Tax Favorable Strategies for High Income Earners

[SensibleandHourly]

Good afternoon and Happy November! 

Curious the collective wisdom from the group in regards to any possible favorable tax planning strategies for a high income earner who also exercised stock options earlier this year? He is wondering if there is anything he can do to alleviate taxes at this late date. Also, he plans to take about this same amount going forward for the next three years until retirement. He and his spouse both born in 1964. I was considering the admittedly somewhat small impact of (a) possibly adjusting 401k contributions, (b) verifying that he is maxing out any opportunity to contribute to his HSA (c) lump sum 529 deposit for only grandchild? (d) donor advised funds? Any other ideas I am missing? (P.S. Any positive impact is better than none! 🙂 

Thank you in advance for any who might have a few minutes to consider the numbers and the dilemma. Approximate numbers taken from last year's tax return: 

Box 1 - -508,223.        Box 12 - C. 1,336. D. 23,700. DD. 17,726. Box V. 253,925. 

Have an amazing Monday,

Dawn . 

[qbteachmt · Accepted solution]

Tax avoidance isn't always the best goal.

One issue is IRMAA. You mention, "for the next three years until retirement." They are 57 now, plan to retire around 61, and that means they still have 4 years prior to Medicare, and that means managing costs based on the IRMAA table would be one consideration because, "SSA determines if you owe an IRMAA based on the income you reported on your IRS tax return two years prior, meaning two years before the year that you start paying IRMAA." Even if they cannot stay in the lowest bracket, perhaps they can use management tools to avoid jumping to the bottom of a next higher bracket.

https://www.medicareinteractive.org/get-answers/medicare-health-coverage-options/original-medicare-c...

To be honest with you, having so much income that this is a problem, then trying to manage 401(k) relative to this, is like digging out a hole and making a pile you later have to dig. Aren't they already maxing this? Sure, deductible retirement is good, now. Not later, though.

They are young enough that non-deductible contributions with tax-free earnings (Roth) would be better, if they have extra to invest, and while backdoor still is an option, I would imagine they have Roth 401(k) as an option. And, they should use some of their funds to make taxable conversions out of Trad IRA/4014(k) and pay that tax now. Then enjoy the tax free growth.

In other words, instead of trying to distribute this into various plans to reduce some proportionate taxes owed, I would use that bonus of found money to start setting myself up to ride into the sunset in a better position. That might mean paying even more taxes now, of course, and clearly, this gives them the headroom for that cost.

And if they have Roth 401(k), they will want to transfer that to Roth when they qualify, to avoid RMD.

And they should give as much as they can to as many programs and functions as possible, because they can.

[PATAX]

In addition to what qb stated you may want to remember the following: last year they made tax law changes in the middle of March and made it retroactive to the prior-year...

[BobKamman]

When you say he exercised stock options, do you mean he exercised and sold?  Doesn't think the company has much future once he leaves?  There are drawbacks to having too many eggs in one basket, but I would look at ways to hedge if the income is attributable to selling, not just exercising.  

[BobKamman]

These why-pay-later-when-you-can-pay-now fans of Roth IRA's always remind me of my client who did a substantial conversion from a 401(k) rollover IRA to a Roth IRA. He invested it in about 1,000 shares of a tech stock trading above $70 a share.  This was before the 2008 crash.  A couple years later it was below $10 a share.  Of course, back then it was predictable that the market would crash.  We know that's impossible these days.  

[Norman2001]

They can look into Qualified Opportunity Funds. I have a client that invested over $200k that would otherwise be taxed at STCG rate.  But, always advise researching the funds since they are  relatively new investment vehicles. 

[BobKamman]

Qualified Opportunity Funds work with capital gains and Form 4797 gains.  I don't see any of those here -- it looks like the stock option exercise-and-sales are reported on W-2 forms.  If the stock can be held long enough for capital-gain treatment, and the QOZ rules aren't repealed, then that may be worth considering.  

[qbteachmt]

"These why-pay-later-when-you-can-pay-now fans of Roth IRA's"

Here's why I'm a fan.

Because a theoretical 30-year old can have $5,000 in either type of account and let's have it double every 7 years on average:

5k at 30

10k at 37

20k at 44

40k at 51

80k at 58

160k at 65

320k at 72

And you would rather pay taxes on each RMD in full, but I would rather pay none and also have no RMD requirement. Remember, either account type, same investment type = same return. And of course I'd rather pay taxes on the $5k, because that taxed contribution is a pittance compared to the end result.

If you do it right.

[SensibleandHourly]

Thank you to everyone who took the time to respond, I appreciate it greatly!!

I would agree that there is much to be said for simply paying the tax now, rather than seeking shorter term deferments that have their own drawbacks and future obligations. We have discussed the advisability of future IRA Conversions in the years after he retires. IF in fact, there are no other changes to the tax code, of course. And, yes, he exercised AND Sold this year, and will for the next three years. I do wish he had been my client many years ago because he is definitely not diversified with industry or account type, but he will be, before we are done. It just might take a few years to get there. 😉 

Again, thank you for being other 'sets of eyes' as they say. I find that sometimes I get too deep into a case and can potentially miss the obvious, lol. 

Oh, and I will check out the Qualified Opportunity Funds, although, I think that might be a long shot at this point, but good information to brush up on. 

Cheers, Dawn

[Taxes-by-Rocky]

With all the uncertainty surrounding Roth conversions, there is one variable that is almost guaranteed:  once you pay that tax on the conversion (or salary), you won't ever be getting it back.  NOLs are a wonderful thing - sort of - but they're rarely available to most taxpayers.  And, in the days when we actually had interest rates, I'd much prefer earnings or appreciation on $10 than on $5.  Further, medical costs and nursing home costs have a funny way of approximating those RMDs, potentially reducing or eliminating their tax bite altogether (better yet, providing conversion opportunities to leave the remainder to the kids).  While I'm not a fan of the estate tax and would prefer a reduced RMD, I'd certainly rather be diversified (from a tax standpoint) having seen enough to know that the odds aren't always in your favor, or the future as predictable as some might lead you to believe.

[qbteachmt]

"We have discussed the advisability of future IRA Conversions in the years after he retires."

At that point, it's hardly worth it. Paying tax on conversion or paying tax on distribution is the same, and there isn't as much time for tax free growth, once you are over 70, unfortunately. It's a bit of a gamble if you will live long enough for that conversion to ROI, and now it significantly impacts IRMAA. So, there is that additional cost on top of the taxes, which would not be a cost under taxable RMD.

I typically advise early retirees (non-working) to do all planned conversions by 66-68 and for workers to do planned conversions by only a year or two later. If IRMAA is a consideration or they need to collect SS at 62, then also do conversions by 62.

But, if they are sitting pretty, then later conversions (although taxable) when they won't touch a Roth, still are nice for the beneficiaries, as long as the 5-year rule is met. And, again, since you most likely don't know when you will die, it pays to make conversions sooner rather than putting them off until later.

[SensibleandHourly]

Good points! 

This client plans to retire at age 60 and does have concerns about his only child inheriting a significant sum in a Traditional IRA. Of course, no one knows how long they are going to live! 

Make it a great day, 

Dawn 

[BobKamman]

@Taxes-by-Rocky  You hit two nails on the head:

there is one variable that is almost guaranteed: once you pay that tax on the conversion (or salary), you won't ever be getting it back.

medical costs and nursing home costs have a funny way of approximating those RMDs, potentially reducing or eliminating their tax bite altogether

@qbteachmt And another point well-hammered

Paying tax on conversion or paying tax on distribution is the same,

But I don't understand the rest of your observation:

and there isn't as much time for tax free growth

Regardless of the time period, the end result is going to be the same, assuming rates don't change. $100,000 compounded at 5% for x years, times tax rate at distribution, is going to be the same as ($100,000 minus taxes) compounded at 5% for x years.

Which brings up the point that no one here mentions:  All the crazy Californians who are doing their Roth conversions before moving to Nevada or Texas, and all the crazy New Yorkers who are doing their Roth conversions before moving to Florida.  If we're going to be blind people describing the beast, at least tell us where the elephant is located, and where it might be headed.  

[qbteachmt]

"But I don't understand the rest of your observation:

and there isn't as much time for tax free growth"

Well, that included "once you are over 70"...

"Regardless of the time period, the end result is going to be the same"

Yep; you're dead, and someone else deals with any residual funds. But, you're either dead sooner, or you're dead later.

If I am converting to maximize tax free growth and earnings, I would rather do so while I have a more statistical probability that paying tax on the conversion will be recouped in growth. And hope I don't die until 5 years after that latest conversion to Roth.

[BobKamman]

@qbteachmt  The whole point is that tax-free distribution on a smaller amount never catches up with taxable distribution on a larger amount after payment of taxes.  Some people just never get it.  And that doesn't take into account that the tax paid years later is due in dollars of lesser value because of inflation (which eventually will return to normal levels).  

[qbteachmt]

@BobKamman 

"Some people just never get it."

If your Roth account isn't doing as well or better than your Trad IRA account, you have a different issue than worrying about timing conversions.

[BobKamman]

If you don't understand basic math, you have the same issue as others  providing poor advice to clients.  

[qbteachmt]

"If you don't understand basic math, you have the same issue as others providing poor advice to clients."

Wow. That really is uncalled for. I could state something similar, but I try to let you rant whenever you want to on all sorts of topics that you insert into your replies on this forum.

If you can't play nice with others, you should not play at all.

[SensibleandHourly]

Good Afternoon, 

This has been a really helpful and eye-opening thread! 
Just for clarity, the client is 57, and would like to retire at 60. It is his understanding that he need to exercise/sell the last of his 600k of stock options before retirement. He has substantial qualified and non-qualified assets as well. (Approx 800k/400k). Spouse has already retired and has approx 100k in qualified assets of her own. They own three homes, with a potential home sale of one of the homes in the next several years- time frame not determined. They have one child and one grandchild. Earned income approx 150k. Looking to be wise over the next few years as they consider all of these moving parts; implications to their retirement, Medicare, future RMDs and ultimately leaving assets to their daughter. 

I do sincerely thank each of you for taking the time to comment and share your perspective. 

[qbteachmt]

It's a great question, and planning is always a bit of a moving target. The last quarter of the year is a great time to work on these issues. I've had to remind quite a few people to take their RMD this year; they thought that was officially suspended as ongoing.

Too often people realize too late, "Oh, that specific step had to be done by Dec 31, to be included on my April 15 filing?"

[BobKamman]

@qbteachmt   "If your Roth account isn't doing as well or better than your Trad IRA account, you have a different issue "

Wow. That really is uncalled for.  If you can't play nice with others, you should not play at all.

I know you will avoid the challenge, but here it is if you choose to stop comparing apples to oranges.  

Take any amount.

Choose any tax rate, and assume it's the same at the time of conversion and at the time of distribution. 

Choose any rate of return, and assume the traditional IRA is invested the same way as the Roth IRA.

Choose any number of years. 

Show just one example of where the Roth account after taxes, is greater than the traditional IRA after taxes.  

[joshuabarksatlcs]

This is generally how I put it when I address the "to convert or not to convert" question.

Mathematically, it doesn't NOT make any difference in the decision in regards to the after-tax result between converting (and pay tax NOW) and not converting (pay tax later) IF:

1.  There is NO change in tax rate; 

2.  Same rate of return for the Roth IRA and IRA accounts; AND

3.  The inflation rate (let's just say it's used as the discount rate for the relevant present value computation) is identical to the rate of return (the growth rate of the investment).

Regarding the impact of each variable:

*  Tax rate hikes make Roth conversion favorable.

*  High inflation (inflation rate exceeds the growth rate) makes Roth conversion unfavorable - you pay tax with "cheaper" dollar if you do NOT convert and pay tax later.

The examples about CA and NY folks doing the conversion and moving to NV or FL, categorically, fall in the consideration under "Item 1", i.e. Tax Rate Change". 

Likewise, a move from a low tax state to CA or NY would practically result in a "tax hike".

That said, I would say @BobKamman has missed a very important consideration in the real world - the issue of rational versus behavioral decision making.

@BobKamman said:

Take any amount.

Choose any tax rate, and assume it's the same at the time of conversion and at the time of distribution. 

Choose any rate of return, and assume the traditional IRA is invested the same way as the Roth IRA.

Choose any number of years. 

Show just one example of where the Roth account after taxes, is greater than the traditional IRA after taxes.  

You can slice and dice the comparison, mathematically and rationally, and conclude there is NO difference.  I'd give @BobKamman  that.        

But I'll also give @BobKamman not ONE but two examples.

Let's take an IRA of $100K at a modest 30% tax rate thru the period.

You would be comparing the growth of $100K in the IRA (at the same rate) and $70K (after tax) in the Roth IRA, and yes, over the years, after paying 30% tax from the IRA withdrawals, it would all be mathematically equivalent to the (nontaxable) withdrawals from the Roth IRA.  Mathematically speaking.  I have no problem there.

However, in the real world, the $100K IRA would be converted to a $100K Roth IRA, and the converter would pay the $30K tax as part of the tax filing for the conversion year.  In the mathematical comparison, it would then be necessary to compare (1) the after tax withdrawals from the IRA PLUS the growth of the $30K to (2) the nontaxable withdrawals from the Roth IRA account that started with $100K tax free growth.  Mathematically, they should be the same also, but this is where rational versus behavioral economics comes in play.  In the real world, the converter would say "ouch!" and pay the $30K in tax as part of the tax filing in the conversion year, while the NON-converter would spend the $30K in upgrading the kitchen, a diamond ring, a wedding for the daughter or in my case a few cases of Kavalan Px Sherry Single Cask 6, for my own consumption or for my friends.

At the end of the comparison period, the converter would have the SAME amount in the ROTH IRA account - tax free - as the non-converter's IRA account because in Year one both accounts started with $100K.

Of course the rational decision maker would (justifiably) argue the value of the utility of the kitchen remodeling, the daughter's wedding, half of the corvette, or (in my case!!) the few cases of Kavalan Px Sherry Single....

Example two, by the same token, and an example that parallels the "To convert or not to convert, that is the" Question.  Twin Brothers B1 and B2 have argued all day about which way to go - universal life insurance or Term Life Insurance. 

B1 says, Universal Life is better because there is this investment element.  B2 says, Term Life is better because if you invest the cost difference prudently and beat the rates provided by the blood-sucking insurance companies in the Universal Life (easy to do because you can find the same hedging investment programs and SAVE the charges charged by the blood-sucking insurance companies), you'd be so much for ahead.

@BobKamman wolud likely agree with B2.  I regrettably did 30 years ago.

But in reality, after 30 years when B1 and B2 met again and made the comparison (both bald by then), B1, the dumb brother, has a pot of investments in his Universal Life Policy.  B2 had a gut from the bourbon and beers that he had paid over the years with the cost difference.

Rational vs behavioral...   Dumb Brother always beats the Smart Brother....

[BobKamman]

You must be really old to be arguing about A. L. Williams insurance marketing from back in the 70s. Certainly too old to know what someone’s tag line about “Level Up” means. But the adage about how “life insurance isn’t bought, it’s sold” certainly applies to Roth IRA’s. A. L. Williams was the Mary Kay of financial products, and its part-time agents had the same sophistication as those touting Roths these days.

The point, of course, is made succinctly here:

“The longer the time period held, the better a Roth is over an IRA contribution. This myth is repeated too often. The premise is the longer a Roth grows tax free, the better it is than an IRA which is taxable upon contribution. It doesn’t matter if you hold 1, 10, or 30 years; if the tax rate at contribution is the same as your tax rate when you take distributions, it will work out to be the same ending value.”

https://www.virtuswealth.com/myths-of-income-taxes/

The discussion these days could be whether to “invest the rest,” or to put that $30,000 paid for the privilege of a $100,000 Roth, when the investor could instead use the funds to pay down a mortgage. For millions of homeowners, there is no tax advantage to mortgage interest. They claim the standard deduction anyway. And if they have kids headed to college, that Roth will scotch scholarship dollars faster than home equity.

I did figure out, though, why tax-depleted Roths are pushed by the “financial planners” who work off a percentage of the value of the accounts they manage. They’re stupid. If they knew how to manage money, they wouldn’t be trying to do it for other people, they would have enough of their own. Roths are a niche, not a panacea. But they have become part of the same game as the Annuity Scam, or the LLC Scam, or the Living Trust Scam. People do them, because everyone else is doing them.

[qbteachmt]

"Show just one example of where the Roth account after taxes, is greater than the traditional IRA after taxes."

I'm certain you can do your own math. Afterall, there are plenty of comparison calculators on the web, and even Excel can be used for this. I doubt you need my help. And that's exactly the exercise you would do, if advising another person.

I already provided an example of why investing in a Roth from the beginning makes more dollars and sense than taking a tax deduction on the contribution, if you have enough years ahead of you. And of course, all of this makes some assumptions as to life expectancy, inflation, growth and earnings, and tax rates. Because that is how modeling works.

"However, in the real world, the $100K IRA would be converted to a $100K Roth IRA, and the converter would pay the $30K tax as part of the tax filing for the conversion year."

Exactly. Out of the proceeds of exercised stock options that get sold. That was one of the parts of the options offered to the original question of this topic.

"Certainly too old to know what someone’s tag line about “Level Up” means."

No one here is too old or too young to know what that tag line means, because I clearly defined it, in the use of it. I used the signature line to describe to Intuit what it means. Right here:

⬇️

[joshuabarksatlcs]

Yes, I'm old.

I'm old enough to know Daniel Kahneman won the Nobel Prize for his studies in behavioral economics - and how he had changed the lay of the land in the field of economics.  But no, I'm nowhere as old as Kahneman, 

I'm old enough to know there are NO one-size-fits-all solutions when it comes to tax or financial planning. 

I'm old enough to know the Asian expression of how a person falls but manages to grab a handful of dirt.

I'm old enough to know the dirt thrown at @qbteachmt was not exactly grabbed when Bob fell, but the dirt about I'm old was.

I'm old enough to have met a man or two, who always thinks how everybody is stupid, and when a smarter guy walks in the room, he would be bitter inside but could always find an angle to show he's smarter than the smarter guy.

Yes, I'm old, but I'd rather describe myself as seasoned. 

[PATAX]

@BobKamman @SensibleandHourly @joshuabarksatlcs @qbteachmt @Taxes-by-Rocky I think Bob  really hit the nail on the head when he said we know that it's almost impossible now for the stock market to crash, here is why in my opinion:  there is too much money out there all over the world that needs to be invested and the USA is the safest place, where else would they invest it that is safer than here, the Middle East? Latin America? Asia? ...Second, due to mergers over the years there are less major American companies to invest in than before , I think people understand what I'm saying here so I won't explain supply and demand ... 3rd I'm sure all of us are aware that it appears that the tax code always favors a bullish  Wall Street, IE low capital gain tax rates if any, increasing IRA and pension contribution amounts, and so forth... maybe that is why my broker is in Europe all the time at his vacation residence there, and I am stuck here ..... he isn't smarter than any of us , he's just in the right field.....