Keith Ellis: Thanks again for joining us. We’re lucky enough to be joined here by Mark Kenney, CFP, advisor here at SHP Financial. And Mark is out there visiting like myself, Derek, everyone here on the SHP team, visiting with families here and really helping assist them and try to point them in a better or right direction for their retirement. And one of the main strategies or ideas or things that people bring up in meetings as we’re working with them is taxes. So, what we figured we’d do here today is talk all things, taxes and really, strategies and ideas and thoughts around certain types of tax planning. So, we figure we’d start at the beginning and work our way through a couple of different ideas that really might be able to help you and put you and help you assess your retirement to see if you’re going on the right path.
Keith Ellis: So, first of all, Mark, thanks for joining us.
Mark Kenney: Thanks for having me.
Keith Ellis: Mark, we’re excited. We’re excited to do this. And one of the main questions I get asked is, and it’s pretty basic, but people need to know this is what’s the difference between an IRA and a Roth IRA? And why is it important?
Mark Kenney: Yeah, great question. So, a Roth IRA is an after-tax vehicle of which you can save money and you don’t take the tax deduction now when you put the funds in, but the money grows tax deferred, and qualified distributions can be taken out tax free. So, it’s a way to save money and have it grow tax free. And although you might be limited to who can contribute to a Roth IRA, anyone has the ability to convert money from a traditional IRA to a Roth IRA when we think it’s in their best interests.
Keith Ellis: Yeah, and let’s talk about that for a sec, contribution, because a lot of people have a tough time wrapping their head around that. And I don’t want to jump right into one of the tax strategies which you mentioned there which is conversion. But let’s talk about contribution and why it’s important to look at and maybe, who should contribute to a Roth versus a traditional IRA?
Mark Kenney: Yeah, great question. So, historically, we were always led to believe that most of us will retire in a lower tax bracket, that we should always take the tax deduction when we put the money in because again, we’ll take the money out in retirement and be in a lower tax bracket. And I think knowing where the tax system is today and where it will be in the future, I think you have to find out is that in your best interest, to take the tax deduction now. So, when people normally make a 401(k) or an IRA contribution, they are taking the tax deduction in the year in which they’re making the contribution, but they’re also making an agreement with the IRS that they want to be taxed later on down the road at probably a higher tax bracket.
So, what we try to do with the families we work with is identify which tax bracket are they in now and which tax bracket will they be in the future. And should they be taking that tax deduction now or forgoing it and having their money tax free later on in life? And I think everyone’s different because you get to find out what rate they’re paying taxes at now and what rate they’ll potentially be paying in the future.
Keith Ellis: Yeah, and you come back to the question of, do we think taxes might go up in the future? And that’s a personal thought, a personal belief, a personal preference of what you believe in, but you can sit with a family, kind of get to know their feelings. And if it’s the right situation, they might be better off not taking the deduction today and putting it into that Roth IRA, and then letting that money compound and grow tax free. Wouldn’t you agree?
Mark Kenney: I would agree, yeah, especially with younger, I think, individuals who are not in their peak earning years, who maybe they’re just fresh out of college and they’re just starting to save for retirement. We see this where again, they’re probably led to believe that they should put money into an IRA, take the tax deduction now, or I’m saying, no, I mean, we want to forego that tax deduction now because when your income is lower, it doesn’t save you as much. Have that money grow over the next 30, 40 years tax free, and you can take it out tax free. So, you’ve got to look at what deal you’re making with the IRS and how you should be saving that money.
Keith Ellis: Yeah, it’s funny because you kind of think of a reference, and I think we’ve talked about this in the past. You and I and our team is, think of it as from a farming standpoint, would you rather tax the seed when you plant it, right? So, you have the seed, which is the money you’re putting into the retirement account, whether it’s an IRA or a Roth IRA. And now, this money continues to grow year after year, kind of like a crop, it continues to grow and grow and grow. Would you rather tax the seed when you plant it or the harvest that it grows into?
Mark Kenney: Correct.
Keith Ellis: Now, generally speaking, most people would say seed, but I think what you said earlier is a really good piece of advice is you have to take a look at your situation individually. what is your tax rate? That’s going to really determine what makes sense or where it makes sense to put your retirement assets, and that’s done. It should be done year to year, wouldn’t you agree?
Mark Kenney: That’s correct. Remember, the IRS just looks at your income on a one-year snapshot, right? So, whatever you made in a prior year, whatever you will make in the future years has no bearing on the taxes that you’ll pay for that tax year. So, there are situations where I will tell a client to take a pretax contribution in one year and maybe change that strategy for the next years, especially if our income varies, if we’re in sales, or…
Keith Ellis: You lose a job.
Mark Kenney: You lose a job, yep.
Keith Ellis: You know what I mean? And you go to work part-time somewhere, you go to make a little bit of money, and maybe your spouse is making a decent amount of money, but you’re still not making what you were making prior.
Mark Kenney: Exactly.
Keith Ellis: It might make sense to contribute to a Roth that year.
Mark Kenney: That’s correct.
Keith Ellis: As opposed to that.
Mark Kenney: Or maybe you didn’t work a full year, maybe in your retirement year, you worked two months. I mean, why would you take the tax deduction based on your earned income for two months when you can save that money in an after-tax vehicle? So, this is why there is no easy answer. It’s just looking at where you are now and where you’ll be down the road.
Keith Ellis: And it’s interesting because you sit with folks, and they might have $500,000, a million, million and a half, two-plus million dollars, and you’re thinking about this, I don’t want to say little contribution, but they’re thinking about this little contribution. They’re just like, okay, yeah, just do that. No, it’s a big deal because this compounds over time, but it also could potentially compound to the next generation.
Mark Kenney: That’s correct.
Keith Ellis: And that’s the power of Roth IRAs, in our opinion. And when you leave money behind, again, I’m skipping over some major pieces that we’re going to go over here in a few minutes, which is some tax strategies for you, but having these Roth IRAs or these tax-free assets, they now pass on to the next generation as well tax free. So, it’s a way to cascade wealth from one generation to the next, tax free. It’s pretty powerful.
Mark Kenney: Yeah, definitely. I mean, definitely, the SECURE Act has changed how we inherit money now. So, if you have children that are in their peak earning years, 40s, 50s, and they now inherit mom and dad’s traditional IRA, they’re forced to take that out over 10 years and adding that income on top of their income just magnifies the amount of taxes they’ll pay. That doesn’t apply to the Roth IRA, whether you use the funds during your lifetime, or they are passed on to the next generation, it’s tax free. So, you not only will look at the taxes that you’ll pay over your lifetime on the IRA, but what potentially your kids or any heirs that inherit the account will pay in their lifetime as well.
Keith Ellis: So, yeah, the SECURE Act was a law that was passed at the end of 2019. It really changed the way that we inherit money, the way we pass intergenerational wealth, right?
Mark Kenney: Correct.
Keith Ellis: You’re right, it made a law that said IRAs, 401(k) s, Roth IRAs, these types of accounts, these “pretax accounts.” Even though Roths are not pretax, they’re considered part of that group, which can get confusing in itself, but these assets need to be distributed over a maximum of 10 years. So, someone passes away, Mr. and Mrs. Smith pass away. They leave their daughter a million-dollar IRA, which is, don’t get me wrong, it’s a very nice thing for them to do. But now, their daughter, like you said, is working in her peak working years, and now, she’s forced to potentially take these distributions over 10 years. That’s adding potentially another $100,000 a year to her income for 10 years. That can have a drastic impact on the amount of taxes she and her family are paying.
Mark Kenney: You see the IRS, they are smart. They understand there’s going to be this huge transfer of wealth from the baby boom generation to Generation X and Y, and they want to be able to tax that as quickly as soon as possible. So, under the old rules, you could inherit an IRA and take distributions in your lifetime.
Keith Ellis: Such a good point.
Mark Kenney: Right? And now, you know the rules change. Now your child has to take that over 10 years. So, by using proactive strategies, you can try to mitigate those taxes. And no one, regardless of political affiliation, wants to pay more taxes. Then they are forced to write, you pay what you have to pay, but you don’t want to leave a tip to the IRS. So, that’s why we try to take advantage of making proactive moves now instead of reactive moves in the future when taxes are most likely higher.
Keith Ellis: And it’s interesting because when we sit with a family, one of the things that we talk about is the idea of holistic retirement planning. It’s taking a look at and developing a strategy to distribute income. You have all these accounts, what pocket, or what economy we’re pulling from year after year, just like taxes that need to be revisited every single year too where we’re pulling from why, then we want to make sure your investments are balanced correctly and fit the type of risk that you have the appetite for? We talk about health care strategies and ways to help either achieve health care, protect the assets from health care, whatever it is. The next one we just talked, is state planning, how do we plan for your state to transfer or your legacy to transfer from one generation to the next, and this SECURE Act has had a massive impact and that paired with finally, the final piece is tax planning is really kind of the linchpin of what we’re really focusing on.
Mark Kenney: And you can see how they all overlap.
Keith Ellis: 100%.
Mark Kenney: And why it’s so important to understand the client’s unique situation because this isn’t being talked about a lot. A lot of the financial advisors out there aren’t being proactive in their tax moves. And I think that’s really what differentiates us from the other advisors out there is we’re saying, listen, taxes really are very low right now. I may not feel like that, but historically, we’re in a low-tax environment. We know taxes are going up in the future, right? With all this deficit and spending that’s going on, they’re going to have to raise taxes. And so, you can be reactive, and remember, with a traditional IRA, you’re forced to take out money at age 72. That amount that you’re forced to take out will increase every year, not only increasing your potential tax liability but having a knock-on effect of Medicare Part B premiums. And so, you’re just letting the problem snowball to later on in life where we can really look at your situation, say, maybe we start moving some money now in buying the IRS out at 12, 15, 20 cents on the dollar versus a higher rate on the thing…
Keith Ellis: And that’s really where this next strategy comes in. It’s not contributions, it’s not legacy strategies or anything like that. We’re taking a look at the tax status of your assets and seeing if there’s a way to enhance or put your future in a better situation. And that’s where we start to break out and look at different strategies around, not Roth contributions, but Roth conversions.
Mark Kenney: That’s right.
Keith Ellis: So, can you take me through that a little bit?
Mark Kenney: So, we actually have more control over the taxes we pay on our IRA than we think. And that’s because everybody, regardless of work status or income levels, can move money from an IRA to a Roth IRA whenever they feel it’s in their best interests. And that’s really what a conversion is, is moving money from an IRA to a Roth IRA and paying the taxes now or in that year versus in the future at potentially a higher rate. And everybody, again, is eligible to do this. It really comes down to where is your income, how much money can we move, and how much taxes is that going to cause us to move that money? And a lot of times, we can do that over, you know what, a four, five, six-year period.
Keith Ellis: Yeah. And how are taxes paid on? Because that’s one of the main questions. If you’re sitting with someone that, then I get asked is like, okay, I love the idea of, like you said earlier, buying out the IRS in a controlled manner, in the manner that I control rather than kicking the can down the road into the unknown tax rates that potentially await us, right?
Mark Kenney: That’s correct.
Keith Ellis: So, I want to do this. How do I pay my taxes?
Mark Kenney: Yeah. So, in the United States, we have a progressive tax system, and that means the more money you make, the more taxes you will pay, okay. And just to understand where the rates stand today, everywhere from 10% all the way up to 37% depending on your tax filing status and the amount of income that you have. Fast forward to 2026, all those brackets are increasing by 2%, 3%, 4%. And so, we want to look at what bracket are you in? What is your marginal tax bracket? Meaning what is that last dollar that you make taxed at? How much room do you have left in that tax bracket? Because each bracket has a certain amount of income that’s taxed at that level and does it make sense to move that amount to a Roth IRA now and pay the taxes at the determined rate? And that’s essentially how a Roth conversion is done looking at someone’s income year after year.
Keith Ellis: Yeah. One of the funnest exercises that I like to show folks is, say, you’re someone who is fortunate enough that you’ve accumulated wealth and you don’t necessarily need these IRAs for a period of time until you’re aged, maybe 72. So, at age 72, there comes a time where the IRS basically comes knocking on your door.
Mark Kenney: Yes.
Keith Ellis: And they say, “Look, you’ve deferred these accounts for so long, you’ve deferred these accounts to the point that we’re not going to allow you to refer them anymore. And that’s called a required minimum distribution, many of you have heard that or the acronym RMD. Well, that’s where the government says enough’s enough. It’s time for us to start receiving tax revenue or taxes on this account. So, they basically force you to take a distribution.
And I always say to folks, “Well, at what rate?” So, if we’re 65 today or 62 today, we’re retired, we’re doing very well for ourselves. We have enough income. We’re probably not going to need to touch our IRAs, let’s use 62, for 10 years. Okay, let’s show what that looks like. Okay, so you have this IRA, it’s compounded for 10 years. Your RMD, that is going to be a massive, massive, massive tax increase to your overall financial picture. But some other things that you mentioned earlier, does it affect the amount of taxes you pay on your Social Security at that point? Does it affect the amount of taxes or the amount of Medicare Part B premiums you pay?
Mark Kenney: Correct.
Keith Ellis: And this could all be avoided or potentially mitigated or did soften the blow, I guess, a little bit if you do proper planning and start looking at this stuff earlier rather than waiting because, okay, great, you wait from 62 today to 72, 10 years from now. Not only is there a massive potential withdrawal that is now forced to be taken, I said this earlier, but at what tax rate, right?
Mark Kenney: And I think that’s even more exaggerated when there’s a married couple, this is something that you’ve got to pay this. When you were a married couple, and you have this income coming in, you also get a standard deduction for both individuals. Upon the passing of one spouse, look what happens, I mean, the other spouse usually inherits the IRA, which means they have now required minimum distributions. But now, the surviving spouse has to file as a single individual, and the amount that they can deduct from their income is half. So, their income is usually 80%, 90%, sometimes 100% of where they were with two spouses, but now, they have double the taxation of that. So, you not only have to look at where you are today with two spouses in the standard deduction but also, what could happen with the potential passing of one spouse in the same amount of income? And so, that’s a huge factor as well when looking to do a Roth conversion.
Keith Ellis: Now, okay, 2022 comes along, I’m sitting with you in January, and we’re planning for my 2022 Roth conversion. Is there a better time of year to execute the conversion? Or does it matter?
Mark Kenney: Yeah. So, there are a few different ways that we do this. For most individuals, we will do it at the end of the year for a couple of reasons. If we don’t know their income, let’s say they work in sales, and we’re not sure if they’re going to get a bonus check in November, December, we might wait to the end of the year to do that Roth conversion. And we do that, one, because once a Roth conversion is completed, it can’t be undone. Meaning if you move the money on December 1st and you happen to get a big bonus check that puts you in a higher tax bracket, it can’t be undone. But if we know your income and we have it nailed down, and there’s no surprises, we can do that Roth conversion throughout the year.
Now, why would we want to do that? Remember that if we move money from an IRA to a Roth, all the growth that’s applicable to that Roth is now tax free. So, what we did for a lot of our clients that we work with is back in March of 2020, when the market’s down, a huge amount in a matter of 21 days…
Keith Ellis: Turn lemons into lemonade.
Mark Kenney: That’s it. You’re going to look for opportunities, right? And so, we said, “Listen, now might be a time to convert” because remember, you pay taxes on what your account is worth on the day you convert. So, if you move $100,000 and you pay, let’s say, $20,000 in taxes and now, the market comes back, all those gains are now in the Roth IRA, where they are now tax free. Remember, there’s no required minimum distribution in Roth IRA. If you don’t need those funds at 72 or 73, you’re not forced to take them out. And again, they pass on tax free. And so, I think for everybody, it’s a little bit different, but you always want to look for opportunities to buy the IRS cheaper. And if the market contracts, that’s a good time to look at, should I be moving my money to a Roth IRA now to get all the growth on the right-hand side of the equation tax free?
Keith Ellis: Yeah, you’re potentially buying what? Tax-free gains at a discount.
Mark Kenney: That’s correct.
Keith Ellis: Given as long as you’re willing to have that money in there for the long run, understand the market goes up, the market goes down, but when that market’s down, it’s a good time to at least look at and potentially considering because you’re right, all that as the market starts to recover, you’re getting those gains tax free. And another thing about Roth IRAs or Roth accounts in general, so we’ve been talking a lot about required minimum distributions. So, how required minimum distributions work is, you’re 72 years old, and 73, 74, and it goes every year until you pass, what they do is they look at the prior year’s balance as of December 31st. And it’s any pretax assets, any IRAs, 401(k)s, 403(b)s, anything like that. What’s not counted in that equation are Roth IRAs. So, it’s a way to get ahead of the potential tax burden that waits. They’re getting their money one way or another. The question is, do you want to be in control of how they get it? Or do you want them to be?
Mark Kenney: Yeah, It is a little bit ironic that in a traditional 401(k) or IRA, you take on all the risks, right? So, you put your money in the market and you grow that balance only to have the IRS participate in all that risk that you took on. So, it’s almost a catch-22, you want your IRA and your 401(k) to grow, but all that does is increase your required minimum distribution. And so, here you are, you’re hoping your account grows at 7%, 8%, 9%, but that also makes your required minimum distribution go up and up and up. The same is not true for a Roth IRA is that no matter what the balance is, there is no required minimum distribution. You’re free to distribute those funds as you see fit tax free or again, pass them on.
Keith Ellis: And that’s an interesting way to look at, is you take on all the risks, and they’re just sitting there waiting to get a bite of the– I mean, you make this, we’re here on the holidays, nice Thanksgiving pie, right?
Mark Kenney: Yeah, boom.
Keith Ellis: They’re getting a piece of that.
Mark Kenney: On the flipside, if your IRA goes down in value, you don’t get to write those losses off. So, the IRS is probably really happy with the way the markets have performed this year, and they’re looking at all these required minimum distributions that will be calculated at the end of December are going to be 10%, 15%, 20% higher because your balances did so well, forcing you to take out more money next year.
Keith Ellis: And then take that same equation and say there’s a new tax law that’s passed that actually increases, think about that. That’s a double whammy in a way that like, okay, now, they’re getting more and they’re getting more.
Mark Kenney: That’s correct.
Keith Ellis: It’s a pretty rough situation, and that’s why these tax planning strategies are so important, and it’s important to get ahead of these different things. So, what are some of the, I guess, misconceptions about tax planning or some of the misconceptions regarding minimizing your tax? I know there’s some out there.
Mark Kenney: Yeah, the first one would be, and we get this a lot, is that I’m only going to take out my required minimum distributions. They believe that to mitigate or reduce taxes, they just won’t take out their money from the IRA until they’re forced to. We have clients well into their 80s or 90s, and I can tell you that’s not the best strategy because that minimum, that percentage goes up every year. So, you could be in your late 80s, early 90s, and you’re forced to take out 10%, 15% of your IRA, which puts you in a higher tax bracket.
And a lot of times, what they will say is, “Well, I really want this money to go to my children.” And so, understanding the legacy piece, and if that’s important, I would actually argue that you should probably start to buy out the IRS during your lifetime so that all that money can grow tax free and be passed on tax free. So, I think that’s the biggest misconception that I’ll only take out my required minimum distribution, and therefore, I won’t owe much in taxes during my lifetime.
And also, understanding that taking the tax deduction in the year which you’re working is not always a great thing. You’re making a deal with the IRS that says, “Okay, I’m going to take a $0.12 deduction right now, but you’re probably going to get taxed at maybe 22%, 37%, 45% down the road. And again, that’s not what we were told when we were growing up, we were told to save money in a pretax bucket because we were most likely to retire in a lower tax bracket. And I just don’t think that’s a case for a lot of individuals.
Keith Ellis: Those are both really, really good points and good takes on that. And here at SHP, if you wanted to find us, you go to www.SHPFinancial.com, that’s SHPFinancial.com. If you want to connect with us on any ideas around your situation, tax planning, just have questions, feel free to reach out right on our website, and we’ll be happy to connect with you. But I think you get the idea here at SHP, we believe in building that five-step holistic plan and taking the families that we work with their goal-based plan and walking them through each and every year these different strategies.
And we’re here today between now and, say, you’re 62, there’s potentially 25, 30 years, maybe even longer if you’re lucky, you don’t think there’s going to be law changes and tax changes and other things that need to be accounted for. I would say having a plan, in my opinion, provides confidence. It allows you to retire confidently, make decisions in retirement confidently because what we do is, someone wants to look at different scenarios, we can show them the potential impact of that in their plan.
So, again, having that five-step plan, an income plan, an investment plan, a tax plan, a health care plan, a legacy plan, kind of all working together now and going forward to help mitigate and puts you in a better position, I think, makes complete sense. So, again, visit us at SHPFinancial.com. Mark, first of all, thanks for coming today. Thanks for helping us out with this. This is amazing. It’s been great. But do you mind kind of summarizing, maybe any last thoughts or anything?
Mark Kenney: If I could summarize it, I think it’s people have more control of how much they will pay in taxes over their lifetime than they truly believe. And I think being reactive is going to cause you to second guess your decisions down the road. We have a limited amount of time that we can look to buy out the IRS over the next five years, and I think everyone should look at what is going to be their biggest expense in retirement. And for a lot of you, it’s going to be taxes. And how can we do some conversions, do some mitigation strategies now so that we buy out the IRS, get the IRS out of our lives, or at least reduce the potential taxes that will pay? So, I encourage everyone, no matter where they are in life, to look at their situation and think long and hard about how they’re going to buy out the IRS over the next 30, 40 years of their lifetime.