A powerful tax strategy worth a second look. By Romar Carl

Transcription

1 A powerful tax strategy worth a second look By Romar Carl

2 A powerful tax strategy worth a second look By Romar Carl Many of the nation s wealthiest individuals are taking advantage of an easy, yet highly effective and powerful income tax strategy that has successfully eliminated a portion of their annual income tax liability. You, too, could benefit from this simple, safe strategy that many have incorrectly assumed was created only for the benefit of the American middle class. The impact of income taxes is taking on greater importance for some individuals as federal, state and local governments are looking for more revenue. Income taxes today The impact of income taxes is taking on greater importance for some individuals as federal, state and local governments are looking for more revenue. The graying of America and the shrinking workforce combine to create additional financial pressure on government. Many individuals are alarmed that income tax rates have recently increased; however, even with the 2013 federal tax rate increases and the Affordable Care Act surtax that became effective in January 2014, we still have what can be considered a historically low top marginal income tax rate. Therefore, it s not hard to imagine that federal, state and local income tax rates may potentially rise in the future. Individuals who are already in the highest marginal tax bracket tend to pay particularly close attention to the impact that income taxes have on their bottom line. Many California high-income earners pay in excess of 50 percent in income taxes today (39.6 percent top federal income tax rate, 3.8 percent Affordable Care Act surtax, 13.3 percent top California state income tax rate). Capital gains are taxed at a preferential rate. However, that fact may not have as much impact on your overall income taxes as you might think. Capital gain income is not only subject to federal taxes, but state taxes as well, which generally provide no break for capital gains. And, as of January 2014, there is an additional 3.8 percent tax on unearned income (the Affordable Care Act surtax noted above) for those taxpayers with adjusted gross income above $200,000 ($250,000 for married filing jointly). Top marginal tax rates on capital gains range from 25 percent in the nine states that do not levy a tax on personal income to 33 percent in California. The average across the United States is 28.7 percent. 1 1 Pomerleau, K. ( February, 2014). The High Burden of State and Federal Capital Gains Tax Rates. Retrieved from: 1

3 Insights A powerful tax strategy worth a second look As wealth gets more complex, so must the strategies. Unfortunately, federal and state income taxes are not the only taxes paid on income. Those with earned income also pay social security and Medicare taxes. In addition to taxes levied directly on income there are also property taxes, vehicle license taxes, sales taxes and multiple hidden taxes that we pay: gasoline taxes, liquor taxes, tobacco taxes, entertainment and restaurant taxes, hotel taxes and luxury taxes too many different taxes to list here, and we haven t even started on the various corporate and business taxes that get passed on to the individual by way of increased product and services costs. Most taxpayers do not want to pay more income taxes than required, and many do some sort of tax mitigation, even if it is as simple as keeping track of deductions and deferring income into retirement accounts. As wealth gets more complex, so must the strategies. Those who are very wealthy often apply sophisticated tax-avoidance and tax-reduction strategies to lower their income tax bill, along with estate transfer strategies to lower their estate tax liability. When they are unable to avoid paying taxes, they look for ways to defer tax payments, such as setting aside substantial amounts of pretax compensation (along with its appreciation) into qualified retirement plans. The power and problem of deferral Individuals who have been diligent in socking away as much compensation as possible into qualified retirement accounts understand the power of deferring income taxes on money they don t need right away. Income is best deferred when the taxpayer anticipates they will be in a lower tax bracket when they draw on it and to leverage the power of tax-deferred compounding. There are two potential problems with these deferred income assets for the wealthy: 1) They may not be in a lower tax bracket if they have other significant income when they make withdrawals, and 2) IRS rules do not allow continued, fully uninterrupted compounding in traditional qualified retirement plans. Those who have been successful in creating or who have inherited significant wealth are often in the position now, as they approach retirement, where they will not need those assets that have been sitting and growing in tax-deferred retirement plans. But whether they need the assets or not, the taxpayer will be required to start taking annual minimum distributions from those plans when they turn 70½. That is when the tax collector will come calling. There s no way to defer those taxes any longer. Every dollar distributed will be subject to taxation at the individual s marginal tax rate as ordinary income. The system is designed to tax all those dollars before the plan owner dies (assuming they live to their expected mortality). They can t even die to get out of those income taxes, because distributions from retirement plans are considered Income in Respect of a Decedent, or IRD, which means that anyone who inherits those retirement plan assets will have to pay income taxes when they receive distributions. 2

4 Tax-deferred to tax-free Not everyone should be clamoring to get out of the tax-deferred game and into the tax-free game. However, individuals who plan to leave assets to their heirs (at least as many assets as they have in their IRA), There is a way to pay income taxes once, let those dollars grow and compound tax-free, and never pay income taxes on the appreciation and earnings. 2. have taxable estates, 3. have more than enough assets to take care of themselves for their lifetimes (and don t need to draw on their IRA assets in retirement) and 4. are in or close to the top individual income tax marginal rate and don t anticipate their tax rates going down in the future...need to seriously consider getting into the tax-free game with those retirement assets. Once those assets are put into the tax-free game, if your investments are successful, there is no limit for how much can be earned with those income-tax-free dollars. In the April 9, 2012, issue of Forbes, Deborah L. Jacobs explains how in 2010, Max R. Levchin, the chairman of Yelp, sold 3.1 million shares of Yelp for $10.1 million dollars. Most of that was capital gain income, but Max didn t pay a penny of income tax on that gain and he never will if he abides by a few simple rules. Deborah states that Securities & Exchange Commission filings show Levchin still has 3.9 million additional shares of Yelp, which in April of 2012 was trading near $22 (in August 2014 it was around $68 per share). So it looks like his tax-free retirement kitty is worth at least $95 million and with today s share value (assuming he hasn t sold them yet) it could be worth over a quarter of a billion dollars. It may even be worth more depending on his other investment successes. 2 If Levchin doesn t spend his massive tax-free retirement fund, he can leave it to his children or grandchildren, who can, under current law, stretch out income tax-free growth and distributions for decades. Levchin isn t the only one who is using this income tax-free strategy to legally and safely shield millions from taxation. Ms. Jacobs states that in 2001, while CEO of PayPal, tech investor Peter Thiel bought 1.7 million shares of that company for 30 cents a share. He bought those shares with assets he had in his tax-free retirement account. In 2002 ebay bought out PayPal for $19 a share an apparent $31.5 million tax-free profit for Thiel. 3 There is a way to pay income taxes once, let those dollars grow and compound tax-free, and never pay income taxes on the appreciation and earnings. You can even provide that your children or grandchildren never pay income taxes on those same dollars and the future tax-free compounded earnings. And in 2 Jacobs, D.L. (2012, April 9). How A Serial Entrepreneur Built A $95 Million Tax Free Roth IRA. Forbes Magazine Article. Retrieved from: 3 Pomerleau, K. Tax Foundation. 3

5 Insights A powerful tax strategy worth a second look We believe that a better statement, more worthy of a genius, would be tax-free compounding interest is the most powerful force in the universe. addition, by taking advantage of this opportunity you also reduce your estate taxes and end up getting more to your heirs than if you don t do it. Sounds pretty good, right? The power of compound interest has been touted for years. An urban legend recounts that Albert Einstein once stated, compound interest is the most powerful force in the universe. 4 We believe that a better statement, more worthy of a genius, would be tax-free compounding interest is the most powerful force in the universe. The solution? At this point, you might wonder if we re talking about life insurance. You purchase a policy with after-tax dollars and it pays an income tax-free death benefit. Additionally, with the right policy, you can generate tax-free compounding in the cash value. No, we re not talking about life insurance: the tax-free compounding of a life insurance policy doesn t last throughout your heirs lifetimes. Are we talking about a municipal bond portfolio? It will produce tax-free income, but, once again, no tax-free compounding. What we are talking about is a Roth IRA and the conversion of a traditional IRA to a Roth IRA. Now, please don t run away if you know about Roth IRAs but thought they weren t for you. Many wealthy individuals are using them to create millions of tax-free dollars. Ed Slott, an IRA guru who travels the country teaching accountants how to squeeze benefits out of the Roth IRA, says, I call this tax break the government s going-out-ofbusiness sale. This is a tax break you could drive 10 Mack trucks through. It s an incredible opportunity to do a totally tax-free transfer of wealth. 5 Maybe you have looked into converting your traditional IRA to a Roth IRA and decided it wasn t worth it. If your profile is similar to the one I have discussed thus far, then I am willing to go out on a limb and suggest you did not get the right look at the benefits of conversion and the costs of not converting. Perhaps, realizing that your IRA has some of the worst tax characteristics of all the various assets you own (primarily because you are still in a high income tax bracket and you don t need the distributions from them taxed to you each year), you decided, like many, to just give all your qualified assets to charity. That can be a great plan if you decide to die at age 70. Under those circumstances, you will not have to include any of the plan assets in your income nor pay income tax or estate taxes on them. However, every year you live beyond age 70½, you will be required to take a distribution from those retirement plans and include that distribution in your taxable income. If you live out to or beyond your life expectancy, and I hope you do, you will end up including many of the assets in your taxable income over the years. The longer you live, the less that will likely go to charity. 4 Quote Retrieved from: Hubb, K. (2011, June 24). The Tax Law that Can Make Your Kids Super Rich. The Fiscal Times Article, Retrieved from: Make-Your-Kids-Super-Rich

6 However, if you convert your traditional IRA to a Roth IRA, you will have no required distributions in your or your surviving spouse s lifetime. The Roth IRA assets will grow and compound tax-free. When you leave your Roth to your heirs, they will be required to take annual distributions over their lifetimes, but those will be 100 percent income tax-free, and what s not distributed will continue to grow and compound tax-free. You may ask, Don t I have to pay taxes on the IRA assets if I convert to a Roth? Yes. Payment of income taxes is the price you have to pay to get out of the tax-deferred game and into the tax-free game. Many people understand the wealth transfer advantage of paying income taxes on assets that belong to their heirs. They do this by setting up trusts, which are effective at removing assets from their estates, but intentionally ineffective at transferring income tax liabilities. These trusts are called intentionally defective grantor trusts. While the assets held in these trusts no longer belong to the grantors that created them, all income tax owed on the trust income each year is required to be paid by the grantors. Why would someone do that? Because by paying the tax, they are, in effect, making a gift to their heirs that isn t treated as a gift by the transfer tax system. In much the same fashion, when you pay the income taxes owed on conversion of a traditional IRA to a Roth IRA that you intend to leave for your heirs, you are, in effect, making a gift to your heirs that isn t treated as a gift by the transfer tax system, and at the same time you are reducing the estate tax liability of your estate. The gift of an income tax-free investment vehicle to your heirs is a powerful one. More powerful than intentionally defective grantor trusts which, after the grantor quits paying the taxes each year, will be subject to income taxes either at the trust level or at the beneficiary s level. With a Roth IRA, once you have paid the tax bill owed at conversion, if no withdrawals are taken within the first five years of setting it up or before the participant turns 59½ years old (but for a few exceptions), there will never be any income taxes owed: not at the IRA level, and not when your heirs take required distributions over their lifetime. That s no income taxes on the Roth IRA assets ever! Furthermore, if your heir is a grandchild, that could be a very long time. When you pay the income taxes owed on conversion of a traditional IRA to a Roth IRA that you intend to leave for your heirs, you are, in effect, making a gift to your heirs that isn t treated as a gift by the transfer tax system, and at the same time you are reducing the estate tax liability of your estate. Analyzing the decision Does it always make sense to convert your traditional IRA to a Roth IRA? Certainly not. There are plenty of individuals for whom a conversion would not make good financial sense. However, if 1) you plan to leave assets to your heirs (at least as many assets as you have in your IRA), and 2) you have a taxable estate, and 3) you have more than enough assets to take care of yourself and your spouse for your lifetimes, without ever needing to draw on your IRA assets, and 4) you are in, or close to, the top individual income tax marginal rate and don t anticipate your tax rates going down in the future, then it is extremely likely that it makes financial sense for you to convert your IRA to a Roth IRA. There are many factors to consider when making the decision to 5

7 Insights A powerful tax strategy worth a second look One should consider overall estate planning goals. convert or not, including your age and health, age and health of your spouse if you are married, age and health of your intended heirs, income tax bracket (now and expected in the future), source of tax payment and several others, including future income and growth projections on the assets. To confirm it makes sense for you, have your financial advisor run the numbers for you. Is there an age where it s automatically not prudent to convert? No, it is different for each person and their individual situation because, as noted above, an analysis involves so many different factors. In addition, one should consider overall estate planning goals. In some cases it may make financial sense for an 80-year-old participant to convert their traditional IRA to a Roth IRA. Let s look at some examples. In these examples we assume a 2 percent income rate, a 6 percent growth rate and a 25 percent turnover rate. We also assume no distributions are taken out during the participant s and spouse s lifetimes and only minimum required distributions are taken out during the heirs lifetimes. In Scenario 1 we have an individual who is approaching the age limit at which he will be required to start taking annual required minimum distributions from his IRA. Scenario 1 facts: Don is 70 years old with a $1 million IRA. His wife, Mary, is 65 and his child, Tom, is 43. Mary is the first beneficiary of the IRA, and Tom is the intended beneficiary after Mary dies. Don has a $15 million estate and has already used his and Mary s lifetime exemptions for gift and estate taxes because of prior wealth transfers. 6 Converting his traditional IRA to a Roth IRA will create an additional $5,114,044 income tax-free to Tom over his lifetime, which discounted to today (at 3 percent) is an additional $1,497,367, even after paying $429,351 in income taxes at the time of conversion. A total of $512,825 of this benefit accrues over Don and Mary s lifetimes while $4,601,219 of the total benefit of conversion accrues over Tom s. Stated differently, if this participant chooses not to convert, they are throwing $5,114,044 of income tax-free money out the window. The benefit can be dramatically increased by selecting a grandchild as beneficiary. The tax-free Roth will then pay out over the grandchild s lifetime. Let s assume the same facts as above and note that Don has a remaining generation-skipping exemption to cover the transfer at his death. If we make the beneficiary after Mary a recently born grandchild, Seth, with an 81.6 year life expectancy, the benefit of conversion increases to $129,719,267 additional income tax-free dollars to Seth over not converting. If there is a concern that Seth might withdraw more than the required distribution and thus reduce the long-term benefit, the Roth IRA can be left to a specially designed trust. 6 6 We also assume a 2 percent income rate, a 6 percent growth rate and a 25 percent turnover rate, basis in other assets equal to fair market value, participant pays the income tax liability incurred on conversion with assets other than the IRA assets and a 3 percent inflation rate. If assets perform better than the above assumed rates of return the benefit is increased. All analyses were run using WealthTec Suite financial and estate planning software.

8 When you run the numbers, a Roth conversion analysis will typically illustrate a disadvantage over the first five years due to the penalties associated with Roth IRA withdrawals within the first five years of being established. If you already have a Roth IRA that has been in existence for five years or more, these disadvantages disappear. At the 47th Annual Heckerling Institute on Estate Planning, Natalie Choate, renowned expert and author on retirement benefits and planning with retirement benefits, encouraged everyone in attendance to open a Roth IRA account immediately to get the five-year period running. When selecting investment opportunities for the Roth IRA assets, consideration should be given to selecting investments that have the greatest growth potential. Let s look at a second example: In Scenario 2 we look at a younger participant with a little larger IRA and estate. Scenario 2 facts: Gary is 65 years old, his spouse, Karen, is 63. Gary s IRA is to be left first to Karen and then 50/50 to two children, Sara, age 36, and Ken, age 33. Gary s combined estate is $80,000,000. His traditional IRA is $2,500,000. Gary has zero-remaining estate and gift tax exemption. 7 Converting his traditional IRA to a Roth IRA will create an additional $11,084,795 income tax-free for Sara over her lifetime, which, discounted to today (at 3 percent), is an additional $2,718,127 and an additional $15,221,756 income tax-free to Ken over his lifetime which, discounted to today (at 3 percent), is an additional $3,316,332. This is even after having to pay $1,112,120 in income taxes at the time of conversion. Stated differently, if Gary chooses not to convert, he is throwing $26,306,551 of income tax-free money out the window. Additional considerations When evaluating the numbers of a conversion analysis, it is important to consider the benefit that accrues over the life of the heir. While a conversion may indicate a positive benefit through the lifetime of the participant and his/ her spouse, failure to consider the benefit that accrues over the lifetime of heirs misses much of the benefit of conversion. When considering leaving a Roth IRA to a grandchild or skip-person, consideration should also be given to the size the Roth may grow to through the death of the senior generation and the impact any potential payment of generation-skipping tax will have on the ultimate benefit of conversion. However, I am convinced that if the traditional IRA participant meets the criteria outlined in this paper, they should convert to a Roth IRA. Outside of leaving income tax-free compounding assets to an heir, it often makes sense from a tax diversification perspective to convert qualified tax-deferred assets to tax-free assets. When selecting investment opportunities for the Roth IRA assets, consideration should be given to selecting investments that have the greatest growth potential. As you saw above, when investments perform well, the tax-free Roth IRA account can have very substantial benefits. A Roth IRA intended for 7 Additional assumptions same as scenario 1: 2 percent income rate, 6 percent growth rate, 25 percent turnover rate and basis of other assets equal to their fair market value. 7

9 Insights A powerful tax strategy worth a second look No one knows how long this window of opportunity will last and some economists have warned about exploding future revenue losses associated with Roth IRAs. heirs generally has a long-term investment horizon, and the asset allocation should be comprised of investments geared toward growth. If you want to put non-publicly traded stock in an IRA or Roth IRA, you will generally need to use a special custodian who handles self-directed IRAs. This is because most big brokers, banks and mutual fund companies generally limit investments to publicly traded stock, bonds, mutual funds and bank CDs. 8 Also, if you own a small business, your IRA or Roth IRA can t invest in it. However, if you are CEO of a small company with many investors and you want to buy some of the company s stock to put into your Roth, be sure to get advice from an attorney before you do as it may be considered a prohibited transaction and render your IRA immediately taxable and possibly subject to penalties. You should also be sure to ask your financial advisor to explain the details around the opportunity to reverse your conversion if the assets perform poorly and the idea of setting up separate Roth IRA s for each different asset class of the investments held in your traditional IRA. Also have your advisor explain how incorporation of charitable giving or taking advantage of a net operating loss can help to lower the tax cost of conversion. Don t procrastinate No one knows how long this window of opportunity will last and some economists have warned about exploding future revenue losses associated with Roth IRAs. 9 How much potential revenue loss is there? In a study for The Tax Policy Center, economist and Forbes contributor Leonard Burman calculated that from 2014 to 2046, the U.S. Treasury would lose a total of $14 billion as a result of IRA-related provisions in the 2006 tax law. The losses stem from both Roth conversions and the ability to make nondeductible IRA contributions and then immediately convert them to Roths. 10 Many are calling for an end of this boon for the rich or for limitations to be enacted. Forbes contributor Deborah L. Jacobs thinks Congress should cap the amount that can accumulate in a Roth IRA to $10 million and limit the amount that can pass to an heir to $1 million. 11 However, she also thinks that these changes should not apply for anyone who has already established a Roth in reliance on the current law usually the typical sentiment when enacting tax law changes. Should you convert? The people for whom a Roth is the best deal are those who really don t need the savings for retirement they re the ones who plan to leave these tax-free accounts to their kids. 12 Only you, in close consultation with your financial advisor can answer the question as to whether converting 8 Jacobs. Serial Entrepreneur. 9 Jacobs, D. (2012, March 26). Why-And How-Congress Should Curb Roth IRAs. Forbes Magazine. Retrieved from: 10 Jacobs. Serial Entrepreneur. 11 Jacobs. Serial Entrepreneur Jacobs. Serial Entrepreneur.

10 your traditional IRA to a Roth IRA is the right step for you. But, as I make clear in this paper, such a step isn t just for the middle class; it has substantial (often overlooked) value for the wealthy too. About the author Romar Carl is a wealth planner at Ascent Private Capital Management of U.S. Bank in Denver, Colorado. He earned a J.D. cum laude from J. Reuben Clark Law School at Brigham Young University, an LL.M. in taxation from the University of Washington and a bachelor s degree in finance from the University of Utah. Romar is also a Certified Financial Planner (CFP ). Important disclosures Investment products and services are: NOT A DEPOSIT NOT FDIC INSURED MAY LOSE VALUE NOT BANK GUARANTEED NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY Wealth Sustainability services are not fiduciary in nature, and Ascent serves in a non-fiduciary role when providing these services. Wealth Sustainability services are not legal or tax advice. You should consult with your tax and/or legal advisor for advice and information concerning your particular situation. These services are provided for educational and illustrative purposes only and do not guarantee the success of any strategy or recommendation. Ascent shall have no liability for losses that result from decisions you make in connection with the services provided. 9

11 The Center for Wealth Impact is Ascent Private Capital Management of U.S. Bank s virtual consulting cooperative for knowledge and thought-leadership development. It is where our experience and research generated inside our organization and gleaned from the world s leading experts come together to drive everything we do. ascent.usbank.com 2016 U.S. Bank 3076-WIP (12/16)