Roth IRA Makes a Big Difference in Retirement
In previous articles, I’ve listed the main benefit of a Roth IRA Conversion. You will have no tax on unlimited earnings for your and spouse’s life; and for the first 10 years that your heirs inherit your Roth IRA.
If Biden wins the election, his Tax Plan outlines a number of changes that will greatly increase the benefit of doing a Roth IRA conversion now.
Example #1: You and your spouse are age 60 with $122,050 of federal taxable income and your federal tax would be $18,431.
You have $500,000 in a traditional 401k and decide to convert $500,000 to a Roth. Your taxable income would be $622,050 and the tax would be $167,307.50. So, the marginal federal tax cost of doing a $500,000 Roth IRA Conversion would be $167,307.50 - $18,431 = $148,876.50. Of course, if one combined the 26% solar tax credit with Section 179 from leasing solar business equipment , one could owe $0 federal tax on the $500,000 Roth IRA Conversion.
Assume that you do not need most of this money when retired due to high social security and perhaps a pension. Assume that by the time both of you die; it will have grown to $4 million. Now your only child who is single inherits it and in 10 years it has grown to $6 million, when it must all be distributed. Assume that your child has other taxable income and is still working a good job. Now his tax on the $6 million times a 39.6% rate = $2,376,000. Under the Biden Tax Plan, the maximum federal rate increases from 37% to 39.6%. In contrast, had you done a Roth IRA Conversion, there would be NO federal income tax.
Example #2: You and your spouse are both age 50 and do not plan to retire until age 70. You have saved $500,000 in your traditional IRA. You are lucky enough to be able to retire on two Social Security (SS) checks, which are $84,000 because both waited until age 70 to take SS and you has a $26,000 pension. Assume that your IRA will be worth $4 million upon your death at age 90.
You also own 3 rental houses worth $1,000,000. You only have 1 child. Because you are both engineers, you like to make detailed plans for the future. If you held the 3 rental houses until death in 30 years , assume they would be worth $2 million. Under current tax law, with the step-up in basis, your child could sell them for $2 million upon your death, and would owe $0 federal income tax.
Under the Biden Tax Law, there is NO step-up in basis or capital gains treatment and the full $2 million sale of the rental houses will be taxed at 39.6%, resulting in $792,000 federal tax (assuming that taxable income is at least $1 million). This is because your child decided to cash in your $4 million traditional IRA that he inherited upon the death of Dad and Mom. He pays 39.6% of $4 million = $1,584,000, or a total of $2,376,000 on what he inherited.
Action Planning Step: You decide to sell your 3 rental houses immediately while the market is hot. You will use the $1 million to contribute to your Roth IRA and 401k accounts over the next 20 years. You will also convert your current $500,000 to a Roth IRA. Now, your son will owe $0 federal income tax on the millions he will inherit. Few advisors plan for the next generation.
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Dr. Wong earned his Ph.D. in Economics at University of California/Berkeley and has appeared on over 400 TV/radio programs.
