Minimizing Lifetime Taxes with Roth Conversions in Early Retirement

Minimizing Lifetime Taxes with Roth Conversions in Early Retirement

 

Minimizing Lifetime Taxes with Roth Conversions in Early Retirement

Moving into retirement is an exciting opportunity to live fully. It can be a time to travel, explore new hobbies, or spend time with grandchildren.

For many, this period at the start of retirement can also be an opportunity to provide additional financial security—and minimize lifetime taxes—by making partial Roth conversions.

 

The Retirement “Tax Valley”

Many retirees will be in a lower tax bracket early in retirement than they were just before retirement while they’re still working—or than they will be in later in retirement. To understand why, consider Jim and Susan (both age 61) who recently retired.

While working, Jim and Susan had a combined household income of $250,000. This put them right in the middle of the 24% tax bracket for a married couple. At retirement, Jim and Susan have the following assets:

  • $1 million (Jim’s IRA)
  • $1 million (Susan’s IRA)
  • $100,000 (Jim’s Roth IRA)
  • $500,000 (Taxable account – with a $300,000 cost basis)
  • $300,000 (Cash savings in bank accounts and CDs)
  • $800,000 (House – No Mortgage)

Jim and Susan will also have the following income in retirement:

  • $50,000 (Jim’s annual pension – starting at age 65)
  • $30,000 (Susan’s annual pension – starting at age 65)
  • $40,000 (Jim’s annual Social Security – Starting at age 70)
  • $35,000 (Susan’s annual Social Security – Starting at age 70)

 

In addition to that income, Jim and Susan will each have to start taking required minimum distributions (RMDs) out of their IRAs starting at age 72. Assuming they don’t make withdrawals from the IRA between now and age 72, and that the accounts grow at 7% annually over the next 11 years, they would each be worth about $2.1 million by age 72. They would each have an RMD of about $76,650 the year they turn 72 ($2,100,000 / 27.4).

This would potentially give them a taxable income at age 72 of about $308,300 from pensions, Social Security, and their RMDs. This puts them back at the top of the 24% tax bracket, and they could easily move up to the 32% tax bracket or higher.

However, in their first years of retirement, they could basically have no taxable income if they are using cash savings and the taxable investment account to fund their goals if they choose to do so. Is it a smart idea to minimize taxes this much during these early retirement years?

 

Strategic Roth Conversions Early in Retirement

Let’s say that Jim and Susan would have $0 taxable income in early retirement. Their modest interest, dividend, and realized capital gain income is offset by their $25,900 standard deduction.

If they each convert $65,000 annually from their IRA to their Roth accounts ($130,000 total), they will initially pay tax on that conversion primarily at the 10% and 12% rates, with just a little being taxed in the 22% bracket each year.

If they do this each year until age 72 when their RMD begins, they would have about $1,079,000 in each IRA, assuming 7% annual returns. This would reduce their initial RMD at age 72 by about half. Their taxable income at age 72 would be reduced by about $74,500 and their tax liability by about $17,880 since they were in the 24% tax bracket.

Much of the earlier conversions each year would have been taxed at 10% or 12% rates, resulting in less overall tax being paid during their lifetimes.

 

Protection Against Rising Tax Rates

The example above shows the benefits of Jim’s and Susan’s Roth conversions, assuming tax rates stay the same. If 10 years from now, tax rates on higher earners increase, they will have less income being taxed at those higher levels due to the smaller IRA balances and smaller RMDs.

They would also have about $1,000,000 in each Roth IRA by age 72, assuming a 7% rate of growth. This can be withdrawn tax-free if additional money is needed. This is always a benefit but especially so in a world where overall tax rates are higher.

 

Roth Conversions to Take Advantage of a Market Decline

In addition to the benefit of taking Roth conversions when in lower tax brackets, Jim and Susan can take advantage of market declines to make strategic Roth conversions.

Say a market decline in the first six months of the year produces the following negative returns:

-2% (Bonds)

-10% (Large US stocks)

-15% (Large international stocks)

-20% (Small US stocks, small international stocks, emerging market stocks)

This becomes a great opportunity for Jim and Susan to strategically move some of the small US, small international, and emerging market stocks from the IRA to the Roth accounts. Assuming the investments recover as expected, Jim and Susan can pay tax on the conversion when the prices are down and enjoy a significant tax-free recovery after the investments are in the Roth account.

 

Additional Factors to Consider

There are several other factors for Jim and Susan to consider when making Roth conversions early in retirement.

When purchasing individual health insurance in retirement before Medicare begins, retirees may qualify for subsidies to reduce the cost of their premiums based on their taxable income. In Jim and Susan’s case, they have retiree healthcare from their employer that doesn’t qualify for tax subsidies, so this is not a factor.

Once Medicare Part B benefits start at age 65, there is an additional IRMAA premium cost when taxable income increases beyond a certain level. In 2022, this additional premium begins when income is above $182,000 for a married couple.

For retirees who expect to have money at the end to leave to an heir, Roth conversions can be an important part of an estate plan, as leaving Roth assets to heirs are significantly more valuable than leaving traditional IRA money to heirs.

 

Conclusion

While they won’t be a perfect solution for everyone, for the right families, Roth conversions early in retirement can be a powerful tool to minimize taxes over your lifetime and maximize overall expected wealth.

This can be one more tool to ensure the ability to make the most of retirement and really live fully!

 

 

 

Disclosure: All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source.  Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be taken as such. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional.

 

 

Guilt-Free Spending

Guilt-Free Spending

 

Just the thought of setting a budget can be enough to send us running for the hills. The other day, I had lunch with a friend who is a fellow career mom. We often swap stories about our busy lives and commiserate about how hard it can sometimes be to balance work and motherhood. Her career has taken off over the last year, but she looked more relaxed than ever. She shared that she and her partner had decided to outsource many of the household responsibilities they had historically struggled to keep on top of and often bickered over. After telling me what an amazing gamechanger this had been for her mental health and her family, her expression quickly changed to one of guilt as she admitted that the services were costing them quite a bit. Despite her increase in income, she felt embarrassed and irresponsible about how they much they were spending on services some would consider unnecessary. To her it sometimes felt as if they had traded their weekly arguments over household tasks with monthly disagreements over money.

I could relate to her experience on both a personal level and a professional one. After assuring her this was a common struggle, I shared tips with her that have helped many of my clients over the years. The traditional guidance for people grappling with feelings of guilt, self-reproach, or insecurity over their finances is to create a strict budget and stick to it. Some people enjoy a disciplined approach to things, but for many of us, avoiding the need for strict budgets can be a primary driver for saving and working hard. Tracking every small expense, feeling guilty about how much you spent last month, questioning partners on their expenditures, and generally feeling restricted—what’s to like? It’s right up there with counting calories, so I understand why people avoid it altogether.

If you’re like many high-income earners and people who have saved well, you might feel that avoiding the need to budget is a right you have earned. After all, you’ve worked hard so you don’t have to count every penny, right? The trouble is that it puts you at risk for not meeting larger goals such as a comfortable retirement, paying down debt, college funding, or making a large purchase; and it can also leave you feeling out of control and dissatisfied. Whether you are a busy professional struggling to figure out why you don’t have more money at the end of every month or you are already retired and unsure how to balance your personal spending with other goals, there is a strategy that can help you feel more in control of your money without having to budget.

 

Pre-Retirement Reverse Budgeting Process:

By taking these steps, you ensure your savings goals are met first, and anything that remains can be spent on whatever you desire, without guilt!

  1. Identify your goals.
  2. Determine how much you need to save on a periodic basis to meet these goals—the easiest way to do this is to work with your financial advisor to create a financial plan.
  3. Set up an automatic savings plan with a combination of payroll deductions and automatic monthly transfers.
  4. Enjoy the freedom to spend what is left as you choose and the peace of mind that comes with knowing you are able to meet your goals!

To make this process work for you, it’s important to start with a cushion in your checking account and to review your checking account at least monthly and before making large purchases to ensure you are maintaining a sufficient balance. If you find yourself running short, you can pull back slightly on small discretionary purchases and build that cushion back up so you aren’t forced to dip into your savings for something other than the goals you have set. We all tend to spend more when we are feeling flush, so checking your bank balance periodically should allow you to reign in non-essential expenses for short periods and return to guilt-free spending in no time. If you find a significant gap, you may need to examine recurring expenses for areas to cut back or reassess your savings goals.

 

Retirement Goal Funding Process:

You worked hard, you saved, and now you are living the retirement dream, but that doesn’t mean you’ve accomplished all your financial goals. Many people in retirement want to leave a certain amount to charity, help their children buy a home or start a business, help their grandkids with college, save for a large purchase such as a second home, or plan ahead for long-term care expenses. When you have a set amount of assets that need to provide for a lifetime of expenses and several other large goals, it can be hard to determine whether you have enough and what you can afford.

It’s also common for retired people to struggle with the transition from saving to spending. If you have been a disciplined saver and enjoyed watching your nest egg grow, the idea of diminishing it can be incredibly stressful. This process has helped many of my clients discover a new sense of financial comfort and freedom.

  1. Identify your goals. What do you anticipate for recurring annual spending? Do you have any legacy goals, plans for long-term care, or larger purchases, gifts, and donations to consider?
  2. Work with your financial advisor to run financial projections that account for investment returns, market volatility, inflation, taxes, etc.
  3. If the projections show you are not able to attain every goal, work through prioritizing and adjusting your goals until your projections show results you are confident in.
  4. The end result should provide you with an annual amount you can confidently spend while giving you peace of mind that you are able to meet your other goals as well!

 

One final, crucial step in the financial planning process is to meet with your advisor periodically to make sure you stay on track to meet your goals and discuss how goals may change for you over time. A great advisor will review your entire financial picture to make your money work its hardest for you and not only maximize your potential for meeting those goals but also encourage you to reach for the stars and live fully along the way. If you’re not already working with an advisor or are looking for someone who can provide this type of comprehensive support, we’re happy to help—schedule a consultation now!

 

 

 

 

Disclosure: All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source.  Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be taken as such.

Boeing Pension and Lump Sum Comparison – Should I Retire Early?

Boeing Pension and Lump Sum Comparison – Should I Retire Early?

 

Boeing Employee – Should I Retire Early?

Boeing employees nearing retirement age are facing a financial decision that will need to be made by November 30—one that could have a significant impact on their lifestyle in retirement.

 

Higher Interest Rates and the Lump Sum Pension Benefit

Boeing offers many employees the option at retirement to either receive a pension, providing monthly income for life, or to have a single lump sum deposited into a retirement account that can be invested and withdrawn as desired.

The amount of the pension benefit is based on several factors, including years of service with Boeing and average salary while employed.

When determining the lump sum benefit, the underlying interest rates are an additional factor to take into consideration. Higher interest rates will create a lower lump sum benefit, and lower interest rates will create a higher lump sum benefit. Boeing resets the interest rate used in the calculation once per year in November.

With the significantly higher interest rates we’ve seen in 2022, an engineer who may currently qualify to choose either a $5,000 monthly pension or a $1 million lump sum benefit may be looking at only $800,000 in lump sum benefit if they retire after November 30, 2022. The exact numbers will vary for each employee.

That $200,000 reduced benefit can be a significant incentive for employees who are planning to retire in the next few years to adjust their plans and retire early.

 

To Whom Does This Apply?

Not all Boeing employees have a pension as part of their benefits. Also, some employees are covered by unions that only offer the monthly pension and do not have a lump sum option.

Boeing engineers who are members of the SPEEA (Society of Professional Engineering Employees in Aerospace) union usually have a generous lump sum benefit compared with the monthly pension and may benefit significantly from comparing their options.

 

Financial Planning to Compare Options

The decision to take either the lump sum in retirement or the monthly pension is a significant one, and both contain risks.

With the lump sum, the employee is accepting the risk of the market and managing the money.

With the monthly pension, the guaranteed income provided to the employee will not increase with inflation. This year has been a good reminder that inflation can significantly reduce the purchasing power of that income.

Also, does it make sense for an employee who originally planned to retire in two years to give up on the years of additional earnings and savings? Can the employee afford to do so?

We help employees compare how a monthly pension or lump sum benefit will interact with other resources (Social Security, retirement accounts, real estate) to determine the ability to meet goals in retirement. We can also compare retiring in 2022 with delaying retirement and possibly receiving a reduced benefit in the future.

 

Deadline and Next Steps

Boeing employees wanting to claim the lump sum before rising interest rates potentially reduce benefits will have to retire and submit the request for a lump sum benefit by November 30, 2022.

If you’re feeling overwhelmed by assessing the pros and cons of this decision, reach out to us for your complementary personalized analysis. We can help you determine whether retiring now would provide you with a sustainable retirement that meets your lifestyle needs.

 

 

 

Disclosure: All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source.  Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be taken as such. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional.

 

 

 

 

Medicare Income-Related Monthly Adjustment Amount (IRMAA) Surcharge – What Does It Mean, What Can I Do, and How?

Medicare Income-Related Monthly Adjustment Amount (IRMAA) Surcharge – What Does It Mean, What Can I Do, and How?

 

 

Co-written with Jeffrey Barnett

 

The first question on many retirees’ minds is how to pay for expensive healthcare costs and health insurance when you’re no longer covered by the employer plan you relied on throughout your career. Medicare is the U.S. government’s answer for supporting healthcare costs throughout retirement. While you might have already enrolled in Medicare or are at least looking forward to beginning benefits at age 65, you may not know how Medicare premiums work. Let’s explore Medicare premiums and an important potential speedbump known as IRMAA.

 

What Is IRMAA?

 

To provide some background, approximately 75% of the costs of Medicare Part B (Medical Insurance) and Part D (Prescription Drug) are paid directly from the General Revenue of the Federal Government, with the remaining 25% covered through monthly premiums paid by Medicare enrollees. If you receive Social Security or Railroad Retirement Board benefits, your Medicare Part B premiums are typically deducted automatically from your monthly benefits. For those who don’t receive these benefits, you’ll receive a bill to pay your premiums instead. Medicare premiums increase as your income grows through Income-Related Monthly Adjustment Amount (IRMAA), which is an additional surcharge for higher income individuals on top of the 2021 Medicare Part B baseline premium of $148.50.

 

Medicare premiums and any surcharges are based on your filing status and Modified Adjusted Gross Income (MAGI) with a two-year lookback (or three years if you haven’t filed taxes more recently). That means your 2021 premiums and IRMAA determinations are calculated based on MAGI from your 2019 federal tax return. MAGI is calculated as Adjusted Gross Income (line 11 of IRS Form 1040) plus tax-exempt interest income (line 2a of IRS Form 1040). The table below details the base premium amount you’ll pay for Medicare in 2021 depending on your MAGI and filing status, inclusive of any additional IRMAA surcharge.

 

 

Fortunately, the Social Security Administration (SSA) tracks these numbers for you and uses MAGI data from the IRS. For every year that they determine IRMAA applies to you, you’ll receive a pre-determination notice explaining what information was used to make the determination and what to do if individuals feel the finding is incorrect, like due to a life-changing event as defined by the SSA. After 20 or more days, the SSA sends another notice with additional information regarding your appeals rights. For the instances you feel an incorrect determination was made, you can request a “New Initial Determination.”

 

Am I Eligible to Request a New Initial Determination?

 

There are five qualifying circumstances where an individual may be eligible to request a “New Initial Determination.” They are:

  1. An amended tax return since original filing
  2. Correction of IRS information
  3. Use of two-year-old tax return when SSA used IRS information from three years prior
  4. Change in living arrangement from when you last filed taxes (e.g., filing status is now “married filing separately” but you previously filed jointly)
  5. Qualified life-changing event(s)

 

According to the SSA, a Life-Changing Event (LCE) can be one or more of the following eight events:

  • Death of spouse
  • Marriage
  • Divorce or annulment
  • Work reduction
  • Work stoppage
  • Loss of income-producing property
  • Loss of employer pension
  • Receipt of settlement payment from a current or former employer

 

A common scenario we often see is with new retirees age 65 or over where income is much lower in retirement than it was two years ago, but the SSA determines that the IRMAA surcharge should be applied to your premium costs given the lookback period. Fortunately, an exception can be requested under the “work stoppage” LCE, and we can help you navigate that process. Luckily, this is typically irrelevant after the first or second year of retirement since post-retirement income is often significantly reduced and naturally falls below the IRMAA threshold. Another common scenario for retirees is having portfolio income that pushes you above the IRMAA tiers. However, it’s important to point out that portfolio income from things like capital gains or Roth conversions are not allowable exceptions to request for the IRMAA surcharge in a high-income year.

 

If you don’t qualify to request a new initial determination based on the 5 qualifying circumstances noted above, you also have the right to more formally appeal the determination, which is also known as requesting a reconsideration.

 

 

Requesting a New Determination

 

If any of the above life-changing events apply, individuals are likely eligible to request a new initial determination by calling their local Social Security office or, alternatively, completing and submitting this form for reconsideration along with appropriate documentation. We highly recommend calling the Social Security hotline at 800-772-1213 to discuss if more than one LCE applies to you, if you have questions about why IRMAA applies to you, or if you have questions about requesting a reconsideration.

 

We know that Medicare can be tricky and that this only scratches the surface, so we also encourage you to contact us if you have any questions. We regularly serve as a resource for questions around enrolling for Medicare along with many of the other factors involved in planning for retirement, and we are happy to help you as those questions move to the forefront.

Sources:
Income Thresholds:  https://www.medicare.gov/your-medicare-costs/part-b-costs

Life-Changing Event: https://www.ssa.gov/OP_Home/handbook/handbook.25/handbook-2507.html

Determination Notices: https://secure.ssa.gov/poms.nsf/lnx/0601101035

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.

The Ultimate Guide to 401k Rollovers

The Ultimate Guide to 401k Rollovers

Introduction written by: Daniel Hill

Meeting new clients is one of my favorite parts of working in wealth management. They come to us from all walks of life, and there’s a certain fascination associated with discovering each client’s journey that brought them to Merriman. Part of that discovery process involves understanding a client’s financial situation and looking at their previous work history. We see asset statements for IRAs, brokerage accounts, and, more often than not, an old 401(k) plan from a previous employer that’s been hanging around. Trust me, I’ve been there. Everyone switches jobs, and in the hustle and bustle of getting set up with a new company, the previous company’s 401(k) plan is left to its own devices with the assumption that it’ll continue to grow in value. But at what cost?

There are several options you can pursue in handling your old 401(k). We’ve put together a great tool to help you decide what to do: The Ultimate Guide to 401(k) Rollovers! We discuss your options, ranging from doing nothing to rolling your 401(k) into a traditional IRA. We walk through the advantages and disadvantages of each option as well as what to think about before making a decision. Every person has a different set of circumstances that must be taken into consideration, so ultimately, the decision you make has to be the one that is best for you. As always, if you find yourself wanting to speak with an expert, don’t hesitate to reach out to us at Merriman.

 

 

 

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.

How Do Incentive Stock Options (ISOs) Impact Alternative Minimum Tax (AMT)?

How Do Incentive Stock Options (ISOs) Impact Alternative Minimum Tax (AMT)?

 

One of the most common areas where we see clients introduced to Alternative Minimum Tax is when Incentive Stock Options (ISOs) enter the financial picture.  To learn more about AMT and how it is calculated, so you can avoid a shock, check our blog post from last week.

ISOs can be a tremendous benefit to creating wealth, but they are often misunderstood and can pack a large surprise if not appropriately planned for.  Here are a few key terms to get us started:

  • Grant Date/Amount– Original date and number of shares awarded
  • Vesting Date– The date at which you are allowed to exercise your options
  • Exercise Price– Price paid for options, usually discounted from the current share price.
  • Bargain Element– Difference between exercise price and fair market value (FMV); drives potential AMT liability

ISO preferential tax treatment is attained when the shares are sold one year after exercise and two years after grant. When this criterion is met, the gains upon the sale will be considered long-term capital gains, as opposed to short-term gains which are taxed at current income rates.

 

Qualifying vs Disqualifying Disposition:

 

Qualifying Disposition
  • Exercise and sell one year after exercise and two years after grant – AMT liability in the year you exercise, and gains are considered long-term capital gains
  • Exercise and hold – AMT liability in the year you exercise but no additional immediate tax liability because the shares have yet to be sold

 

Disqualifying Disposition:
  • Exercise and sell within one calendar year – no AMT liability and gains are taxed as regular income
  • Exercise and sell within 12 months, across two calendar years – AMT liability in the year you exercise, and gains are taxed as regular income
  • Exercise and sell more than one year from exercise but less than two years from grant – AMT liability in the year you exercise, and gains are split between regular income rates for the bargain element and capital gains depending on holding period

 

The AMT tax liability mentioned in the scenarios above is determined based on the difference between the exercise price and the fair market value (FMV) of the shares on the date of exercise. AMT may result in a larger tax bill than a typical year without exercising options and thus will directly affect your household’s cash flow.  The good news is that when you end up paying AMT related exercising ISOs, you will likely receive an AMT tax credit, which can be used to offset your federal income tax bill in future years.  This is a great reason why involving a CPA to help keep track of all the moving pieces is highly recommended.

The 83(b) Election is an alternative approach to divesting company stock. If your company allows, you have 30 days from the grant date to notify the IRS and your company of the 83(b) election. This involves paying tax on the exercise price from the grant at regular income rates; there would be no AMT implication and depending on when you sell the shares, you would later realize short- or long-term capital gains. For shares which you expect to increase in value, this can provide a fantastic tax break. This is however considered a risky approach because the shares could lose value and you would have overpaid on taxes by making this election.

Please reach out to us if you would like to work through your specific situation.

 

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place.