President’s 2015 Budget Reinforces Need for Tax Diversification

Last Wednesday at The Slott Report, we released our analysis of the retirement provisions in the President’s 2015 fiscal year budget, breaking the news that, as part of that budget, Roth IRA owners would have RMDs during their lifetimes. Since that time, we’ve been hit with emails, calls and other inquiries about what, if anything, makes sense to do in light of that proposal.

First off, it’s important not to rush and overreact to the budget. Let’s not forget that last year, President Obama’s budget included six key retirement-related proposals. None of them were implemented. In fact, they can all be found again, in the same or similar form, in this year’s budget, along with the seventh key retirement-related, Roth IRA RMD proposal. So, the bottom line is, there’s no need to panic.

On the other hand, just because proposals weren’t enacted in the past doesn’t mean that they won’t be in the future. So should you stop making Roth IRA conversions and contributions just because the President’s budget includes a proposal calling for RMDs for Roth IRAs? Probably not. That said, it does bring to light and, add more value, to an already important planning consideration. Tax diversification.

What is tax diversification? The simplest explanation is having a number of different types of accounts that are taxed differently for federal and/or state income tax purposes. For instance, it might be wise to have some of your money in a taxable account – like a regular brokerage account, some of it in a tax-free account – like a Roth IRA, and some of it in a tax-deferred account – like an IRA. Many people are familiar with the idea of investment diversification, understand its benefits and incorporate it into their planning. Fewer people, however, actively think about their tax diversification.

Diversification of this type has several advantages. One advantage of this approach, apropos to the President’s budget proposal, is that you can help reduce your legislative risk. What in the world do I mean by that? Well, let’s define legislative risk like this … The possibility that the value of certain transactions, decisions or plans you make relying on the current rules is diminished at some point in the future by a change to those rules.

For example, imagine you are 69 years old and decide to convert your entire $300,000 IRA in 2014 to avoid future RMDs. Chances are, adding that much income to your return will push you into a higher tax bracket and increase your marginal rate, but you might think it’s worth it to avoid RMDs (that will soon be required at age 70 ½) and preserve more of your tax-favored retirement funds for your beneficiaries. Now suppose that in three years, Congress enacts President Obama’s Roth IRA RMD proposal. If that were to occur, you’d end up having to take RMDs anyway, and the price you paid to get the money into the Roth IRA almost certainly won’t have been worth it. That’s legislative risk. Tax diversification can’t eliminate the risk, but it can help to reduce it.

Another advantage of tax diversification is that whether your future tax rate is higher or lower, a portion of your savings will have benefited. For example, if your future tax rate is lower, a traditional IRA, 401(k) or similar plan generally gives you a pretty good bang for your buck. It helps you reduce your taxable income in years when your marginal tax rate is higher and allows you to distribute the tax-deferred growth in later years when your marginal rate is lower. On the other hand, if you end up in a higher tax bracket later on in life, due to higher income, tax rates going up, or some combination of the two, your Roth IRA will have been the more valuable move.

A third key advantage of tax diversification is that it can help you manage your tax liability later in life. Sometimes we oversimplify the tax planning of retirement account distributions. For instance, it’s often said that “Roth IRA money is the last money you should ever touch.” That’s a good rule of thumb, but it’s not an absolute. Another common piece of advice you may have heard is “Let tax-deferred accounts, like IRAs, grow for as long as possible.” This, again, is a good rule of thumb, but shouldn’t be an absolute. Let’s look at a few examples to see what I mean…

Imagine you’re retired and file a joint return with your spouse. You’re receiving Social Security benefits, you have a pension, you take periodic distributions from your IRA and you have dividends, interest and capital gains from a taxable account. All together, let’s say you have $230,000 of income – not too shabby! Now imagine that some significant expense comes up that you haven’t already accounted for with your existing income. Maybe you decide to take the whole family on a once-in-a-lifetime trip to Europe, maybe you decide to buy that vacation home your spouse has always wanted, or maybe it’s the classic muscle-car you’ve dreamed of owning since you were a kid. Whatever it is, it’s going to cost you a pretty penny and you’re going to have to come up with the money from somewhere.
You could follow conventional wisdom, leave your Roth IRA alone and take money out of your IRA first. That IRA distribution, however, could lead to some pretty significant tax consequences. Depending on how much you take, you could:

• Push yourself into a higher tax bracket
• Cause some or all of your personal exemptions to be phased-out
• Cause some (up to 80%) of your itemized deductions to be phased-out
• Push yourself over the married-joint health-care surtax threshold, subjecting some or all of your interest, dividends and capital gains income to the additional 3.8% surtax
• Increase your Medicare part B premiums in the future

Do any of those sound particularly appealing to you? I didn’t think so. A second option would be to sell additional stocks, bonds, mutual funds, etc. in your taxable brokerage account, but that could lead to all of the same consequences as above (although, if you have investments that are currently at a loss, you could use tax loss harvesting to minimize or eliminate that impact). Plus, if you hold on to the appreciated capital assets, like stocks, bonds and mutual funds, in your taxable account, your beneficiaries will get a step-up in basis upon your death and will pay no tax on the gain up to that point. Thus, this may not be the best option either.

Cue the third option, your Roth IRA. Although conventional wisdom says to leave the asset that’s growing tax-free alone for as long as possible, given the host of negative tax consequences that could befall you by adding more taxable income to your return – either in the form of IRA distributions or capital gains – it may be worth dipping into your Roth IRA to supplement your income for this particular year.

Now let’s flip the example on its head a little bit. Let’s imagine that you’re 65 years old and receive Social Security benefits and a modest pension. The pension and Social Security benefits cover your expenses, so you don’t need to supplement your income with other sources. Let’s also assume that you have about $500,000 in an IRA that you rolled over from an old employer. You don’t need the money and you haven’t reached the age at which you must begin taking required minimum distributions, so you leave it alone.

Depending on the size of your pension, you could find yourself in an extremely low tax bracket, and you may even be avoiding tax on your Social Security altogether. Although conventional wisdom says to let your tax-deferred IRA grow untouched for as long as possible, it may pay to start pulling money out of your IRA sooner, rather than later. Doing so might allow you “fill up” your 15% tax bracket which, conventional wisdom (there’s that term again) says, is generally a good move. On the other hand, leaving your IRA alone might let it grow more tax-deferred longer, but by the time you turn 70 ½ and have to take RMDs, your distributions might be large enough to push you into higher tax brackets or cause more of your Social Security benefits to become taxable. There are other scenarios, similar to those outlined above, such as the option of using more IRA money earlier in retirement to provide enough income so that you can delay taking Social Security – a more tax efficient type of income.

The common denominator in all these scenarios is that by having multiple types of accounts with different tax properties – tax diversification – you can increase your flexibility during retirement and, from a tax perspective, you can better cope with the challenges that are thrown your way. Not to mention, as discussed above, tax diversification can help you minimize risk. More flexibility? Less risk? Do these sound like things you want during retirement? Well then make sure tax diversification is part of your retirement conversation.