Are you a CPA who has questions about individual retirement plans (IRAs)? Or maybe you just want to know more about IRAs to make sure you’re doing right for your own future.
In part one of his new mini-series, Marc Bautis throws light on 10 things CPAs should know about IRAs. This informative and energetic episode is all about helping you plan for a financially free retirement.
In this episode, you will learn:
- What the current contribution rates are for IRAs
- Which factors determine your eligibility to contribute
- How to use an NUA strategy to save on taxes
- Whether it makes sense to convert to a Roth
- And more!
Tune in to learn about IRAs and consider if you’re using it to its greatest potential.
Marc: The topic of today’s show is 10 things CPA’s should know about IRA’s. We’re going to make it a two part series. We will cover the first five today and the next five on our next show. A lot of Americans are dependent upon Social Security income, however it will only cover a percentage of your retirement. We are now being forced to save to make sure our money doesn’t run out. A lot of it is on us to make sure that our IRA’s are lasting and they become an important part of financial planning.
On top of it, we’re all living longer. A study was recently published where a husband and wife that reaches 65-there’s an 88% chance that one of them will live until 80, and almost a 50% chance that one of them will live until 90, and almost a 20% chance that one lives to 97 years old. Our retirements are lasting 20, 30, 40 years and maybe even longer. If managed correctly your IRA or retirement account should last as long as you do. On the flip side, managed incorrectly your IRA may be depleted.
Aric: And nobody wants to be a 90 year old Wal-Mart greeter, who has to eat ramen noodles.
Changes in Contribution and Income Limits
Marc: We are going to start off with a couple easy straightforward ones. So the first one I want to look at is: what are some of the changes to contribution and income limits?
In 2019 we saw a couple of key contribution limits that increased. The maximum that you can contribute to an IRA or a Roth is now $6,000 and the deferral limit on 401k plans has increased to $19,000 a year. So on the retirement accounts, there is a decent amount that you can put away per year. The catch up contributions remain the same. So, if you’re over 50 years old, you still – on the IRA or Roth side – can add an additional thousand dollars so you can get up to $7,000 that you can contribute. On the 401k or 403b or the employer sponsored retirement plan, you can actually put away an extra $6,000 so you’re up to $25,000 that you can put away. It’s pretty straightforward, but every year the IRS looks at what the limits are and for the most part they’ve been consistently raising what we can put away each year. Make sure anyone contributing, who is looking to maximize their contribution, actually hits the maximum amount.
Turning 50 is one of the milestones that not just CPA’s, but everyone should be checking. Some of the popular milestones when it comes to retirement are:
- 50 – when you can start making those catch up contributions
- 59 ½ – when you can actually start pulling money out without having to a 10% penalty
- 70 ½ – you may have to start taking required minimum distributions
Those are three milestones that we all should be thinking about.
IRA Contribution Eligibility
Topic number two is on IRA contribution eligibility. We looked at what the limits are, but actually not everyone is allowed to contribute to an IRA. There’s certain factors that go into whether you can contribute. The second piece is whether you can actually deduct that contribution. In order to contribute you need to actually have compensation, which usually means earned income. It could also mean other types of income like taxable alimony.
That’s one of the things that I wanted to go into: any alimony payment made pursuant to a divorce agreement signed in 2019 or later is not deductible by the payer and so it’s naturally not taxable to the recipient. This was one of the recent tax law changes that went into place. Previously, alimony was deductible. What that means going forward is it’s not considered compensation. It is compensation for the person receiving, but they’re paying tax on it.
The other thing to note is that compensation does not include things like interest, dividends, Social Security benefits; that’s all considered unearned income. Unemployment insurance benefits is another example where if that’s your only source of income, you wouldn’t be eligible to contribute to an IRA.
Aric: Got it. Are there any other factors that don’t allow people to contribute?
Marc: Yeah, there is an age limit once you hit 70 ½. That’s another reason why you can’t contribute. Now let’s go into a little more detail on eligibility when it comes to any other types of retirement plans that you have. Even if you have a 401k at work and you’re maxing it out, potentially you still could contribute to your IRA. However, it depends. There are some factors that go into whether or not you can contribute:
- If you’re filing single vs. married
- If you have a 401k at work
- If your spouse has a 401k at work
- What your income is
What the IRS did is they put out all these different tables and it’s pretty much like a flowchart. It shows you how to to look at it and how CPA’s should look at it to determine whether someone can contribute. You have to look at those factors: are you filing married or single, what your income is, whether you’re covered by a 401k at work, or whether your spouse is covered by a 401k at work.
Just to go a couple of those numbers, if you are married filing jointly, you can’t take a deduction if your combined income is over $123,000. Let’s say you don’t have any plan at work, but your income is over a certain amount, you’re not able to take a deduction on it. If the IRA owner is a participant of their 401k at work and let’s say they’re single, if their income is over $74,000, they’re not able to take a deduction.
I mentioned taking a deduction. That’s really one of the main reasons why someone would contribute to the IRA; you get that deduction. If someone earns $100,000 dollars a year in income and they contribute $6,000 to an IRA, when it comes time to pay taxes they’re only paying taxes on $94,000 of income. Everyone likes to pay less taxes. That’s actually one of the three reasons why to contribute to an IRA, so you get a tax deduction in the year that you make the contribution. You’re also deferring tax on any gains or interest that the IRA makes.
So, if you had saved $6,000 on a regular account, at the end of the year you would get a 1099 that says that here’s how much income you earned, here’s how much tax you owe. In an IRA, you defer paying taxes on any of those gains or interest.
Option number three is we’re all going to need some kind of pool of money once we do retire to pay our bills in retirement. This is one of the ways to build up that pool of money by saving it in an IRA.
The third kind of number/income limit we want to look at is if you’re married filing jointly, and covered by a plan at work and if your combined income is over $123,000. I use the word combined because it’s important, people will look at their own and their income might be lower, but it actually takes your spouse’s income into account as well.
Net Unrealized Appreciation
Marc: The next topic we want to talk about is net unrealized appreciation. This is one of the topics that you don’t really hear about too often, but one of the topics we want to dig a little deeper in because there may be a pretty big benefit to utilizing this strategy. It’s often referred to as its acronym which net unrealized appreciation: NUA. What this is, is let’s say someone’s been saving in their company retirement plan and a lot of public companies offer the ability to purchase stock in their company retirement plan. A lot of times, they’ll incentivize someone to do that by offering a discount. So you may get a 15% discount, a 10% discount.
What happens is people, obviously we all like discounts, over time I’ll see a lot of people that have worked for the same company for a long time. They build up these really big positions in company stock where I’ve seen everything from $100,000 all the way up to a couple million dollars where their entire retirement savings is all in company stock. Now that’s a topic for a separate show on why that’s probably not a good idea, but let’s look at it from the tax perspective and what happens; how they can potentially use this NUA approach to save on taxes.
Let’s talk about the person that has that big position in company stock. They leave their job. They decide to rollover that 401k or a company retirement plan into an IRA. What happens is, everything gets liquidated, it goes into an IRA. Then, when they start pulling money out of the IRA, it gets taxed at ordinary income. So the ordinary income rates range based on what your income is. Let’s say someone’s accumulated a lot. They’re pulling out a lot of money each year. It can be as high as almost 40%, which is pretty significantly high.
Now, if we take a step back and we just compare it to what the capital gains rates are, dependent upon income, is usually either 15% or 20%. Let me define what capital gains is. Let’s say you purchased a stock for $1,000 and you sell it at some point in the future for $5,000. The capital gains are the gain that you had on that $1,000, which is $4,000, right? So you’d have to pay tax on that gain at the capital gains rate which like I said, is usually that 15% or 20% rate. Whereas, if it’s ordinary income, you could have to pay as much as 40% in taxes. To summarize all of this: capital gains rates are usually more efficient, or they are what people would prefer to pay tax at.
Going back to our to our net unrealized appreciation example, traditional approach- someone pays tax when they start withdrawing money from their IRA at ordinary income rates. However, there is a rule on the tax book where if you do have company stock, when you do leave the company and rollover your 401K to an IRA, you can carve out that company stock portion of your account and not liquidate it and actually move it to a regular taxable brokerage account. So the question that would automatically come up was why would I take this thing that’s in a qualified tax efficient account and move it to a taxable account, because then wouldn’t I have to pay tax on it? The answer is yes, you’d have to pay some upfront tax on it. The tax that you have to pay at ordinary income is whatever you purchased that company stock for. So we’re going to look at an example in a second.
So you’re only paying ordinary income tax at the price that you paid for the stock. Everything else, all the appreciation, you now have the ability to pay it out of capital gains tax rate. It’s the more efficient tax rate. Basically, what you’re trading is an asset that you’d have to pay tax at the less favorable ordinary income rate to that capital gains tax rate. So, that’s why someone would do it. I think if we look at an example, it may be a little bit clearer on how how someone can save taxes taking this approach.
Let’s actually see some numbers. So, let’s look at someone who purchased company stock for $100,000 in their retirement plan. Let’s say they did this 20 or 30 years ago. Over the years it’s grown and it’s worth $1,000,000 today. Right now, they’re sitting with $1,000,000 of company stock that they paid $100,000 for in their retirement plan. If they take advantage of this NUA approach, here’s what would happen: they would take that million dollars of stock from the 401k and it would get moved into a taxable account. They’d be on the hook to pay taxes on the stock, but only on that hundred thousand that they paid for.
Let’s say someone is in the 28% tax bracket; they’d have to pay about $28,000 of tax on the stock this year. If they keep that stock in that account and it appreciates, let’s say another 10%. So now, instead of being worth $1 million, it’s worth $1.1 million and they decide to sell it. They’d only pay long term capital gains rate on that million dollars of gain which would probably be at the 20% tax rate rather than having to pay tax at 28%. And what would happen is if they withdraw the whole thing, it’ll probably even bump them up into a higher tax bracket. So there’s a couple of different variables that could make this even more appealing to use the NUA strategy. If we actually crunch the numbers they’ll pay two amounts of tax:
- $28,000 on the cost basis of the stock and
- $200,000 which is that 20% long term capital gains on the million dollars
- This totals $228,000 of tax they would owe
A lot of tax, but let’s look at the other scenario: if they take the traditional approach. So if you look at the normal approach and they cash out the stock rolled into an IRA, what would happen is when they withdrew the money they’d have to pay ordinary income tax on that $1.1 million, which potentially could be in that 39.6% bracket. Even if they were still using that 28% example, they’re looking at over $400,000 of tax that they would have to pay. It’s potentially a significant savings to take this approach.
Now, we looked at a simple example. Obviously things are never simple. Each situation is different, each scenario is different. You have to look at: when are they going to withdraw the money out? How much of a gain do they have? What tax brackets are they in? There are different calculators or different ways to crunch each number separately, but at the end of it you can look in and make a determination of this is the better approach to take or what approach is better to take and will result in less taxes paid.
Aric: Yeah and you’ve said it before on this podcast that it’s just worth repeating: every person’s situation is different, just like you said. It’s never just a simple cut and dry. This is exactly how much I have. This is how I got it. So what do I owe? There’s complications and there’s a lot of different strategies that you’re not talking about on this podcast that you’ve talked about in previous podcasts that could be used or implemented. So anybody listening to this please reach out to your CPA and chat with them about this. Give them this podcast or reach out to Marc and his team to say okay my situation is kind of like what you talked about, but I’ve got some other things involved. Can we talk about it? I know Marc would be happy to do that or if you have an advisor already, reach out to them to talk about different types of strategies that’ll help you. Don’t take our advice or don’t take this as as the Golden Rule and go out and do this. Go talk to a professional about it.
Marc: Yeah and I think that’s really the point we’re trying to hit. Any of these strategies are not the optimal strategy for every single person. However, these are the things that should be at least analyzed. I’m a big proponent of when making any financial decision, really looking at the different options, putting the options on paper, looking at the pros and cons, looking at is there a quantitative advantage to taking one versus the other. Then, on top of it, not everything is just numbers-based. You need to look at how it fits into everything else that someone has going on in their lives.You take all those factors into account and like you said, every situation is different. Then, from there, that’s where you can make that analysis and that judgment on this is the approach we’re going to take. But what I see so often is the approach that people take is they do nothing. We shouldn’t be ostriches putting our heads in the sand. Even though that is a choice that we’re making, it really should be to analyze it. If you don’t do anything then that’s fine. At least you did the analysis and you know you made a determination of what scenario or what option is the better path to take.
Roth IRA Conversions
Marc: We’re going to hit the last topic that we’re going to talk about; topic five, which is Roth IRA conversions. This one I’ve talked about on a couple of previous shows, which I’m a huge proponent of and almost everyone that I sit down with and work with, we crunch numbers and look at does it make sense to convert any of your IRAs into a Roth IRA. Same as the previous topic, there’s some situations where it does make sense and some situations where it doesn’t make sense.
What we’re doing with a Roth conversion is we’re actually taking money that’s in a traditional pre-tax IRA. We’re paying the tax upfront and we’re putting it into this bucket or this umbrella of a Roth IRA where the investor or the client wouldn’t have to pay tax on it in the future. So there are a couple of reasons why someone would do this. I know it actually goes against how a lot of CPA’s are hardwired. What they want to do is look in that specific year, and they want to see how can I save the person the most taxes possible right now in this current year.
There are a couple factors where or why this may make sense to look at whether paying the tax upfront, paying the tax now, is a better situation. One of those reasons is that tax rates are relatively low, or tax brackets are relatively low when you compare them historically. Obviously no one has a crystal ball and no one knows what the tax rates or tax brackets are going to be in the future. But, if you can pay your tax now and let’s say you’re in a 20 percent tax bracket and even if you maintain where you are with your income, just from the tax bracket changes by the IRS, the middle income person might be paying 40% of their taxes in 10, 15, 20, or 30 years. We just don’t know what the tax brackets are. A Roth IRA is good because it actually takes the whole tax bracket changes-will they go up, will they go down- out of the equation. It is tax free income that you can withdraw. So that’s one of the reasons for doing it; that’s probably the main reason.
How is it you can strategize it? Actually, let me take a step back and define what happens when you convert to a Roth.
Let’s say you have $100,000 in a traditional IRA that you actually took. You got the tax deductions when you put the money in, so it’s all pre-tax money. When you retire and take the money out, like we said in the previous scenario, you’re going to pay tax on it at ordinary income rate. But, you have the ability to convert some or all of it to a Roth IRA. What that means is, let’s take the example of where you’re going to take the whole $100,000 and convert it to a Roth IRA. You would pay tax on that $100,000 today or the end of the year that you did the conversion and it would look like you earned $100,000 of extra or additional income. At the end of the year or quarter, you get that tax bill that you have to pay and you’d have to pay tax on it. But now, what happens is when you retire and you take money out of that Roth IRA, there’s no tax that has to be paid on it. So, with the pre-tax IRA you’re getting that benefit upfront. With the Roth IRA, you pay the tax upfront but you get the benefit at the end when you pull the money out. So, they’re different vehicles.
Sometimes it makes sense to hedge and kind of have some in pre-tax and some in a Roth but there are a couple of things to consider. I think it was in topic two that we talked about what are some of the limits or why someone wouldn’t be able to contribute to an IRA. When you convert to a Roth, there’s no age limit, there’s no income limit and there’s no requirement that you’re working and have any compensation. It’s very flexible in terms of who can convert to a Roth IRA. It’s something that anyone can take advantage of of doing.
The other thing that’s really good about a Roth IRA is that I come across a lot is that because you’ve already been taxed on it, the government doesn’t force you to withdraw money from it. The government has RMDs (required minimum distributions). Once you hit 70 ½ they start forcing you to pull money out. I’ve come across a bunch of people that say, “I don’t want to pull money out,” or, “I don’t know what to do with the money,” or ,“I don’t have anything to use it for.” Is there some other tax vehicle that they can put this into? The answer in most of those cases is no. The IRS is going to collect their money and they’re going to force you to take money out of your traditional IRA. With a Roth IRA, there’s no RMDs. It’s a great estate planning tool, so you can pass some of this money to future generations tax free. It really has a lot of things going for it.
One last benefit of Roth IRAs is that there’s flexibility with what you can use it for. So again, if we do the comparison between traditional IRA and Roth; on a traditional IRA, if you want to take money out and pay for your kid’s college or buy a car, you really don’t have any flexibility to do that. The government says this is a retirement account. You have to use it for retirement and really no options to use it before retirement. However, a Roth IRA has a five year rule on conversions. After you hit that five year period of time your contributions (which you’ve already been taxed on) technically, you can use them for whatever you want. You can pull it out and help pay for an addition on your house Obviously, this is a retirement account and we want to look and make sure your retirement is all secure and sealed up. But, you do have the flexibility where some people will use it for an emergency fund or as part of their college planning for saving. So the Roth IRA is really a multi-purpose tool that someone can use for multiple uses of financial planning.
Aric: It seems really flexible. That’s the key for anybody. I don’t care what age you are, right? I mean we all need some of that flexibility. How often are you helping clients to convert? You said you always look at it because obviously that’s your job as a fiduciary. You want to make sure that you have every option on the table that’s in your client’s best interest. But how often are these conversions happening?
Marc: We’ll take the first step or first part of the question. We will do an analysis on almost everyone where we’ll look at if we did the conversion, how does this project out? Are they better off not converting? That’s a quantitative look where we can actually pinpoint and say yes you would have X percent more money if you do the conversion. There’s a lot of factors that go into it:
- Tax bracket
Especially working with a lot of business owners, one thing we know about business owners is that their income isn’t always consistent. So, they may have years where their income explodes and it’s a great year or they may have years where the income is not that high. We look for those types of situations where they may have a year where their income isn’t that high because what it means is we’re adding taxable income by doing a conversion. If their income isn’t that high it actually is not a big tax hit because they may be in a lower tax bracket for a particular year. We can convert money when you look at it really cheap in terms of the tax that we have to pay for it. So that’s one scenario.
The other scenario we look for are opportunities where we can fill the tax bracket bucket up. So we all know how there’s different tax brackets dependent upon how much income you earn. Let’s just take two examples and I’ll just use round numbers. Let’s say someone is in a 20% tax bracket and let’s say they have an extra $15,000 they could show as income for the year before they fill the bucket and move to the next let’s say 25% tax bracket. What we would do is we would convert $15,000 of their IRA to a Roth IRA where now they only have to pay it at the 20% tax bracket. Whereas, if we said all right let’s convert $30,000, there’s a portion they’d have to pay at the higher tax bracket. So, that’s why it’s not a simple calculation; and that’s where you want your help from your CPA and that’s what we do as part of this conversion discussion.
We’ll ask the CPA, we’ll say how much left do they have in their current tax bracket before they get bounced to the next tax bracket? That’s the amount that I would recommend converting. So it comes up all the time and we’re doing conversions all the time, especially with the tax brackets being relatively low. I think everyone doesn’t think they’re low and thinks they’re paying too much tax. But if we compare it to historical data, there are definitely opportunities for people to do this.
Aric: Fantastic. You actually answered both of my next questions in that statement which is if you’re able to convert partial, which you already answered.
Marc: Yes, you can do a partial conversion because it gets them to fill that one bucket up until the next tax bracket. That’s number one and the number two is something that you are actually looking at on a yearly basis by just saying hey is this a good year to do this? Yes or no? No, then we wait and we just keep the status quo and if it’s a good year to do it then that discussion is opened up so then that’s fantastic.
Aric: Marc, I appreciate the work that you do with your clients because as a fiduciary you’re constantly trying every time you meet, to make sure that they’re in the best situation possible. So any closing thoughts for today?
Marc: We touched on five topics that CPA’s should be having discussions with their clients on. Some of these things are definitely slam dunks and things that a lot of people should be doing, but some are not. It’s not that everything is going to be a strategy that everyone should take. But, these all should be in their conversations. You want your CPA to be a strategic partner with you and these are the types of topics that you should be talking to them about.
Aric: All right. Thank you Marc this is great and we’ll look forward to part two. And thank you all for listening to the Agent of Wealth podcast with Marc Bautis. If you have not subscribed to the podcast yet, please click the subscribe now button below. This way, when Marc comes out with a new podcast will show up directly on your listening device. This makes it much easier to share these podcasts with your friends and family and your CPA, of course. Thanks again for listening today for everyone at Bautis Financial this is Aric Johnson reminding you to live your best day everyday. And we’ll see you next time.
Thank you for listening to the Agent of Wealth podcast. Click the subscribe button below to be notified when new episodes become available. The information covered and posted represents the views and opinions of the guests and does not necessarily represent the views or opinions of Bautis Financial financial. The content has been made available for informational and educational purposes only and is not intended to be a substitute for professional investing advice. Always seek the advice of your financial advisor or other qualified financial service provider with any questions you may have regarding your investment in financial planning.