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Investing Specialists

Tim Steffen: Tax-Saving Strategies for a Falling Market

Baird's director of tax planning discusses tax-loss selling, Roth conversions, and the new rules for inherited IRAs.

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Our guest on the podcast today is Tim Steffen, director of tax planning for Baird. In his role, Tim researches, writes, and speaks about various tax matters, including retirement planning, executive compensation, legislative changes, and overall best practices. Tim originally joined Baird in 1999, serving in a variety of planning-oriented roles, most recently as director of advanced planning. He left Baird in 2019 to join the Advisor Education team at Pimco, then returned to Baird in 2021. Prior to 1999, Tim worked in Arthur Andersen's Private Client Services group. He earned his bachelor's degree in accounting from the University of Illinois. He is a Certified Public Accountant/Personal Financial Specialist, a Certified Financial Planner professional, and a Certified Private Wealth Advisor professional.

Background

Bio

Student Loan Forgiveness and Inflation Reduction Act

American Rescue Plan

5 Questions About Student Loan Forgiveness,” by Lia Mitchell and Karen Wallace, Morningstar.com, Aug. 29, 2022.

What Student Loan Forgiveness Means for Your Finances,” by Amy C. Arnott, Morningstar.com, Sept. 2, 2022.

Fact Sheet: The Inflation and Reduction Act Supports Workers and Families,” whitehouse.gov, Aug. 19, 2022.

IRS Tax Return Audit Rates Plummet,” by Ashlea Ebeling, forbes.com, May 18, 2022.

S Corporations

Tax-Loss Selling in a Weak Market

What Is Tax Selling?

It’s Time for Tax-Loss Selling,” by Christine Benz, Morningstar.com, June 3, 2022.

Michael Kitces: Does Portfolio Customization Pay Off?The Long View podcast, Morningstar.com, Aug. 23, 2022.

IRA Conversions

IRAs: To Convert or Not To Convert?” bairdwealth.com, August 2022.

Surprising Upsides in a Down Market,” bairdwealth.com, June 22, 2022.

Are IRA Conversions a Good Idea During Volatility?” Interview with Christine Benz and Tim Steffen, Morningstar.com, May 12, 2020.

Is the Backdoor Roth Still Legit?” by Christine Benz, Morningstar.com, Jan. 21, 2022.

Don’t Let Pro Rata Rules Trip Up Your Retirement Plan,” by Christine Benz, Morningstar.com, Feb. 27, 2018.

Inherited IRAs

The Secure Act, RMDs, and Beneficiaries: Another Wrinkle,” by Natalie Choate, Morningstar.com, Dec. 8, 2021.

Why You Should Review Your Estate Plan This Year,” Interview with Christine Benz and Ed Slott, Morningstar.com, March 23, 2022.

Transcript

Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance and retirement planning for Morningstar.

Jeff Ptak: And I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.

Benz: Our guest on the podcast today is Tim Steffen, director of tax planning for Baird. In his role, Tim researches, writes, and speaks about various tax matters, including retirement planning, executive compensation, legislative changes, and overall best practices. Tim originally joined Baird in 1999, serving in a variety of planning-oriented roles, most recently as director of advanced planning. He left Baird in 2019 to join the Advisor Education team at Pimco, then returned to Baird in 2021. Prior to 1999, Tim worked in Arthur Andersen's Private Client Services group. He earned his bachelor's degree in accounting from the University of Illinois. He is a Certified Public Accountant/Personal Financial Specialist, a Certified Financial Planner professional, and a Certified Private Wealth Advisor professional.

Tim, welcome to The Long View.

Tim Steffen: Thanks, Christine, for having me. I'm looking forward to this.

Benz: Thanks for being here. We wanted to start with a couple of ripped-from-the-headline-type items, starting with student loan forgiveness. What are the tax implications of this program for people who take advantage of it?

Steffen: That's a good question, because that was the first thing that came to a lot of people's minds when we heard about this debt forgiveness thing. Under normal circumstances, if somebody has a debt and it's forgiven by the bank or whoever the lender is, in most circumstances, that's considered taxable income to you. You no longer owe that. So, you have to report that as income. That's the general rule. Now, there have been exceptions over time. You go back to the great financial crisis of a decade ago or so, and there were some provisions put in for excluding mortgage debt forgiveness from income, some specific rules related to that.

When it comes to these student loan programs, we go back to the American Rescue Plan that was enacted in 2021, and one of the provisions in there said that any form of student loan forgiveness for the next few years through 2025 is excluded from income. That was before we knew this was going to be happening. It was a kind of a preemptive attack, I guess, or a preemptive strike, to say if we ever do forgive student loans, let's make them tax-exempt. And so, now, that's what's happened. For federal purposes, if you get the $10,000 with a $20,000 forgiveness, it's going to be federally tax-exempt.

The issue you might have, those on the state side, some states are exempting them from income, others are treating them as fully taxable. I live in Wisconsin. Wisconsin is going to treat that forgiveness as taxable income. But there are plenty of other states who have said, no, we're going to follow the federal treatment on that. So, federally, no problem. States, it depends on your specific state where you live in.

Ptak: Congress also passed the Inflation Reduction Act in August, and one of its provisions increased funding for the IRS by about $80 billion. Given that a big share of those funds are meant to go toward enforcement, do you think taxpayers should be bracing themselves for audits?

Steffen: Well, that's the big fear, is that there's going to be all these new agents running around just looking for ways to audit tax returns. I would say, perhaps we should be preparing for that, but a couple of caveats on that. For one, just because the IRS has the funding doesn't mean they now have, all of a sudden, all these agents. The IRS has to go out and hire these people too, and they're going to run into the same issues finding people to hire that every other employer is running into. Just because they've got the funding doesn't mean they have the people yet. So, it's going to take them a little while to find the people to staff up these areas, and then they've got to get trained to get up to speed on actually how to do these things. You're looking at a lead time of maybe two or three years before you really start to see a massive impact on this. I think it's reasonable to expect an uptick in audit activity, but it's going to be a while.

A couple of other things to consider on that. One is, if you look at the audit right now, it is very, very low. Very, very few people ever get audited, and you got to have something pretty unusual for it to really flag them. We might go from a very low audit rate to a relatively low audit rate. So, there will be an uptick, but it's still going to be a pretty low rate overall for most people. And then, of course, Congress also said, hey, let's make sure none of those people are used to go after people with income under $400,000. I don't know how the IRS is going to enforce that or apply that, but that was kind of the general instructions given by Congress. So, we'll see where that goes. But overall, you would be reasonable to expect an uptick in activity from the IRS once these people get up and running.

Benz: You mentioned, Tim, that there tends to be quite a low audit rate today. Can you generalize about the types of people, the types of situations, entities that tend to be most likely to be audited today?

Steffen: The IRS has their methods, their formulas they use to identify higher risk or higher likelihood returns to audit. And as you can probably imagine, that's a fairly closely held secret. That's not something they're publishing and tell you, hey, here's everything we're looking for. But they do give you some indication you can tell from just past history. I would say, a self-employed person who maybe has large levels of expenses probably is a little bit more likely to get at least looked at. Whether that results in a full-blown audit or not remains to be seen, but they're at least going to maybe have a higher risk of being selected. Business owners, pass-through entities, a common one over the last several years has been this issue with S Corp owners and how much are they paying themselves in wages versus how much of the income is coming through the K-1. So, that could be an area where you might see some risk there.

Another area I would watch for would be people who take aggressive valuations on, let's say, charitable contributions. So, if you're giving not so much stock and publicly traded things where value is pretty easy, but if you're giving artwork or vehicles or collectibles of some kind to charity, those who take aggressive valuations are probably more likely to get a letter or a notice from the IRS. Or the flip side of that, if you take aggressive valuations on the low side for things like estate and gift taxes, that could also be an area of concern. So, your typical W-2 employee with a little bit of interest and dividend income, may be a capital gain and they give some money to charity over the year, pretty low likelihood that they're going to get audit. You might get a notice if the IRS finds a matching error or some other kind of calculation error in your return. Notices are automatic. Those are pretty straightforward. The full-blown audits are still going to be pretty rare. But I'd say, those are the things that they'd be looking for most likely to get the IRS' attention.

Ptak: We wanted to shift and ask you about tax-loss selling in a weak market. Both stocks and bonds have declined in 2022. One strategy that's been coming up a lot is tax-loss selling. Maybe you could talk about who should consider it and also what benefits it confers?

Steffen: I would say, just in general, strategies that people implement from a planning standpoint that are strictly tax-focused—I'm doing this simply to get the tax benefits—don't often provide the same kind of benefit you might think they would. Maybe you get a bit of a tax break. But in the long run, maybe it wasn't the right thing for you to do. So, when it comes to tax selling and tax-loss selling, I always tell people, think about the investment merits, the investment decision that you're making for this, how is this decision to buy or sell something going to impact your portfolio, your asset allocation, your ability to meet your longer-term goals?

Once you've gotten past some of those bigger-picture issues, if you've decided that maybe some tax-loss selling is right for you, who are good candidates for that? I'd say if you're looking at rebalancing your portfolio, we've seen major market moves in one direction or the other and it's time to rebalance back to your target asset allocation—take advantage of that to do some tax-loss selling and recognize some losses. Maybe they'll provide you some tax savings in the current year. Or maybe you've decided your target asset allocation isn't right for you. Maybe you're not that far out of balance. But you've just decided you need to dial it back a little bit, you're willing to take a little bit more aggressive portfolio stance. That can be an opportunity to do some tax-loss selling as well.

In general, if you can recognize a loss for tax purposes, it's going to provide you a benefit. The benefit, you have to understand, is sometimes limited. There are some rules that limit just how big of a loss you can claim. And we can get into that. But in general, recognizing a loss for tax purposes does provide a benefit to you, at least immediately. Maybe not a long-term benefit, but at least, in the immediate, you'll get a tax benefit for it.

Benz: One potential pitfall related to tax-loss selling is the wash-sale rule, which stipulates that you can't go out and rebuy an identical or substantially identical security within 30 days of having sold it without negating the tax loss. So, people struggle with this substantially identical definition. Can you talk about how Baird defines it for its clients?

Steffen: Substantially identical, that's a pretty prototypical IRS tax law kind of term, isn't it? I've always viewed it as the IRS—the substantially identical rule as—you go ahead and do your transaction, Mr. & Mrs. taxpayer, and we the IRS will come back and let you know afterward if what you did was OK. I was doing some research on this recently and came across a court case that goes all the way back to the 1930s. And at that point, even then, whoever wrote the opinion of this case referred to this substantially identical rule as an elastic weasel word. So, even back in the 1930s, people were saying, this thing just doesn't make any sense. But it is what it is. We have to deal with it.

What advice do we give people on this? It's probably the question I get asked the most throughout the course of the year. An advisor will call and say, “I'm looking to sell something for a loss and I'm going to sell X and I'm going to buy Y. Is that OK? Am I going to run afoul of the wash-sale rules?” What I usually say is, if we're dealing with selling a stock and buying a stock, that's pretty straightforward. It's easy to tell if the stock you're buying is the same as you sold, you've got a problem. If you're buying an option on the same stock, it can a problem.

You get beyond stocks, though, it gets a lot tougher. Part of the issue is, when you talk about mutual funds and ETFs, these kinds of securities didn't even exist when the wash-sale rules were created. So, there's not a lot of guidance on what we can do there. What I generally tell folks is, if you've got an actively traded fund, you're selling an actively traded fund, and you're buying another actively traded fund, a different fund, you're generally going to be OK in those cases. It's the advice we give. Where it gets trickier is when you start getting into some of these index-oriented funds where they're not just benchmarking an index but actually trying to track an index —so a lot of the ETFs that are out there—then it gets a lot harder. If you sell an S&P 500 fund or ETF and buy another S&P 500 fund or ETF, I'd say you probably got a wash-sale issue there. They're going to be substantially identical. You go with a broader index, maybe something a little bigger, there might be a little bit more room for them to be different, but that's going to be tougher. As long as you go with the actively traded ones, I think you're generally going to be OK there.

Benz: When you say actively traded, you're talking about actively managed funds, funds where there's an active fund manager, stock-picker, bond-picker, or whatever?

Steffen: That's exactly right, as opposed to one where it's just simply tracking an index, so an S&P 500 fund where they only buy and sell when there's a change in the components to the index. But you just buy a large-cap growth fund where the manager is actively managing the positions in there and buying and selling, you unload that and you purchase a different large-cap growth fund from a different manager, I think then you're generally going to be OK. They're going to have different positions, different weightings of those positions, different buy and sell criteria, different expenses. I think there's enough differences there in general. There can be exceptions, obviously. But in general, I think you're going to be OK there. It's the index ones that I'm more concerned about.

Ptak: I wanted to ask you about direct indexing. One of the advantages that proponents of direct indexing tout is the tax-loss harvesting that typically accompanies it. But there's some debate about how great those tax benefits are in that tax-loss selling lowers the investor's cost basis, so the investor pays the taxes on those gains, eventually. Michael Kitces made that point on our podcast a few weeks ago. Do you think the benefits of tax-loss selling are overblown in that respect?

Steffen: Overblown might be too strong a word, but there clearly is an advantage to recognizing a loss today. Taking a loss now will save you tax dollars, and I'd rather save tax dollars today than save tax dollars in the future. But there is a flip side to that. To Michael's point, when you repurchase, you're buying it back at a lower cost basis. And when that position recovers, if you think it's a good position and it's going to recover, well, that recovery is going to result in a gain for you at some point. So, you could just hold it, wait for the recovery, and then not pay any tax at all. Or you could sell it, get the loss now, repurchase it in 30 days, and when the recovery happens, you pay tax in the future. So, there is a time value of money component that is in the taxpayer's advantage there. But to say that it's overstated, I think it's probably true. A loss today is something you don't have available to offset a gain in the future. You've got to understand that it's going to reverse itself at some point if you really believe in the position, you expect a recovery in it. A tax benefit today is good, but it's not going to last forever.

Benz: One related question that has occurred to me is whether if these tax-loss harvesting systems are as good as they're purported to be, could they be at legislative risk if people really take it and run with the tax-loss harvesting? Do you think there's any risk that there would be a cap on the dollar amount of losses that could be realized or something like that?

Steffen: When I think about the legislative risks that are out there and the things that could change maybe the way we approach some strategies, frankly, that's one that's not high on my radar. Obviously, anything can happen. When I think about legislative risks, I think about things like backdoor Roth, I think about valuation discounts, I think about aftertax contributions to 401(k)s, and all those other strategies that are out there. Limiting your ability to use capital losses, not probably very high on my radar. Again, anything can happen. But that's not one I get too concerned about, to be honest.

Ptak: Wanted to switch gears and talk about IRA conversions. We've also been hearing more about converting traditional IRA balances to Roth in this year's down market. Before we get into why this could be an opportune time to consider converting, can you discuss the cheap benefits of Roth IRAs and why a conversion might be advantageous in some situations?

Steffen: The two broad categories of IRAs, you've got traditional and Roth, and they are almost mirror images of each other. The traditional IRA, you put money into that account, you generally get a deduction today for whatever you put in. So, you get a tax savings today. While the money is in the account, it grows on a tax-deferred basis. No tax on any of that growth. And then, when you take the money out later in life during retirement, you pay tax on everything you take out. The Roth is kind of the exact opposite of that. You put money into the Roth, there's no tax issues, no tax benefit for putting anything in there today. It's all considered aftertax money. It grows on the same tax-deferred basis. But when it comes out, it's completely tax-free. That's the general difference between the two. IRA is deductible going in, taxable coming out, or traditional; Roth IRAs, nondeductible going in, nontaxable coming out.

The other big difference between the two is, when you get into retirement, with a traditional IRA, you're required to begin taking money out of that once you turn age 72. With a Roth, no such required minimum distributions. You can put money into a Roth and leave it in there for the rest of your life, the rest of your spouse's life. And under the latest rules, for the first 10 years after your death, in most cases, depending on who your beneficiary is, another 10 years of tax-free growth.

Now, the other way that people fund Roths, other than just the annual contributions, would be this conversion that you referred to. And that's where you're making a conscious decision to say I'm going to take some money that's in this traditional IRA account that is growing tax-deferred, I'm going to take it out, I'm going to pay tax on it. I'm going to move it to this other account, this Roth, and I'm going to let it grow tax-free from that point forward. So, I made a decision that instead of letting the money stay in the traditional and grow tax-deferred for as long as I can, I'm going to take it out now and pay the tax, and then let it grow tax-free from there. I'm accelerating a tax. I'm paying a tax I don't have today. But in return, I want to get that tax-free growth.

Done correctly—if you meet a few of the general tests that we try to apply to conversions—it could be a very powerful planning tool. It's not always done correctly. Sometimes people do these conversions and then make some of the cardinal mistakes that we talk about with conversions. But in general, if it's done right, a Roth conversion, can be a very positive and very powerful planning tool.

Benz: You just mentioned no required minimum distributions and no taxes on qualified withdrawals as the chief advantages of Roth IRAs. One question that sometimes comes up when you talk about those benefits is whether Congress could change the rules related to Roth withdrawals, start taxing the withdrawals of investment earnings, for example, or maybe imposing required minimum distributions to bring Roth IRAs in line with traditional IRAs. How likely would changes on that front be, in your mind?

Steffen: Being a little Pollyannaish when I think about these, I just don't see Congress ever turning earnings in a Roth IRA into taxable income. I don't think they're going to do a bait-and-switch on people like that. Maybe I'm wrong. Maybe I'm being too positive on the outlook there. I know a lot of people might disagree with that. But I just don't see that happening. I think there's a lot of things they could do to cap these benefits. We saw a little bit of that with the new 10-year rule, where maybe they start imposing required minimum distributions on Roth IRAs, not just after your death, but even during your own lifetime. I could see that start to happen. I could see them maybe limiting your ability to put money in there. We saw some of that with the Build Back Better bill, that was all the rage late 2021 into early 2022 that ended up not going anywhere, where they were going to perhaps limit the ability to do Roth conversions and some of the other things that are out there. But again, in the list of things that concern me about future tax law, turning Roth accounts or taxing income from a Roth, I'm not overly concerned about that one, to be honest.

Ptak: Let's talk about the tax implications of conversions. What should people think through before undertaking a conversion, the pros and the cons?

Steffen: Again, every dollar you take out, for the most part, from a traditional IRA and then convert to a Roth is going to be considered taxable income. There are some exceptions there, if you've got some aftertax funds in the traditional, which you can talk about. But in general, when you take money out of the traditional, move it to the Roth, it's going to be taxable income. And you could do that at any age. Normally, if you take money out of a traditional IRA before age 59.5, you get hit with a 10% early withdrawal penalty. That's not the case if you do a conversion. There's an exception to the penalty for those kinds of cases. So, you can just roll it from one account to the other, you got to pay tax on.

It’s going to be ordinary income, taxable at whatever your normal ordinary tax bracket would be—based on your other income, your wages, your other retirement distributions, Social Security, whatever it might be. A couple of things we always tell people to be cautious of when you do these conversions. One is, we try to make sure you pay the taxes on the conversion from dollars outside the traditional IRA. Often, we'll see people do a Roth conversion, and they'll say, can you just withhold from the money that comes out to pay the taxes on it, so I don't have to write a check for the tax liability? And what we often see is that if you run the numbers on it, if you pay tax on X, but you only put Y into the Roth and the rest goes to the IRS, it's really hard to make up for the fact that you've accelerated that tax liability. The real power of the Roth comes from getting as much into the Roth as possible and then using other dollars to pay the taxes. That's one thing we try to get people to avoid is to not pay the taxes from the IRA dollars themselves.

That's especially true for somebody who is under 59.5 and doing a conversion. If you do a Roth conversion under 59.5, and let's say, you take money out of the traditional, but some of it goes to the IRS in the form of withholding, well, those dollars are not exempt from the penalty. If you take out $100,000, you withhold 20% to go to the IRS, that $20,000 would be penalized in that case at the 10% early withdrawal penalty. So, we really try to avoid people using the IRA dollars to pay the taxes on it.

The other big thing that we try to encourage people on is that once it's in the Roth, you really want to let it stay in the Roth for as long as you possibly can. The biggest mistake we see with Roth conversions is people do the conversion and then decide, “You know what, I need some extra money this year, I can pull that out, I don't have to pay taxes on it, because I've already paid the tax, which is true.” But now, you've given up the tax-free growth you were getting on that. So, Roth conversions really work well if you can let the money stay there for as long as possible. And in fact, the best dollars to convert are IRA dollars you don't think you're ever going to need. Your spending goals are modest. Your resources are large relative to your goals. You just got money there you're not going to need. So, you can convert those, leave it to your heirs. Consider the taxes you pay a gift to your heirs. That's really the best strategy we've seen from Roth conversions. It doesn't happen all that often, because people are concerned about writing that big check for the Roth conversion. But to me, that's the ideal scenario for a Roth.

Benz: This year's down market may provide an opportune time for some people to consider conversions, but life stage, I think, can also figure in here. And we sometimes hear about the post-retirement, pre-required minimum distribution years as a really good time to consider conversions. Can you talk about that? What about that particular season of life might make conversions worth considering?

Steffen: One of the tests that people use to determine should I convert or should I not is what is the tax bill I'll pay to do the conversion versus what is the tax bill I would pay in the future if I just took the money out of my traditional IRA. And generally, if you can do the conversion when you're in a lower tax bracket than when you would maybe take the money out of the account, that's an ideal scenario. It doesn't have to be that way. We can show examples where you can even pay a really high tax on your conversion and still have it work out right, even though you might be in a lower tax bracket in the future.

What you're referring to, Christine, I often call it the tax trough, that period of time between when you've stopped working, so your W-2 income has gone away, and before you started Social Security, your RMDs haven't kicked in—typically, we're looking at mid- to late-60s time period for most people, when you've got more control over what your taxable income is on an annual basis. Take advantage of the fact that you're artificially in a low tax bracket. And if you could take money out of the IRA at a low rate and then put it into the Roth where it grows tax-free, that's really the ideal time to do the conversion. Again, take advantage of any period when you're in an artificially low tax bracket, something that's not going to last forever—typically, that's that period between retirement and starting RMDs, but it might also happen, say, for a business owner who maybe generates or has a loss from their business one year. So, their taxable income is way down. Maybe that's a year to take advantage of being in a low bracket and do a Roth conversion, too. You can apply not just at retirement, but even during your working years as well if the right scenario pops up.

Ptak: I wanted to ask a related question—I think it's related—which is, whether someone can be too old to convert traditional IRA balances to Roth that they'll pay the taxes that are due but not be around to enjoy the eventual tax savings. And so, how do you think people should think about that issue?

Steffen: Just to be clear, there is no age cap on Roth conversions. Anybody can do them at any age. So, there's no limitation on being able to do that. The question is, to your point, Jeff, are you as the IRA owner going to reap the benefits of that Roth? Because remember we said, the best Roth conversions are those that you can let stay in the Roth for a long time and let it really accrue that tax-free growth. If you're in your 40s or 50s or even 60s when you do a conversion, you might have enough time to see that account grow large enough that you can access it on a tax-free basis. You do it later in life, in your 70s or 80s even, in all honesty, you may not live long enough to actually see the true value of that tax-free income in the future.

That doesn't mean you shouldn't do the Roth. In that case, your goals, what you're trying to accomplish with the conversion maybe shifts. Instead of for a younger person who is trying to generate tax-free income for themselves in retirement, an older individual might be doing it as an estate planning play for their kids, saying, “I'm going to pay the tax on your behalf, my kids, my heirs, because I'm at a lower bracket perhaps maybe than you are. I'll pay the taxes now. When you inherit this account, you'll be able to take it out tax-free, and perhaps in a period of time when you're in a much higher tax bracket than I, your parents are.” The reason for the Roth conversion might change as you're later in life, but the benefits haven't changed. They can still be very powerful to do.

Benz: I wanted to ask, Tim, about contributions. We've been talking about conversions, but I'm wondering if you can provide any general guidance about who should be making traditional tax-deferred contributions and who should be doing Roth. And this would apply to 401(k)s and other company retirement plans as well as IRAs.

Steffen: It’s especially a good question with employer plans like 401(k)s where you don't have any of the income limitations that may dictate what exactly you can contribute to. For example, with an IRA, once your income hits a certain threshold, you're no longer even eligible to contribute to a Roth. So, you don't have any choice but to do the traditional, and even then, you might not be able to deduct that contribution. If we take those off the table and just focus on the employer plans, you don't have any of those income thresholds to worry about. If your employer offers you both the traditional and a Roth plan, you can contribute to either one regardless of your income level.

Some of the same rules apply. And you can't make maximum contributions to each. You have to decide which plan you're going to contribute to. Or maybe you can contribute to both of them, and you split your contributions between the two. When people ask, which one should I contribute to, one of the things we look at is, what tax bracket are you in right now? What is the value of the tax deduction you get for contributing to a traditional plan compared with the value of the tax-free income you might get in the future from a Roth plan? Generally, what I would say is, if you're a younger individual early in your working career, maybe at the lower levels of income than you might earn later in life, you might really benefit from a Roth plan. The traditional plan doesn't provide you a big deduction right now. You're not paying a high tax rate, so you're not getting a lot of tax benefit for that traditional contribution.

As you get older and your income goes up and you find yourselves in higher and higher tax brackets, then the traditional plan makes more sense. Get the benefit of that tax deduction today. And then, presumably, later in life when you retire, I think it's fair to say, most people find themselves in a lower income level in retirement. Not universally, but a lot of people find themselves in a lower income level at retirement. You can take the money out of the traditional IRA at a lower tax cost then. Generally, when I say younger workers, Roth accounts make a lot of sense. As you get a little higher income, a little older, further in your career, maybe the traditional plan makes a little more sense.

Then, you've got to figure out, how much exactly am I putting in there. People often compare putting the full $20,500 into a traditional plan to putting the full $20,500 into a Roth plan. That's not really a fair comparison because it's not an apples-to-apples comparison. Putting $20,000 into a traditional plan is not the same as putting $20,000 into a Roth plan. It's actually much more expensive to do the $20,000 into the Roth plan because you're not getting any tax break. Putting $20,000 into a traditional might only actually cost you out of pocket today, $15,000. So, when you're doing the comparison of the two, which one should I contribute to, make sure you're doing an apples-to-apples comparison here. Some of the online calculators on that that are out there will assume that those two contributions are equivalent, and if you follow that assumption, well then, yeah, the Roth is going to be significantly better for you. But it's not exactly a fair comparison. So, just be careful how you use some of those online tools, for example, to analyze which plan you should contribute to.

Ptak: The backdoor IRA maneuver was reportedly under legislative threat last year, but it made it through unscathed. Should everyone with earned income who earns too much to contribute directly to a Roth be making a backdoor contribution? And what are the key advantages?

Steffen: You said, should everyone do that? I'm always cautious about the word everyone, because there's always exceptions to every rule. There's always a scenario where I could say, oh, that's probably not the right thing for you, or at least I'm open to the idea there's a scenario where it might not work. But in general, I would say, yeah, if you can do the backdoor conversion or backdoor Roth and then get it into the Roth that way, that's probably a good idea for you.

Should it be the first thing you do in terms of contributions? Probably not. You want to make sure you're maximizing those deductible contributions. If you're a high-income individual who can't do a direct Roth contribution, make sure you're taking advantage of the deductible contribution options you've got—so, the traditional 401(k), traditional IRA, if you could claim that. But if you have maxed those out and you're looking to put additional money into the Roth, a nondeductible contribution to a traditional IRA that you then convert to a Roth IRA can be a very powerful planning tool. There's always a risk that this is going to go away. As you said, we thought we were going to lose it earlier this year. It didn't happen. That may come back again at some point. But while it's still alive, I'd say, continue to do it if you're eligible.

Benz: I wanted to discuss this pro rata rule, which can sometimes come into play when people do the backdoor maneuver, and they have a lot of other IRA assets over on the side. So, what should people know about that rule before they go ahead and do the backdoor contributions and conversions?

Steffen: The pro rata rule is designed to address those scenarios where an individual has different types of dollars in their IRA, both pretax and aftertax. What do we mean by those? Pretax are the contributions you made that you took a deduction for. You got a tax benefit for it before, you've never paid tax on the money that went in there. Those are your pretax dollars. Your aftertax dollars are contributions you made to the account that you didn't get a benefit for. You've already paid taxes on that money, and when those dollars come back out, they'll come out tax-free. It's not uncommon to have an IRA that might have a combination of those two. You've got pretax and aftertax money in the account. Or you might have multiple IRAs. You've got one IRA that was a rollover from an employer plan. That's all pretax money. And then, you've got another one that you made an aftertax contribution to that's got some aftertax dollars in it. I should clarify that the earnings on both types of contributions fall in the pretax bucket, so they're going to be taxed when they come out. Even though you didn't get a deduction for the contribution into the IRA, the earnings will still be taxable when those come out.

Where people have run afoul of this pro rata rule is they put money into the traditional IRA that they don't deduct—so, it's aftertax dollars—and then, they want to convert those specific dollars to a Roth. They're saying, I paid tax on it when it went into the traditional, so, when it comes back out into the Roth, it's nontaxable, which is correct, except you can't with an IRA just isolate those aftertax dollars. What the pro rata rule says is that if you have any other IRAs—traditional IRA, SEP IRA, simple IRA, any of those kinds of accounts—you have to combine them altogether. And you may have one IRA that's got aftertax money in it, and you've got another one that has pretax. But when you take money out of either of those accounts, it comes out pro rata from the two pools. Even though you took it from just one account or the other, you have to treat it as if it came from both of them on a pro rata basis.

What that means is, let's say, you've got a large rollover from an employer plan at one IRA, and you make an aftertax contribution to a different IRA. When you take money out, even though you're taking it from that aftertax dollars, it's really coming from both, and that's where people get tripped up on the whole pro rata thing and the backdoor Roth. They make the aftertax contribution to the traditional, but forget they've got another IRA out there that's got some other dollars in it that have to be factored into this pro rata calculation.

That's the biggest risk we see with the backdoors. People aren't figuring out the tax implications of the subsequent conversion appropriately. And we see it happen a lot. There are some timing issues to consider. For example, you may not have any IRAs at all right now. So, you go ahead, and you make an aftertax contribution, nondeductible. You then convert it to the Roth. You've done the backdoor Roth successfully. You followed it exactly as it's supposed to be. But then, later that year, you retire, and you take your employer 401(k) plan, and you roll that into your traditional IRA. Might have happened months later, but as long as it happened in the same calendar year, when you go to figure out how much of my conversion is taxable, you have to factor that 401(k) rollover into the pro rata formula.

What we tell people is, if you're going to do a backdoor Roth, just do it and be done for the year. Don't do any rollovers, any other activity with your IRAs. Just leave it alone. If you're going to do a rollover, wait till the next calendar year because we've seen a lot of early-in-the-year backdoor Roths, late-in-the-year rollovers. And the two don't mix well together. It kind of blows the whole backdoor Roth strategy. So, you got to be careful with that. That's the pro rata rule, sometimes called the Cream in the Coffee rule. You can't separate the cream from the rest of the coffee. That’s the biggest risk we see with the backdoor Roths right now.

Ptak: You might have addressed this in your previous answer, but do you think the pro rata rule should be a disincentive for people with substantial traditional IRA assets to do the backdoor maneuver?

Steffen: I guess you could call it that. If you think about what you're trying to accomplish with the backdoor—I can't put money into my Roth directly. I'm not allowed. So, I'm going to put it into the traditional and then move it into the Roth at no extra tax cost. That's what you're trying to accomplish. But if you've got that other traditional IRA out there, well, you're never going to be able to just do a conversion at no tax costs. You're always going to have to factor those pretax dollars in. At that point, then you should just convert the traditional IRA to a Roth and pay the tax on it. All you're doing by making the additional aftertax contribution, the first step in the whole backdoor, that's just complicating the whole situation for it. Yeah, it's not a bad thing. You're getting more money in your retirement account. That's ultimately a good step. But it does complicate it, and you're not accomplishing maybe what you'd hoped to by doing a tax-free conversion.

The best scenarios we see for backdoor conversions are people who don't have other IRAs. You're talking about perhaps a spouse who has been a stay-at-home spouse, has never worked, so doesn't have a retirement benefit of their own. Or maybe the inverse of that, somebody who has worked at one job for their whole career, and they've never rolled a retirement plan from employer out to an IRA. Employer plans are not part of the pro rata rule when it comes to this backdoor conversion thing. As long as the money is in your 401(k), you can exclude it from the formula. It's when you roll it out that you've got a problem. So, if you've never left your employer and you've got a big retirement plan there, you're a good candidate for a backdoor Roth because you don't have any other IRA dollars, most likely.

Benz: We previously asked you to address that fork in the road, whether you do traditional, tax-deferred contributions, or Roth contributions. How about aftertax contributions? We've been seeing them pop up in more company-provided retirement plans. Can you discuss these aftertax contributions, how they're different from Roth contributions, and also who should consider them?

Steffen: This goes to what are sometimes referred to as the 415 limits or the limits on how much can actually go into an employer retirement plan. For 2022, the overall limit is $61,000. That's the most you can contribute to a retirement plan through your employer. Part of that can come from you as an employee making deductible contributions, the amount that's withheld from your salary every paycheck. That amount is capped at $20,500. So, keep the numbers simple. There's about $40,000 of additional contributions that can be made to that employer plan beyond what you would do on a deductible basis. Some of that comes from employer matches. Maybe your employer makes a profit-sharing contribution that uses up some of that $40,000 of space you've got. But it's unlikely that's going to use all of that. You may have some additional room between what you put in and your employer has put in to still get you up to that maximum $61,000 total contribution. This is where the aftertax contribution play comes in.

And it's not a universal thing, but more and more employer plans are offering this as an option. So, you've maxed out your contribution that you can do from paycheck withholding, your deductible contribution. Now, you want to put some more money in there. You can do that. You don't get a tax benefit for it today. It's nondeductible. But at least it goes into the plan. And the idea is that while it's in the plan, at least now, I'm getting some tax-deferred growth on that money. It's growing. I don't have to pay taxes on the earnings, like if I saved it in my taxable account, for example.

The idea of putting money in there, it's fine. No benefit today, but it's additional savings so that in the end it's all good. Where this really becomes powerful though, is if you can then take that aftertax contribution you made to the employer plan and convert it to a Roth. It gets a little technical, but generally, those aftertax contributions are separate from the pretax. There is no pro rata rule to worry about. You can take that aftertax contribution and move it into a Roth plan. Maybe the employer offers you a Roth plan, a Roth 401(k) or something. Or maybe they let you take it out and move it to your Roth IRA. There's a lot of stars and moons that have to align to make this strategy work perfectly. Employers have to offer the right kind of plans for you to do this and allow these transactions. But again, more and more of them are doing it. This has ultimately what's led to the term, if you've heard this, the mega backdoor Roth, where it's not just the $6,000 or $7,000, whatever you're putting into the traditional IRA that you're converting to a Roth, now we're talking about perhaps as much as $40,000 you could put into this account and then convert it to a Roth to grow tax-free.

When does it make sense? First of all, you always want to take advantage of your deductible contributions first. Make sure you're maxing out those. Take advantage of employer matches. Get your profit-sharing and all those kinds of things. Get those all in the account. And then, to the extent you've got room, if the employer allows it, fill that up with the aftertax contributions that you then convert to the Roth. It's good to make the contribution, just to get it in the plan, but it's really good if you can then convert it to a Roth and get tax-free growth going forward. So, make sure you're taking advantage of all your other deductible savings plans first, not just the 401(k). Max out your 529s and maybe get some state tax benefits for those. Max out your HSA, your health savings account, because you get a deduction for those. Maybe you look at an annuity as an alternative to this aftertax contribution to the plan. Those are all the things you consider. And they all have their pros and cons. But the aftertax contribution to the employer plan, the mega conversion strategy is a good one and a popular one right now.

Ptak: We wanted to ask you about in-retirement tax planning. Most people come into retirement with their assets in multiple silos—Roth, traditional, tax-deferred, and taxable. And then, they struggle with figuring out which accounts to prioritize if they need cash flow from their portfolios. Can you share any guidance about how retirees should approach that decision about withdrawal sequencing?

Steffen: I'll preface it with a little bit of my CPA bias here. I grew up as a CPA, and I've always been focused on minimizing taxes when you can. So, my default in cases like these is to not touch the 401(k)s, the traditional IRAs, those taxable retirement accounts until you have to. Let those continue to grow tax-free as long as you possibly can, which in most people's cases, at least by 72, you've got to start taking money out of those accounts. But there's a school of thought out there, and it's a legitimate one, and I do agree with it, that there might be some scenarios where it makes sense to take money out of those accounts sooner than you're required to. Maybe in your late 60s even you start taking money out. You don't want to do it before 59.5. You get the 10% penalty unless you meet an exception.

But you're a 67-year-old retiree and you need to take some money out of savings to live on, there can be some advantages to taking money out of those taxable retirement accounts first. This is all a tax bracket play. How much can I take out of the account to maximize the 10% bracket? How much can I take out to maximize the 12% bracket? Now I've gone past that; now I'm into the 22% bracket. Does it make sense to take money out of my 401(k) or traditional IRA and pay 22%? At some point, you say, you know what, I don't want to pay any more tax. I've kind of maxed out. Now, I'll switch to a different account. I'll go to my Roth account, or I'll go to my taxable account, or maybe I've just got some capital gains I've got to pay.

It's a laddering thing. Maybe at real low levels of income, there's some advantage to taking money out of the traditional IRA at a very low tax bracket to fund your early levels of spending and then, layer on top of that, maybe selling some stocks or funds, or maybe even accessing the Roth as you get into a higher tax bracket down the road. It's a challenging thing to plan for. It's hard to do it over more than a multiyear period. It's almost a year-by-year strategy thing you have to plan for because every year is going to be a little different. Once Social Security kicks in, for example, that changes your dynamic of how you're going to pull money out of those accounts. Once you hit RMDs, that changes your analysis as well because you have to take those dollars out. You don't have any flexibility there. But there is some opportunity for planning. It's pretty advanced-level planning. It's not an easy thing to do, and you almost have to do it every year on its own. But there's some advantages to it, no doubt.

Benz: Wanted to ask about inherited IRAs. Tim, you did a session at the Morningstar Investment Conference this past spring that was really focused on some of the changes in the inherited IRA ushered in with 2019 SECURE Act. Can you talk about what the key changes are with respect to inherited IRAs and IRA beneficiaries?

Steffen: For a long time, we've always had this concept of a stretch IRA. You inherit an IRA from a parent or a sibling or a grandparent, whoever it may be. You have the ability to take distributions out of that IRA over the rest of your life expectancy. And if this is a younger beneficiary that inherits it, you've got a long time that you can stretch those distributions out. You can always take more than that, but your minimum amount was relatively low based on your age and the life expectancy factor. That's been the rule for forever up until a couple of years ago.

What the SECURE Act did is it created something called the 10-year rule. And what it basically said is that most beneficiaries of inherited retirement accounts are required to liquidate that account within 10 years of inheriting it. There are some caveats and some details in there. But generally, the idea of stretching those distributions out over the rest of your lifetime if you're a 40, 50, 60-year-old beneficiary, it's not going to happen anymore. You've got to liquidate it within 10 years. There are plenty of exceptions to that. For example, if you're a spouse that inherits an account, you're not subject to that. You get to stick to the old rules. If you're a minor child of the individual who died, you get to use the old stretch rules, or at least until you're no longer a minor. And there are some other exceptions for health-related issues and for people whose ages are very close to the age of the deceased owner. But your traditional thing where mom or dad passes away, leaves the IRA to their adult children, those adult children are now subject to this 10-year rule.

It's really limited some of the planning. We used to say you could take these payments out over the rest of your life and manage how much you want to take, take more in certain years, less in other years. We don't quite have that flexibility anymore. The net impact of this is that beneficiaries are going to have less net value that they inherit. They're going to be taking larger distributions out of the retirement account than they used to. So, the tax costs on those will be more. And they have fewer years of tax-deferred growth. The money can't stay in the IRA or the Roth IRA forever anymore. It's only in there for 10 years. After 10 years, the tax benefits are over as opposed to letting them stay that way for the rest of your life, basically. The net impact is a real loss of value to beneficiaries on these things. And so, there are planning steps that can be done to mitigate some of that, but it's really neutered a lot of the tax strategies that we used to have for clients on managing inherited retirement accounts.

Ptak: From a practical standpoint, and I think you've just been alluding to this, the new laws would seem to make IRAs less advantageous tax-wise for adult children to inherit than was the case before when beneficiaries had that option to stretch out their withdrawals and the tax bill on those withdrawals over their lifetimes. How do you feel the new rules around beneficiaries affected the advice that you're giving clients, and have any other strategies come to the fore to replace the old stretch IRA?

Steffen: This whole thing is an interesting dichotomy. You've got these new stretch rules, this new 10-year rule that have absolutely no impact on the owner of the retirement account. I have my IRA. This 10-year rule isn't going to change anything I do. I'm going to take my RMDs, I can do whatever I want, leave it to my spouse. She can do whatever she wants during her lifetime. No impact on her. When we die and our kids inherit those accounts, though, they're going to be subject to the 10-year rule. But the flip side of that, all the really good planning strategies have to be done by the owner of the account. Once the beneficiary inherits it, there really isn't much the beneficiary can do anymore other than taking larger distributions in certain years to take advantage of being in a lower tax bracket, for example. But once it's passed to the beneficiary, the beneficiary can't do a whole lot. So, the impact is on the beneficiary, but the planning has to be done by the owner.

The other thing we try to tell our owners is, let's just accept the fact that it's going to be really hard to make up for the fact that your child is going to have a lower inheritance now because of the tax impacts. They're going to pay more taxes. They are going to get fewer years of tax-free growth. There aren't a lot of things we can do to totally offset that. But there are some things that can be done. In that presentation you referred to, Christine, we went through a number of different strategies. Probably the two most commonly discussed ones are the idea of having the parents do a Roth conversion. So, the parents pay the tax on the IRA and then leave it in a Roth. No tax liability ever again on the account. Still subject to the 10-year rule. The beneficiary still has to empty that Roth within 10 years of the owner's death. But at least the tax liability is gone and paid for. That's one strategy. It can work really well, again, in the right scenarios with the right tax scenarios and distribution scenarios, that can work really well.

The other one that's been talked about a lot is leaving your IRA to a charitable remainder trust. Again, also can work very well, but not a perfect replacement for the old stretch IRA. The stretch IRA was a great tool. I don't know if we can ever get back to that, but there are things we can do that can get us close and mitigate a lot of the impact of these new 10-year rules. So, those are the two we're talking the most. There are some other things out there too, but those are the two big ones that people are asking about.

Benz: Wanted to ask a really general question, Tim, which is, whether there is a tax strategy that you really like that you think deserves more attention among financial advisors and people who do tax planning than perhaps it has gotten.

Steffen: I address this with a little bit of trepidation because we've seen before that when we as planners come up with really great planning ideas, the IRA says, hey, that's a great planning idea you got there, too bad if something happened to it, and then they take it away from us. We saw that a lot with some of the great Social Security strategies we've had in the past and now we're all worried about the backdoor Roth going away. I answer this question hoping that the IRS isn't listening, and they don't try and take this away from us. But the one that I think that probably doesn't get as much attention as it deserves is this idea of bunching deductions. It became a really big thing after the Tax Cuts and Jobs Act passed in 2017, where a number of the deductible expenses, the things we used to claim as deductions, went away, the standard deduction went up quite a bit and frankly, fewer and fewer people are now itemizing deductions. I think we went from something like 30% of taxpayers itemizing to more like 10%. So, two thirds of the people who used to itemize don't anymore.

The easiest way or the best way I've found to mitigate that is to do a bunching strategy. And really, when we're talking about bunching, we're talking about charitable contributions. The other deductible expenses, you don't have a lot of control over the timing of those, but charitable contributions you do. So, being thoughtful about the timing of your charitable gifts. We're getting to the end of the year here now, believe it or not, and people start thinking about doing their charitable giving in the last quarter of the year often. Maybe it makes sense to push those deductions off into January of next year and then combine them with the deductions you do at the end of 2023, so you get a double effect for your deductions. Or maybe it's the inverse. Maybe you take those deductions or those gifts you would have made in 2023, and you accelerate them into 2022. The idea is, get enough of your deductible expenses in one year so you can very clearly exceed the standard deduction. And then, the next year, you don't have any deductible expenses, you still get the full benefit of that standard deduction, which for a married couple these days is roughly $26,000. That's a big number for deductions. Playing with getting way over it one year and way below it the next year is probably the best way to maximize deductions.

And this is even true for people who itemize on an annual basis. If you're someone who itemize, you're just barely getting over that $26,000 standard deduction number, you're not really getting the full benefit of those expenses. Maybe you're better off to try and, again, combine them into one year and then skip them the next. And, again, charitable contributions are the ones we really have the most flexibility with. So, that's where being really thoughtful about the timing of your charitable gifts makes a lot of sense.

Ptak: Do you have a favorite change to the tax laws that you'd like to see Congress consider?

Steffen: I don't know if there's about a specific change. I think just the general direction. I think we saw a lot of it with the Tax Cuts and Jobs Act, and we'll see where that goes in a couple of years as that gets closer to expiration. But what I would prefer to see from a tax code standpoint is fewer deductions, fewer credits, fewer exclusions, fewer of those kinds of things that frankly lead to a lot of the abuse of the tax code. Eliminate a lot of those things, which is going to, of course, drive up taxable income. You're not going to get all these deductions and credits anymore. Income is going to be higher. But then, offset that with lowering the tax brackets. So, large amount of taxable income but with a lower tax rate can ultimately lead to a lower tax cost overall. That's essentially what happened with the Tax Cuts and Jobs Act. We'll see if that lasts when that expires here in a couple of years. But that would be my general theme for tax planning is, eliminating a lot of those things that are out there for abuse and just have lower rates overall.

Do I expect that to happen? No, not really. There are too many special interests out there. They're going to fight for their specific deductions. The banks aren't going to let the mortgage interest deduction going to go away. States still want tax-exempt treatment on their municipal bonds. The charities want to make sure the charitable contribution deduction stays in place. You've got all those special interests out there that are going to fight for their specific deductions. I don't think it's going to happen. But if this were the Tim Steffen tax code, you'd see a lot more direction in that way.

Benz: Well, Tim, we've really put you through your paces today. Thank you so much for being game to answer all of our tax questions. We've learned a lot.

Steffen: It's been a lot of fun, Christine, and looking forward to doing it again sometime. Thanks for having me.

Ptak: Thank you.

Benz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Christine_Benz.

Ptak: And @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)