Moving Assets To A Tax-Free World
From: www.fa-mag.com
Change is in the air. And since the tax law is involved, you can be certain that “change” doesn’t mean the final version.
At the moment, no one knows for certain what will happen to taxes in the United States, but people do know rates are far more likely to increase than decrease. In the immortal words of Jimmy the Greek Snyder, a once-famous Las Vegas bookmaker: “The race is not always to the swift, nor the battle to the strong—but that is the way to bet.”
So let’s assume as a thought experiment that significant hikes are in the offing. The point of this article is to point out, and then parse out, the obvious: Tax-free investing can be attractive on any given day, but it will be especially remitting the day after a tax hike, and especially if you have already been invested since at least the day before the hike.
There are three investment structures that every U.S. taxpayer should carefully consider at this time as a hedge against higher tax rates:
1. Roth IRAs or Roth 401(k) plans;
2. Investments in qualified opportunity funds and related opportunity zones; and
3. Qualified small business stock.
Each of these is worthy of its own, separate article (which might be forthcoming if tax rates jump as expected).
What’s Right With Roths
The Roth IRA has been around for almost a quarter of a century, and its virtues are well understood by some people, but hardly at all by others.
A Roth IRA acts like a photographic negative of the regular IRA: It is funded with after-tax dollars instead of pretax dollars, and the distributions are tax-free when the money is distributed while regular IRAs are taxed when they pay out. Another important difference is that there are no minimum required distributions for a Roth IRA during the owner’s lifetime. Roth IRAs can be funded both by direct individual contributions and by converting regular IRAs.
How do the two investment strategies compare? A simple mathematical model explains the relationship—and the importance of anticipated tax rates in evaluating the vehicles.
Assume Taxpayer A is an individual who owns a regular IRA with $1 million in assets. Assume his effective tax rate is 40% and that he has an investment strategy that doubles his investment every 10 years.
After a decade, the regular IRA doubles in value to $2 million, and if Taxpayer A then distributes the $2 million out at a 40% tax rate, he will have $1.2 million after taxes ($2 million times 40% equaling a tax of $800,000 that’s carved out).
If instead Taxpayer A decides to convert his $1 million regular IRA into a Roth IRA, the $1 million is subject to tax, and at Taxpayer A’s current rate of 40%, the tax generated is $400,000. If he pays the tax using the funds in the IRA (we will discuss a better strategy in a moment) then he has $600,000 to invest in his Roth IRA. Assume that he then doubles his money over 10 years, so that he now holds $1.2 million in his Roth IRA account. This can be distributed tax-free at the end of the 10th year, leaving him with $1.2 million after tax.
On the face of it, both strategies seem to produce $1.2 million after tax a decade into the future. However, the Roth is better for two reasons. First, Taxpayer A can pay his $400,000 in taxes on conversion from a taxable account (assuming he has one) and thus can convert the full $1 million from the regular IRA into the Roth IRA for a payment of $400,000 in taxes to the U.S. government. Ten years from now, he will have $2 million (instead of $1.2 million) in the Roth that can be distributed tax free.
Next, assume Taxpayer A anticipates that 10 years from now the tax rates will have increased to 50%. At that point, the $2 million regular IRA will trigger $1 million in taxes, leaving just $1 million after taxes.
If the tax rates go down rather than up, a Roth conversion ends up looking less attractive next to the strategy of keeping the money in the IRA. But at the moment, The Greek’s betting line is favoring a tax increase—and that is definitely the right way to bet it.
The amount you can contribute to an IRA or a Roth IRA is currently $6,000 per year ($7,000 if you are age 50 or older). You need to make this contribution from “compensation” you earned during the year. Roth IRAs also have some restrictions based on your income. Your Roth contribution amount is phased out in 2021 (extremely quickly) at between $198,000 and $208,000 of modified adjusted gross income for married couples filing jointly.
Many employer retirement plans, including 401(k) plans, 403(b) plans and 457 government plans, allow designated Roth contributions. The contribution limits for a qualified plan are currently $19,500 per year ($26,000 for those age 50 and older).
This contribution limit is not affected by a person’s filing status or adjusted gross income as it would be in a Roth IRA. Note that Roth IRAs don’t have minimum required distributions until after the original IRA owner’s death, while a Roth retirement plan will generally be subject to required minimum distributions (with a special rule that postpones the RMDs if and while you are still working for the employer that sponsored the plan).
It’s important to keep in mind that a tax-free return becomes more exciting whenever the effective income tax rates rise.
Moreover, a Roth would become even more advantageous if current policy proposals come to fruition that eliminate a step-up in the basis of assets at the owner’s death: Whereas highly appreciated assets in an estate would eventually trigger gain on the full appreciation, a Roth in effect allows for tax-free growth in a wide range of common investment assets.
Remember, again, that even though the taxpayer who funds a Roth IRA does not have required minimum distributions, the beneficiaries will be subject to them.
Opportunty Zones
Opportunity zones were added to the Internal Revenue Code by the Tax Cuts and Jobs Act of 2017 and immediately became part of the American tax vernacular. Opportunity zones allow investors to put money into distressed areas and offer three specific tax incentives to do so:
The first incentive is deferral. Any capital gain in a qualified opportunity fund is deferred until the date that the taxpayer sells or otherwise terminates the interest in the fund (this is called an “inclusion event”) or otherwise deferred until December 31, 2026, whichever comes first.
The second incentive is tax basis adjustments: If the taxpayer invests in a qualified opportunity fund for at least five years, the outside tax basis increases by 10% of the original gain—and the added basis reduces the gain recognized when the deferral ends. (The original bill said there could be an additional 5% increase in basis if the investment lasted for at least seven years, but that was no longer possible by 2020.)
The third incentive for investors here is an appreciation exclusion. If a taxpayer’s investment in the qualified opportunity fund is held for at least 10 years, the basis in the fund is increased to the fair market value on the sale, and the gain is eliminated.
The main drawback of investments in opportunity zones is that they are tied up for at least 10 years and could continue until 2047—almost 27 years if you invest today. That is a long time for many people to stay in the same investment. Still, it could be ideal for long-term estate planning strategies for children and grandchildren. Grantor trusts in particular are a powerful, supercharged way of transferring qualified opportunity fund investments to heirs. The qualified opportunity fund investment can be sold after 10 years with all the appreciation being tax free—making it roughly the equivalent of a powerful Roth IRA investment (without the required minimum distribution limitations imposed by the SECURE Act, which stopped distributions from paying out longer than 10 years).
Qualified Small Business Stock
Qualified small business stock has been around since 1993, but for a variety of reasons it didn’t really become a valued and treasured tax incentive until about 2010—and even then the word was initially slow to spread.
Today, however, qualified small business stock has become the unquestioned diva of the tax planning world—the riveting center of attention in every sophisticated conversation on tax and business structuring issues.
In 2021, this stock does not, by itself, make you rich, but when used as part of a successful investment strategy, it does make you considerably richer.
Qualified small business stock allows a successful investor in an entity that meets the definition of a qualified small business to exclude 100% of the gain recognized on the sale of the stock up to the greater of two figures:
• Up to $10 million of the cumulative gain on dispositions of the stock issued by the particular qualified business to the taxpayer (this is called the “$10 million limitation”); or
• Up to 10 times the aggregate adjusted tax basis of the qualified small business stock issued by the business and disposed of by the taxpayer in a taxable year (this is called the “10-times-basis limitation.”)
To qualify, the stock and the underlying business must meet certain technical requirements, and the investor has to hold it for at least five years before selling—just half the holding time required by the opportunity zone tax incentives.
Moreover, the investor can share the wealth and make the tax savings multiply with tax planning that successfully transfers the small business stock through gifts to children and also through transfers in trust for the benefit of children and other parties.
This transferability is a particularly attractive trait of this type of stock in 2021, since the current political dynamics suggest a significant possibility of large tax increases on the horizon.
In summary, there is change in the air and as summer draws to a close there is a very real expectation that tax rates could go up—perhaps by a lot. Tax-free returns are a very real antidote to higher taxes—free, after all, is free—and so the three strategies discussed in this article should be something you consider carefully while making the best of the remaining days of summer.
