Myth Busters: Income Taxes

The next topic in our series of myths in wealth management is regarding income taxes.  Who doesn’t want to pay less taxes and take home more pay?  The first important point to make here is Congress did a good job of simplifying our tax code with the recent changes.  They have eliminated many tax planning options.  Now, that doesn’t mean all hope is lost.  What it means is more planning is needed.  Following are the top 5 myths of Income Taxes, specifically on the planning side.

• The best time to plan is April before taxes are due. Ok, I must come clean.  I am not sure this is a myth or just poor planning by many, but we get numerous calls every year from people who want a quick fix to their tax liability two weeks before the taxes are due.  At that point it is simple; max out your IRA contributions and other tax-deductible savings accounts.  Real planning must start at least early in the tax year you are filing, if not before then.
• Roth IRA contributions are limited or not possible if you make over a certain income level. There are several ways to get money into a Roth IRA even if you make too much.  For example, limitations on IRA contributions only reference tax-deductible contributions.  You can make additional non tax-deductible contributions.  You can then do a non-taxable Roth conversion out of that additional contribution.  Voilà, you now have more in your Roth.  This one can get tricky so we suggest that you speak with your tax advisor before taking any action as individual situations will vary.
• The longer the time period held, the better a Roth is over an IRA contribution. This mythis repeated too often. The premise is the longer a Roth grows tax free, the better it is than an IRA which is taxable upon contribution.  It doesn’t matter if you hold 1, 10, or 30 years; if the tax rate at contribution is the same as your tax rate when you take distributions, it will work out to be the same ending value.  The primary reason to do a Roth IRA over a traditional IRA is if you think your tax rate at distribution will be higher than your tax rate today.  This rule not only applies to you, but your beneficiaries as well.

The normal assumption is tax rates will automatically be higher in the future even though throughout the history of the U.S., we have seen tax rates higher and lower than today.  The error in just thinking about tax rates in general is it misses the important question, which is how much money will you be making when you start taking money out of the IRA?  The bottom bracket tax rate in the U.S. has never been above 20%.

• IRAs/401(k) are the most tax favorable way to save for retirement. Most younger people are not familiar with RMDs, or Required Minimum Distributions.  Currently, at 70 ½ you must take a distribution from your traditional IRA/401(k) whether you need the money or not.    This is key because if you don’t need the money, you still must take it out and pay taxes on the distribution.  In addition, this impact can also jump you up in your tax rate, impact Medicare part B premiums, and affect your taxes on social security benefits.  There are more tax favorable options than IRAs for the upper middle class or high-net-worth individuals (meaning those at that level when you reach 70 ½, not today).

The other more tax favorable options are Roth IRAs or cash value life insurance.  As I stated above, the primary reason to do a Roth over a traditional IRA is if your tax rate is expected to be higher.  Another reason would be if you don’t plan on needing the money.  That is hard to know when young, which is why we believe using all three strategies sets the client up best for successful, tax-favorable retirement benefits.

• You must use the funds in a Health Savings Account (HSA) by the end of the year.That applies to flexible spending accounts but not HSAs. HSA amounts “roll-over” year to year until you use them.  They can also be invested in mutual funds for growth.  You can also contribute to them with, in some cases, a health care deductible of $2,700 for a family coverage.  One of the biggest concerns people often have regarding retiring early is health insurance costs.  If you can plan ahead and invest in a HSA, you could pay your insurance with these funds, ultimately paying up to 37% less in real after-tax dollars for married couples filing jointly (highest tax bracket in 2019 per Internal Revenue Service, “Revenue Procedure 2018-57).

Again, proper tax planning starts now, not next year or when you retire.  A milestone or Retirement plan should include a section on tax planning.  Please feel free to call me if you have any questions about this article.

The information provided here is for general information and educational purposes only. This information should not be considered an individualized recommendation or personalized investment advice. Each person’s situation will be different, we suggest speaking with a financial advisor and tax advisor about your individual situation before taking any actions. The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.