Did The SECURE Act Set A Time Bomb In Your IRA?

To Roth Or Not To Roth

Did The SECURE Act Put A Time Bomb In Your IRA?

Updated April 15, 2024 

As we approached the normal tax filing deadline, did you ask yourself if there are any moves  to  consider making to save money on taxes?  Would you like to save money on taxes in future years?

Traditional IRAs and 401(k)s have long been promoted as tools to reduce your taxable income while serving to grow your nest egg.  But those types of accounts have limitations and some pitfalls.

One of the long term solutions can be utilizing Roth retirement accounts.

Imagine yourself having carefully planned a nice retirement with more than enough money coming in from your retirement accounts.  You may already have this plan in place.  You have the ability to travel and spend many vacations with friends and family.  And donate to charitable organizations.  And after you leave this world your heirs will be able to enjoy a nice lifestyle.  But a time bomb has been planted that could disrupt those plans with heavy taxes.

THE SECURE ACT planted a time bomb.  It was passed in 2018.  All funds from an inherited IRA must be distributed within 10 years.  This does not apply to a surviving spouse, but does apply to all other heirs.  

What would a $1,000,000 IRA do to an heir’s tax bracket?  Imagine them having to take $100,000 per year out of a taxable retirement account instead of the previous smaller RMD, or required minimum distribution.  Would that push them into a higher tax bracket and subject the inheritance to higher taxes?  And that is without considering the additional growth over the next 10 years.  What if all the money was left in the account for 10 years and then taken out as a lump sum?  

The value of an inherited Traditional IRA as an estate planning tool has been greatly diminished.

One solution to diffuse the bomb is to convert the retirement account to a Roth.  This requires paying taxes now instead of paying them when the money comes out of the account.

Unlike contributions to Traditional IRAs or Roth IRAs, conversions from a Traditional to a Roth account need to be made by December 31 of the current tax year.  

OTHER REASONS TO CONVERT

There are other reasons why you might want to convert to a Roth account.

You expect your tax bracket to be higher in the future than it is today.

The current tax rate cuts are scheduled to expire in 2025.  Do you think our elected officials will extend the tax cuts?  Or do you think they will let them rise to help cover the additional national debt incurred during the pandemic?  This could be a reason to convert to a Roth now.

Your income during retirement may be higher than during your earning years.  

While many people are wondering whether or not they will be able to survive retirement, a better question to ask is “How can I thrive in retirement?”  

Looking back, I think one of the bad pieces of financial advice that I received from a financial professional was to expect our expenses to go down in retirement.  After all, we would no longer need to fund our 401(k) or retirement accounts and would no longer have to contribute to Social Security.  We could live off of our investments and the taxes would be lower.  The reality is that we have higher income available during retirement than when we worked W-2 jobs.  And our travel budget has increased significantly.

The key lies in consistently making our investments grow year after year.  My wife likes to call this situation the wealth snowball.  It’s similar to Dave Ramsey’s debt snowball that is used to pay off debt.  But it pays for your dreams instead of paying your creditors.  And it grows faster as time goes on.  

If you have invested well over a sufficient period of time you might find yourself with a higher income in retirement than during your peak earning years.  This can come about when you add up income from any pension, Social Security, retirement plan RMDs and withdrawals, and any income from other investments including real estate, stocks and bonds.

I’m not suggesting that Social Security income be counted on, but rather it is icing on the cake.  If you don’t plan on it, but it is available when you reach the age of eligibility, enjoy the cake.

Some people are running into tax concerns with having to take RMDs.  

They don’t need the money but have to take the Required Minimum Distribution.  Their accounts have grown to the point the RMD puts them into a higher tax bracket.  Or they may have to pay a higher rate on capital gains, such as on the sale of real estate or stocks.

High RMDs can cause another hit to your cash flow.  The additional income may bump you into a higher bracket for Medicare premiums.

WHAT IS THE SOLUTION?

While we cannot predict the future we do have the ability to prepare ourselves for changing situations.  One solution is relatively simple.  Establish three buckets of income separate from any pension or Social Security income.

Bucket One consists of any investments outside of your retirement accounts.  This would include real estate partnerships, passive income from rental property, and any stock brokerage or mutual fund accounts.

Bucket Two contains all traditional qualified accounts including IRAs and 401(k)s.  You pay the taxes when the money is withdrawn.  RMDs will start at around age 72. But you are not limited to taking just the RMD.  

Bucket Three has your Roth accounts including IRAs and 401(k)s.  The withdrawals are tax-free provided underlying conditions are met.  Many IRA custodians offer free information about Roth accounts and the basic rules and benefits.  Bucket Two assets can be converted to Bucket Three through a Roth conversion.

By having three buckets of income you can decide each year how much you want to take from each bucket.  This gives you more control over how much of your income is taxable and how it is taxed.

HOW MUCH SHOULD I CONVERT?

Of course we like tax-free income better than taxable, so Bucket Three is my favorite.  When asked “How much should I convert?”, the most common answer I get from trusted experts is to convert as much as possible while staying in your current tax bracket.

That is a simple and easy to understand position.  However, if your future tax bracket will be higher, then it might make sense to convert as much as possible while staying below your anticipated future bracket.

On the other hand, if you are getting close to  withdrawing funds from a Traditional account, then you might be expecting to be in a lower tax bracket when you start to withdraw.  Converting may not be beneficial in this case.

If Buckets Two and Three are similar size then you will have greater flexibility to control the amount of taxable income that you receive.  And by converting to a Roth you reduce the effect of RMDs.

Everyone’s situation is different.  I am an investor, not an accountant or attorney. Roth accounts can be powerful but they are not ideal for every situation.

Of course, any of the buckets can be used to invest in real estate partnerships or a number of other investments.  To learn more about how you can fill your buckets, download our ebook at www.AttuneInvestments.com  

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