Whether a client’s retirement dreams are five years away or 50, the single greatest threat standing in their way is taxes, warns Ed Slott of Ed Slott & Co.
The right tax management strategy can save clients hundreds of thousands of dollars, while the wrong strategy — or no strategy at all — can bring undue hardship during their golden years.
That’s the central thesis of Slott’s new book, “The Retirement Savings Time Bomb Ticks Louder.” Reflecting the complexity of the topic, the book stretches to some 430 pages, but as Slott told ThinkAdvisor in a recent interview, he strove to make the material as approachable as possible. “With untaxed retirement accounts likely to become your clients’ largest asset, they face an explosive landscape of costly tax traps, penalties and a complex maze of rules when the time comes to tap into those savings,” Slott said.
The book includes up-to-date tax information, Slott said, including new issues and opportunities presented by the Setting Every Community Up for Retirement Enhancement (Secure) 2.0 Act and other legislative changes with the potential to affect all Americans with a retirement savings account.
During the interview, Slott took particular interest in discussing the sections of the book that urge advisors and their clients to consider the particular virtues of Roth individual retirement accounts and Roth 401(k)s — especially in the current tax environment.
Simply put, tax rates are low from a historical perspective, and there are big budget pressures facing the federal government in the years ahead.
This means the traditional IRA is in a precarious position, as the funds in such accounts are not avoiding taxes — they are merely delaying them. And so, a future with a high likelihood of higher taxes makes the Roth account type look particular attractive today, Slott said.
By making Roth contributions and Roth conversions, investors can effectively “lock in” their tax rate and take future “tax risk” off the table.
Taxes in Their Historical Context
Early on in the new book, Slott offers readers an important history lesion about tax rates in the United States. While history doesn’t repeat itself, he warned, it does rhyme.
“I give the history of tax rates from 1913 and the ratification of the 16th Amendment, which granted Congress the authority to issue an income tax without having to determine it based on population,” Slott said.
“I take the story up through today, but I specifically highlight the years when the baby boomers were being born,” he noted.
Many people don’t realize how high taxes were back then and just how low tax rates are right now, Slott said.
“U.S. income tax began in 1913 at a starting rate of just 7%,” Slott said. “Those were the days. At the time, opponents argued for a provision to cap the tax rate at 10%, but tax proponents pooh-poohed such a cap as unnecessary. They couldn’t imagine rates would ever exceed 10%.”
Just five years later, when the government sought funds to fight World War I, the top rate spiked to 70%. Flash forward another three decades and the rate topped 90% following World War II.
“Not until 1982 did the top tax rate finally drop from 70%-plus down to 50%,” Slott observed. “The whole country did a happy dance. Finally, taxpayers were equal partners with the government on our own money, and we thought that was fantastic. Today, of course, the rates are much lower.”
Today’s top tax rate reaches just 37%, Slott said, although many people pay rates as low as 22%, 12%, or even 10%.
“In other words, these are bargain-basement prices!” Slott said with a laugh. “But these rates can’t remain this low. It’s simple math. Congress needs money, they’re going to have to raise the rates, and the last thing you want is to have your money subjected to the uncertainty of what future higher rates can do to your retirement savings.”
Roth IRAs and Estate Planning
Beyond helping clients lock in today’s low tax rates, Roth accounts are also a much more attractive estate planning vehicle now that the Secure Act and Secure 2.0 Act are the law of the land.
Particularly important is the fact that the original Secure Act of 2019 upended the withdrawal and taxation rules for inherited IRAs for most non-spousal beneficiaries.
The Secure Act established a 10-year rule for inherited IRA withdrawals that eliminated the popular, but at times controversial, ability to “stretch” distributions across most beneficiaries’ lifetimes.
The law and its follow up Secure 2.0 Act also included a significant number of other important policy changes that financial advisors and their clients have to grapple with in the income planning and estate process.
“The end result of all this is that people who inherit IRAs in the next decade are going to be pretty much shocked by the level of taxes they’re expected to pay — unless they inherit Roth IRAs,” Slott said. “More people should consider putting much more of their retirement or legacy money into Roths, it’s just that simple.”
Slott said he frequently gets questions from people in their 70s and 80s who hear this perspective and realize they have almost all of their wealth tied up in tax-deferred accounts.
“They often ask, should I convert to a Roth if I’m 80 years old? What’s it going to do for me?” Slott said.
“Unfortunately, I have to tell them that they are not going to personally see a big benefit from making conversions, but that’s not the end of the story. When it comes to legacy issues, conversions can be very powerful, because your heirs will inherit these accounts absolutely income-tax free,” he explained.
This is especially important when inheritors are themselves in their peak earning years and facing high levels of taxation. When such people inherit IRAs under the new 10-year rule, the negative tax results can be enormous.
“Congress has made the traditional IRA probably the worst single asset to use for wealth transfer or estate planning,” Slott said.
Roth Conversion Pioneers
Slott concluded his remarks by sharing an anecdote about the power of Roth conversions.
“I remember when the Roth first came out and this concept of a Roth conversion was first being talked about,” Slott said. “Frankly, nobody wanted to pay the up-front tax on a conversion, because Accounting 101 tells us to always delay the payment of taxes where possible.
“I was one of the few advocates, and I had one client couple who were both teachers who were a few years out from retirement. They sided with me and went for a conversion strategy decades ago,” he added.
The two teachers each had high salaries (for the time) of over $100,000, thanks to their long tenures, so the conversion had to be carefully considered. “What we ended up doing was having them each take a nonpaid sabbatical so they could keep their income under $100,000 while also doing a big conversion,” Slott said.
“At the time, their teacher friends all laughed at them for leaving wages on the table and paying the taxman early. Well, fast forward a few decades and their combined Roth account value for the two of them is now over $8 million, totally tax free. Now who’s laughing?”
By: John Manganaro
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