Congress has been getting better at hiding tax increases on the middle class the past decade or so. The Secure Act, and to a lesser extent Secure Act 2.0, are prime examples of how Congress saddled the middle class with higher taxes under the guise of providing better opportunities in retirement planning.
Let’s review two features of the much lauded Secure Act and Secure Act 2.0.
- The Secure Act increased the Required Minimum Distribution (RMD) age to 72. Secure Act 2.0 increased the RMD age to 73 in 2023 and will climb to 75 in 2033.
Raising the RMD has been a proposal both sides of the aisle embraced. The problem is that many people have very large traditional IRAs already and this will create an even bigger problem for those people when RMDs kick in at a higher age.
The attorneys over at the U.S. Treasury felt the IRS has too much budget (before the IRS got an $80 billion increase from the Inflation Reduction Act) so they took a simple concept, distributions over 10 years, and complicated it. Under old rule you were required to distribute the entire IRA within 5 years unless you opted for a stretch IRA where distributions could be taken over life expectancy.
The old 5-year rule was simple. Restated: You had 5 years to completely distribute all funds from the inherited IRA; distributions could come in any amount in any year as long as the IRA was depleted by the end of year 5.
The Secure Act 10-year rule was expected to be treated the same way until Treasury attorneys made a mess of it. The 10-year distribution rule on inherited IRAs require you take an RMD for all years there are funds in the inherited IRA with the account depleted by the end of year 10. I guess the government wanted a little bit each year for the tax increase Congress passed.
The Secure Act Tax Increase
How can any of this be a tax increase? Congress allowed taxpayers more time before they had to take money from their IRA as an RMD and inherited IRAs got 10 instead of 5 years to take distributions. Never mind the removal of the pesky Stretch IRA. (The Stretch IRA was never pesky, BTW.)
The tax increase buried in the Secure Act is hard to notice at first. You need to follow the money all the way to the end to see it.
First, notice Congress now allows IRAs to grow bigger before distributions are required. One one hand the higher RMD age provides more planning opportunities, but also means IRA balances will be higher for at least some people.
Now we need to ask, who inherits an IRA?
In most cases an IRA is inherited by the kids if there is no surviving spouse. How old are the kids typically when they inherit these IRAs? In their 40? 50s?
Life expectancy in the U.S. is in the mid to upper 70s. Parents are in their mid to upper 20s when they have children. That means, on average, the kids inherit from parents when they are approximately 50 years old.
And what can we expect to see financially from the kids when they are 50 years old? They are probably at their peak earning years.
And when Congress required inherited IRAs to be distributed within 10 years they knew all that accumulated family wealth would be taxed at the highest tax rate in the inheritor’s life.
Why the Rich are Unscathed
At first glance you might think the top 5% of wealthy people would suffer the same fate. But there are two reason this is not so.
First, wealthy people are locked into the upper tax brackets to start. New monies will not increase their tax bracket. For the wealthy, the Secure Act accelerates their tax bill, but rarely increases the total liability.
The second reason the wealthy are less affected is due to how they invest.
The middle class has the bulk of their net worth locked up in either their home and/or retirement accounts. Wealthy people have more non-qualified (non-retirement account) investments.
Traditional retirement account distributions are taxed at ordinary rates, which currently top out at 37%. Long-term capital gains and qualified dividends from non-qualified accounts are currently taxed at a maximum of 20% with the Net Investment Income Tax (NIIT) adding another 3.8% for many.
A quick glance shows that the middle class is taxed at a higher rate than the wealthy not only by accelerating when income is claimed, but by the investment mix. Even with NIIT, non-qualified account LTCGs and qualified dividends are taxed at a 13.2% lower rate than the highest ordinary income tax rate!
Beat the Tax Increase
The middle class tax increase can be averted with tax planning. You will need to think like the rich to achieve the goal of lower taxes, but it is doable.
First, the traditional IRA is a sucker’s game. You get a deduction on contributions, but pay tax on all the gains at the higher ordinary rate.
If you are a hyper saver and amass $1,000,000 in your traditional retirement account by the time you are 40, the value of this account will reach $10,834,705.94 without adding another cent, assuming you invest in an equity index fund and the stock market continues to average a 10% long-term rate of return.
Under the new Secure Act 2.0 rules allowing you to wait until age 75 before starting traditional IRA distribution, the account value climbs to $28,102,436.85! Your RMD will approach $1 million per year!
And before you say your retirement account value isn’t that high, you can adjust for the account value you do have. Still, many people are now accumulating large amounts inside their retirement accounts and the tax consequences are severe. You can use this future value calculator to see how your future account values will stack up.
Before your account balances in your traditional retirement accounts become an issue it is wise to consider alternatives.
Many people fear the non-qualified account. There is no upfront deduction and gains are taxed either as earned (dividends and capital gains distributions) or upon sale of the asset.
But the taxes on capital investments enjoy preferential treatment. While the long-term capital gains tax rate can go as high as 20%, many taxpayers, especially in the middle class, only pay 15% or less. Under current tax law, qualified dividends and long-term capital gains enjoy a 0% tax bracket if total taxable income is less than $44,625 for singles; $59,750 for heads of household; and $89,250 for joint returns in 2023.
The math isn’t so simple as comparing taxes on retirement plan income and non-qualified accounts. With tax rates nearly 50% lower and more compared to non-qualified investments in equities, it starts to look like traditional retirement plans have serious headwinds to overcome compared to alternatives.
You also have an ace in your back pocket: the Roth.
The problem is plain to see in the example earlier in this article. $1 million can turn into $28 million given enough time. And that means the $1 million deduction will cause an additional $27 million to be taxed at ordinary rates.
The Roth retirement product flips the equation around. Instead of paying tax on all distributions at the higher ordinary rate, the Roth product gives you no deduction now and tax-free growth forever.
Using the example above, we pay tax at ordinary rates on the million now, forgoing any time value of money from the tax savings, and gain $27 million in tax-free income later. And if you don’t use it up, your beneficiaries also enjoy the same tax-free income.
How do you get a large amount inside a Roth? There are three ways to super-charge your Roth. Your 401(k) at work may allow all elective deferrals to be placed in the Roth vehicle. You can also use the mega-backdoor Roth to send your Roth into warp speed.
Then we come to the strategy used by billionaire Peter Thiel. Thiel took a Roth IRA worth under $2,000 and turned it into $5 billion, all of the gain tax-free.
Thiel invested the money into a company he started called PayPal. You may have heard of it. When the company was all grown up he sold for a nice gain. Since the stock in the company was owned by his Roth IRA he didn’t have to share with his uncle in Washington.
You don’t have to swing as hard as Peter Thiel to use this tax strategy. If you are starting a business you can organize as a regular corporation, sometimes called a C-corp, and have your Roth IRA buy the shares of the corporation. Wages go to you personally while dividends and capital gains go to the Roth where they are untaxed.
The Importance of Planning
Tax planning is not as simple as considering the current tax year or a few years out. When I consult in my office I consider “all years.”
All years considers the consequences of actions on the future and even the far future of your life, including legacy. RMDs, since they are required, can mess up a tax plan in retirement. High RMDs can increase your cost for Medicare premiums when you reach age 65 and older, a de facto tax increase. You can even mess up your beneficiaries taxes with a poorly designed tax plan.
The kind of planning I suggest is very wholistic. Factors not considered taxes are sometimes affected (Medicare premiums as an example).
It takes time to structure an optimal tax plan. A qualified tax professional is virtually a necessity. There are just too many factors for someone not working taxes daily to consider.
This article is not all-inclusive. I outline the basics so you understand the thought process in developing an optimal plan. I also wanted you to see how things are not always as they appear when it comes to taxes.
Armed with the basics, you can build a team that will help you develop a tax plan that serves you and the beneficiaries of your legacy for decades to come.