Two Smart Retirement Tax Moves to Consider Before Year-End

With the end of the year just around the corner, now is the time to consider year-end strategies for tax planning. Ed Slott, CPA, suggests that low tax rates offer opportunities for some taxpayers to make some smart retirement moves.

We know what tax rates are today, and they are historically low, but this may not last much longer given our nation’s fiscal situation.
The foundation of all good tax planning is to always pay taxes at the lowest rates. For many, that may be now in 2021. That can be true, even if you believe you will be in a lower bracket—at lower marginal tax rates—in retirement. We don’t know what Congress has up its sleeve, but we got a peek at recent proposals. At some point taxes will have to increase, so it’s best to bring down taxable IRA balances now, before year-end when we may still be able to take advantage of lower tax rates.

Two ways to remove funds from growing retirement accounts are through Roth conversions and charitable gifts.

Year-End Roth Conversions
Roth conversions can be done at any time. But you may want to consider getting a Roth conversion done before year-end to lock in today’s tax rates.
Yes, that will increase taxes this year, but the long-term benefits will likely far exceed today’s tax cost. If Roth IRAs are used for their intended purpose—in retirement—then distributions will generally be income tax-free. Plus, Roth IRAs have no required minimum distributions—RMDs—like IRAs do, so the funds can continue to accumulate tax free if not needed. If the funds are needed, they will not increase your income since distributions will most likely be tax free. That will be a good hedge against the uncertainty of future tax rates.

If tax rates increase, Roth IRAs will become instantly more valuable, both during your lifetime and to pass on to beneficiaries.

RMDs Conversions Before RMDs Begin
RMDs were waived for 2020, but they are back for 2021. The SECURE Act increased the RMD age to 72. Roth conversions will be more advantageous if they are done before RMDs begin. That’s because RMDs cannot be converted to Roth IRAs. RMDs must first be satisfied, and then any part of the balance can be converted. But at that point, the Roth conversion becomes more expensive.

If you will begin RMDs next year, or even in 10 years or so, it might pay to start doing conversions now. Consider a series of smaller annual Roth conversions so that over time, you are getting those funds out and using up the lower tax brackets. This will also help you dollar-cost average into the Roth over time to buffer against market volatility along the way.

Roth conversions done before RMDs begin will bring down the balance of the IRA, so that when RMDs begin, they will be based on a lower balance resulting in tax savings in retirement. This is a good defensive move against the prospect of increased taxes in the future.
To qualify as a 2021 Roth conversion, the funds must be withdrawn from the traditional IRA before year-end. The funds can be converted early next year—if done within 60 days of the distribution—but it’s always best to do a direct transfer from your IRA to your Roth IRA to make sure it gets done timely.

Remember that Roth conversions are permanent. There’s no going back. Once you convert, you will owe the taxes even if your financial situation changes. That should not deter you from converting but before you do, make sure you will have a good estimate of what the tax bill will be.

Converting near year-end helps you estimate the cost, since by this time you are likely to have a better idea of your 2021 income, including those capital gains that mutual funds will throw off at year-end, and any other spikes in income. The reverse is also true. You might see that you can convert more than you thought by taking advantage of a lower income this year, maybe due to a retirement, a business pass-through loss, job loss, or large deductions that could lower the tax cost of the conversion this year.

QCDs—Qualified Charitable Distributions
If you give to charity, you are probably not receiving tax benefits for the gifts you make. That’s because most people no longer itemize their deductions due to the higher standard deduction. Yes, non-itemizers can still get a $300 deduction for cash donations—$600 for married-joint filers—but many people give much more than that. QCDs can fix that problem if you qualify.

A QCD is a direct transfer from your IRA to a charity. It’s considered a distribution from your IRA, but is excluded from income. It’s one of the best tax benefits in the tax code. The only downside is that it’s not available to enough people.

The QCD is only for IRA owners and IRA beneficiaries who are age 70 ½ or older. You must actually be 70 ½. For example, if you will turn 70 ½ tomorrow, you don’t qualify today.

Even though the RMD age was raised to 72, the QCD age remained at age 70 ½. This means that you can use QCDs even before RMDs begin. Making your charitable gifts this way each year can lower your IRA balance so that when RMDs begin, they will be lower.

You can give up to $100,000 per year—not per IRA—through the QCD. A married couple can each give $100,000.

Distributions from company retirement plans don’t qualify for the QCD. Donor-advised funds also don’t qualify.

IRA funds are the best assets to give to charity since they are loaded with taxes. It’s best to give more of your IRA funds to charity and leave more non-IRA funds, say stock investments, to your beneficiaries who can receive a step-up in basis, where the lifetime appreciation escapes taxes when those funds are inherited. IRAs never receive a step-up in basis, so they are much better assets to use for charitable giving.

By using your IRA for QCDs, you are getting those IRA funds out at a zero % tax cost. With QCDs you receive better than a tax deduction. You receive an exclusion from income. An exclusion decreases AGI, or adjusted gross income, which is a key number on your tax return that determines the availability of other tax benefits, deductions, and credits.

Another little-known benefit of QCDs is that they are an exception to the pro-rata rule. If your IRA includes non-deductible contributions—after-tax funds—each distribution would be part tax-free and part taxable depending on the percentage of after-tax funds in your IRAs compared with the total balance of all your IRAs. You cannot simply withdraw your after-tax IRA funds and pay no tax. This is known as the “pro-rata rule.” QCDs, though, are an exception to this rule. For QCDs, only pre-tax funds qualify and that’s good. The more you give using QCDs, the more the percentage of after-tax IRA funds increases. That can lower the tax bill on future IRA withdrawals or Roth conversions.

Caution: Watch the QCD Timing
A QCD can also offset the tax on an RMD, but only if the QCD is taken first. If you have not yet taken your RMD and want to offset some or all that RMD income with a QCD—up to the $100,000 annual limit—do the QCD first. If you do the RMD first, you cannot offset that income with a QCD done after.

You can do a QCD at any time, but if you want it to count for this year, it must be completed by year-end.

The MEGA QCD
Don’t look this up anywhere because it doesn’t exist. I totally made up this name to call attention to another major charitable tax break that will expire after this year. This can super-size the QCD benefit, especially for those with larger retirement accounts who wish to make charitable gifts.

Last year’s stimulus tax act allows cash donations to be deductible up to 100% of AGI.

That special provision ends after this year and goes back to 60%. Here’s why I call this opportunity a Mega QCD. Let’s say you wish to give large amounts to a charity, but you don’t qualify for the QCD either because you are too young, your retirement funds are still in a 401(k), or you wish to give more than the $100,000 QCD limit.

The Mega QCD will be attractive to those who:
• Are charitably inclined,
• Wish to make large gifts to charity, and
• Have very large retirement accounts—and thanks to the booming stock market there are many new 401(k) and IRA millionaires and multi-millionaires this year.

You can take a distribution of say $1 million from any retirement account and then use those funds for cash donations to qualified charities—donor-advised funds do not qualify for this benefit. The $1 million would be included in income, raising your AGI. But now that $1 million can be gifted to a charity and fully deducted using the 100% of AGI benefit for this year. That itemized deduction would offset the $1 million of retirement income. Retirement funds that would otherwise be heavily taxed at some point—both for income and possibly estate tax, too—will be withdrawn with almost no tax cost at all.

Once again, you are using the best assets—retirement funds—for your tax-efficient charitable giving, while at the same time lowering the balance and your future tax exposure on these accounts, given the likelihood of large RMDs in the future.

If you also qualify for QCDs, you can do both. You can do the QCD up to the $100,000 annual limit, and then the Mega QCD for unlimited gifting. But remember—the Mega QCD benefit ends this year.

Caution: Don’t do this before age 59 ½ because you would likely be subject to the 10% early distribution penalty. Don’t do this from Roth IRAs because there is no tax benefit.

Extra Year-End RMD Tax Tip: RMD Withholding
This year’s RMDs may be larger than you thought, for two reasons. One is that there were no RMDs last year, so the IRA balance was not reduced, and more of the funds remained invested. The other reason was that the market for many accounts was up at the end of last year, and that is the balance that this year’s RMDs are based on.

Make sure that enough tax is being paid on those larger RMDs, so you can avoid an underpayment penalty. One way to avoid a penalty is to have at least 100% of last year’s (2020) tax paid in either through withholding or estimated taxes—or 110% if income for 2020 exceeded $150,000. You can also avoid the penalty if you will have 90% of this year’s tax paid in.

One way to make up any shortage here at year-end, due to unexpectedly higher RMDs, is to have withholding tax taken from the RMD. The benefit of using withholding is that withholding tax is deemed to have been paid in evenly throughout the year, even if that withholding is taken late in December.

Depending on your tax rate this year, compared with what it might be next year, you might even want to take more than the RMD to use up this year’s lower brackets. Chances are that your IRA balance coming into the end of this year is up substantially due to the bull market. That will result in a larger RMD due for next year as well. Taking more funds out this year, if it can be done at lower tax rates, will reduce that IRA balance and lighten the RMD tax bill for next year as well.

Copyright © 2021 Ed Slott and Company, LLC Reprinted from The Slott Report11/26/2021, with permission. Two Smart Retirement Tax Moves to Consider Before Year-End (bloombergtax.com) Ed Slott and Company, LLC takes no responsibility for the current accuracy of this article.