Potential tax hikes propel wealthy seniors into tax-advantaged retirement plans

Potential tax increases under President Biden are quickly upending how some wealthy older investors think about their retirement savings.

Amid the prospects of higher individual rates, steeper taxes on investment profits and a major shift in tallying retirement benefits, many advisors say they’re increasingly urging wealthier clients to take a tax hit now on their stockpiles, while rates are at historic lows. The delayed benefit: locking in tax-free gains in the future, when rates may rise under Biden.

Bloomberg News

It’s a big change from the financial planning industry’s conventional wisdom that it’s better to save now and pay taxes later, when future tax bills are often lower because you’re no longer working and thus likely to be in a lower bracket.

Mitch Reiner, a managing partner and senior investment advisor at Capital Investment Advisors, an RIA in Atlanta, says that his wealthy clients who are in or near retirement are “actively converting” portions of their traditional IRA and 401(k) plans to a Roth variant. The traditional plans hold pre-tax dollars whose gains are taxed at ordinary rates upon withdrawal or conversion. Switching them to a Roth means immediately paying taxes on the amount converted, with that pot then growing tax free. “In paying taxes on the seed versus the harvest,” he says, “the seed strategy makes more sense.”

Roth plans have historically been pitched as ideal for younger investors, who have decades in which gains can compound tax free—the “time is your friend” proposition. Millennials lead the charge according to Fidelity, with 73% of their contributions going to Roth IRAs in the last quarter of 2019.

Now Roth plans are increasingly seen as a tool for older investors as well.

The shift in thinking comes amid Biden’s campaign pledges to roll back the 2017 tax cuts, which are set to expire at the end of 2025 unless renewed, and return the top individual rate to 39.6% from 37%, with anyone making more than $400,000 a year paying higher rates. For people making above $1 million a year, Biden has proposed nearly doubling the current top capital gains rate of 23.8% (20% plus the Obamacare tax) by making it the same as the highest individual rate. During his campaign, Biden also proposed replacing the deduction for contributions to a traditional IRA or 401(k) with a refundable tax credit equal to 26% of an investor’s contributions — a level that can raise an individual’s annual tax bill.

Treasury Secretary Janet Yellen is eyeing unspecified changes to retirement calculations. Under the current rules, if someone who is aged 52 and in the 35% bracket contributed a maximum of $26,000 this year to a traditional 401(k) — $19,500 plus a $6,500 “catch up” — she would be able to deduct $26,000 from her taxable income, saving $9,100 in federal tax (equal to 35% of her contribution). But under Biden’s proposal, she would get a tax credit of only $6,760 (26% of her contribution). The upshot: she pays $2,340 more in tax.

Biden’s $2 trillion infrastructure and jobs plan announced on March 31 didn’t directly mention hikes in individual or capital gains rates. Any major tax plan will face a tough fight in Congress. But market watchers are on tenterhooks wondering if those changes might be coming down the pike.

CFP Sandi Bragar, a managing director in planning strategy and research at Aspiriant, an RIA in Los Angeles, says that the potential for higher rates, combined with the IRS’s announcement on March 30 that individuals have until the filing deadline of May 17 to make 2020 contributions to their retirement plans, has lit a fire under wealthy clients to sidestep IRS rules on income limits for Roth plans by funding a traditional plan, then immediately converting it to a Roth. “We love the backdoor Roth conversion strategy — we’ve had clients on autopilot,” she says. “Tax rates are so low now, we advise Roth contributions” as well as conversions.

Bloomberg News

Reiner says that conversions work best for older investors when they have more in their pre-tax IRAs and 401(k)s than they will need to live on in retirement. Such clients often have income from brokerage accounts, pensions or real-estate investments, so moving some money out of a traditional plan prevents their taxable income — and annual tax bills — from spiking once they begin taking required distributions at age 72. While Roth plans don’t have mandatory distribution rules, people (other than spouses) who inherit a Roth or traditional plan now have to withdraw all the money within 10 years, under a major law passed by Congress last December. That money is tax-free. Meanwhile, owners of traditional IRAs now have only 10 years in which to spend them down — and pay the tax bills that go with doing so.

With older investors steering clear of major withdrawals from their retirement plans, there’s a mountain of additional taxable income in those accounts. A January 2021 report from the Investment Company Institute (ICI) found that 95% of IRA holders aged at least 70 took only an RMD in 2019, leaving most of their money in their accounts. Traditional IRAs had $10.3 trillion in assets at the end of 2020, while Roth IRAs had $1.2 trillion, according to ICI.

The prospect of higher taxes makes Roth plans increasingly used as an estate planning engine for wealthy investors, says Tasha Borglum, a CFP and senior advisor at Moneta, an RIA in St.Louis, Missouri. “Rates now will probably be lower than if they just left the money in a pre-tax account” like a traditional lRA or 401(k). That means an investor can pass on a chunk of change to heirs tax free — even if rates rise.

“Roths are an excellent intergenerational wealth transfer tool,” says Reiner. “Paying taxes today for the benefit of your heirs is good — you’re basically doing legacy planning.”