniques around retirement accounts that deserve to be explored and, if needed, exploited to maximize benefits afforded to us by the current federal and state tax laws.
Converting to a Roth IRA
It has been almost ten years since Congress lifted the AGI-based Roth conversion restriction, making the conversion available to everyone regardless of their income level.2 Nonetheless, it is still one of the most overlooked tax savings opportunities, albeit dealing more with long-term benefits than immediate savings. That said, in certain situations a partial, or sometimes even full, Roth conversion can be very attractive. A Roth IRA’s two most extraordinary features are its superior deferral potential and next-generation tax benefits. Unlike Traditional IRAs, Roth IRA owners do not need to take any distributions during their lifetimes,3 thereby letting the balance in their retirement accounts balloon tax- and RMD-free. Secondly, future distributions from the inherited Roth IRA are completely tax-free to next-generation beneficiaries.4
In most cases, though, a Roth conversion is an expensive proposition, since the converted amount is generally included in the gross income during the year of conversion.5 That may not matter if the taxpayer has a year with a large loss event or a relatively flat year with modest income and unusually high business or itemized deductions. In such cases, it is worth weighing the option of converting a part of a traditional or rollover IRA into a Roth IRA at a nominal tax cost, as future benefits of such conversion could be enormous.
Qualified Charitable Distributions from IRAs
The Qualified Charitable Distribution (QCD) is yet another provision that was languishing in relative obscurity until the 2017 tax legislation breathed new life into it. The law was introduced by the Bush Administration in 20066 as a two-year incentive for charitably inclined retirees and had suffered continuous expirations and subsequent revivals by Congress at the end of each congressional term for nearly ten years, until it was finally made permanent in late 2015.7 This provision has often been misunderstood, even though it merely allows retired taxpayers aged over 70½ to re-route all or some of their IRA RMDs to a charity of their choice (subject to a $100,000 maximum), without having to include the RMDs in gross income.8 When most high-net-worth seniors itemized their deductions (and could thus simply donate the cash and include it on their schedule A as a charitable contribution), the benefits of QCD were tenuous at best. They were thus mostly relegated to planning around Pease limitations that are now suspended until 2026.
Enter the 2017 tax legislation. Starting with 2018, SALT deductions are all but gone,9 and the miscellaneous itemized deductions for items like advisory fees are eliminated until 2026.10 On top of that, a retired couple over 65 years old can take a standard deduction of up to $27,000 in 2019,11 which oftentimes now exceeds their dwindling list of what still qualifies as an itemized deduction. As a result, married couples without a mortgage will not see the same tax bang for their charitable buck, as they were used to in the past. If they donate their RMD to charity, however, it will totally bypass their tax return. An added bonus to this approach is that monthly Parts B and D Medicare premiums are based on the previous year’s modified AGI.12 Omitting the RMD from AGI could save thousands of dollars in future years in reduced Medicare premiums.
Converting IRA Contributions into Deductible Charitable Giving
For those inclined to be charitably generous during their future retirement, but still fully employed now, a new strategy has emerged. If you anticipate that in the years after you turn 70½ you will not itemize your deductions (for the reasons discussed above), you can make maximum contributions to one or more traditional IRAs during your working years. This will allow a full contemporaneous deduction on your current return.13 Then, when you reach age 70½, you can make charitable donations by way of QCDs from your IRA, without having to include that portion of the distribution in taxable income.14 As a result, this strategy allows you, in effect, to convert otherwise nondeductible charitable contributions that you will make after you turn 70½ and in later years into currently deductible IRA contributions and reductions of AGI, without ever including distributions from these IRAs in your future income.
There are numerous other ways to structure retirement accounts planning to harvest various tax benefits, but the techniques described here are applicable to a broad range of taxpayers, spanning multiple income and net-worth ranges. As such, tax practitioners and financial planners would be well served by adding them as additional tools to their professional advisory toolboxes. ■