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Financial Advice

Tim Steffen: Smart Tax Moves for 2024 and Beyond

Baird’s director of advanced planning discusses Secure 2.0 changes that are phasing in next year, as well as strategies for Roth conversions and tax-savvy portfolio management.

The Long View podcast with hosts Christine Benz and Jeff Ptak.

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Today on the podcast we welcome back Tim Steffen, who is the director of advanced planning for Baird. In that role, he researches, writes, and speaks about various planning and tax matters, including retirement planning, executive compensation, legislative changes, and overall best practices. Steffen originally joined Baird in 1999, serving in a variety of planning-oriented roles. He left Baird in 2019 to join the advisor education team at Pimco, then returned to Baird in 2021. Prior to 1999, Steffen worked in Arthur Andersen’s Private Client Services Group. He earned his bachelor’s degree in accounting from the University of Illinois. He’s a certified public accountant/personal financial specialist, a certified financial planner, and a certified private wealth advisor.

Background

Bio

Tim Steffen: Tax-Saving Strategies for a Falling Market,” The Long View podcast, Morningstar, Sept. 20, 2022.

Tax Changes in 2024

Highlights of the Secure 2.0 Act,” by Tim Steffen, Baird Wealth, September/October 2023.

Secure 2.0 Act Summary: New Retirement Plan Rules to Know,” by Kelley R. Taylor, Kiplinger, July 17, 2023.

A Smaller Tax Bill in 2024 Starts in 2023,” by Tim Steffen, Baird Wealth, Oct. 18, 2023.

“‘Tis the Season for Giving,” by Jonathan Raymon and Scott Grenier, Baird Wealth, Oct. 18, 2023.

Pros and Cons of Donor-Advised Funds,” by Amy Arnott, Morningstar, Nov. 6, 2023.

Tax Cuts and Jobs Act

Tax Cuts and Jobs Act: A Comparison for Businesses,” IRS.gov.

2024 Tax Brackets,” by Alex Durante, Tax Foundation, Nov. 9, 2023.

State and Local Tax (SALT): Definition and How It’s Deducted,” by Michelle P. Scott, Investopedia, Oct. 29, 2023.

Alternative Minimum Tax (AMT) Definition, How It Works,” by Jim Probasco, Investopedia, Jan. 2, 2023.

Don’t Get Tripped Up by These Tax-Reporting Missteps,” Interview With Christine Benz and Tim Steffen, Morningstar, Jan. 8, 2019.

Tax-Efficient Portfolio Planning and Retirement

Why Municipal-Bond Funds Are Worth a Look,” by Amy Arnott, Morningstar, Nov. 14, 2022.

Understanding 401(k) Contribution Limits,” by Debbie Carlson, Paul Curcio, and David Tony, CNN, Nov. 15, 2023.

The Three Tests Before a Roth Conversion,” by Tim Steffen, Baird Wealth, Oct. 16, 2023.

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

4 Timeless Tax Planning Insights for Advisors,” by John Manganaro, Think Advisor, Oct. 11, 2022.

Transcript

(Please stay tuned for important disclosure information at the conclusion of this episode.)

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: Today on the podcast we welcome back Tim Steffen. Tim is Director of Advanced Planning for Baird. In that role, he researches, writes, and speaks about various planning and 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. 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’s a certified public accountant/personal financial specialist, a certified financial planner professional, and a certified private wealth advisor professional.

Tim, welcome back to The Long View.

Tim Steffen: Thanks, Christine. Thanks for having me.

Benz: Well, thanks for being here. So, we want to talk about 2024. We’re taping this in late 2023, but we want to look forward to next year. There are a whole bunch of inflation adjustments going into effect in 2024, affecting the standard deductions, tax brackets, retirement plan, contribution limits, and so forth. Are those larger than usual to account for the outsize inflation that we’ve had over the past couple of years?

Steffen: Our view of larger has been a little bit tainted thanks to some of the big inflation adjustments we’ve seen elsewhere these days. So, the adjustments in 2024 will be a little bit lower than what they were in 2023, but on a historical basis, they’re still pretty big. So, generally, the tax brackets, standard deduction, those kinds of things are all increasing by about 5.5% or so, which is lower than what we saw last year, but on a historical norm, again, still pretty significant increases across the board. Other things like retirement plan contributions and those, those are a little bit more controlled in how they increase. They usually increase in flat-dollar increments. So, it’s a little harder to judge the increases on a percentage basis there. But for the things that do go up every year, brackets and standard deduction, some of the other phase-ups, these are pretty big increases, historically speaking.

Ptak: In 2024, some provisions of Secure 2.0 will be available for retirement plans. For example, companies will be able to match employees on their student loan paydown. Do you expect to see significant adoption of these options? And if so, which ones?

Steffen: Just to recap what the provision is, what employers were finding is that some of their younger employees weren’t able to contribute to the 401(k) plan that they were offering, because they were paying so much on their student loans, and because they weren’t contributing to the plan, they were losing out on matching contributions that the employer was offering. So, what’s happened with this new law that’s taking effect is that employers can treat student loan payments as contributions to the employer plan and then make those employees eligible for a matching contribution. So, it’s a nice way for employers to help out some of those younger employees who maybe don’t have the cash flow to do both the 401(k) and the student loan and still get a match.

Is this something we’re going to see systemwide right away? Probably not. It does require a plan amendment to offer this. So, it will take employers a little bit of time to roll their way through and get these things offered. But like we saw with things like the Roth 401(k) and other plan provisions, they may start slow, but over time this will become a relatively common thing, I would suspect.

Benz: Speaking of Roth 401(k)s, another provision of Secure 2.0 that kicks in in 2024 is that they will no longer have required minimum distributions. Previously, they had been a weird outlier where Roth IRAs didn’t have RMDs, but Roth 401(k)s did. Do you expect that that sort of thing will prompt people to stick around in their retirement plan longer than they might have otherwise done?

Steffen: I would suspect that they will. It certainly eliminates one of the big differentiators between a Roth 401(k) and a Roth IRA. Between regular 401(k)s and regular IRAs, there’s not a lot of difference in the tax rules. They’re pretty equivalent. But this is a real differentiator between Roth 401(k) and Roth IRAs. So, Roth IRAs are not subject to required minimum distributions. Roth 401(k)s have been subject to them. And through 2023, they remain subject to them. So, if you retired in the past and you had a Roth 401(k) balance at the beginning of 2023, you still have to take an RMD this year. But beginning in 2024, that’s no longer the case. So, with that differentiator eliminated, I think people will be more thoughtful about do they really want to roll things out of the plan into an IRA or not? They’ll still look at things like what are my investment options inside the plan, what are the expenses inside the plan, and some of the other things that are there. But this does level the playing field quite a bit between those two types of plans.

Ptak: You’re a fan of a strategy called bunching deductions to help elevate your itemized deductions over the standard deduction. Can you discuss who might benefit from that strategy and maybe share some examples of how it would work in practice?

Steffen: So, the idea of bunching, it’s nothing new, but it’s become more and more popular over the last several years thanks to some of the more recent law changes we’ve had. It’s the idea of being strategic in the timing of the payment of your deductible expenses in order to maximize the tax benefit. Rather than spreading expenses out over multiple years, you try to bunch them or combine them into one calendar year in order to maximize their benefit.

So, for example, the most common thing we see this done with is charitable contributions. Most other deductible expenses—your mortgage interest, your income and property taxes—you don’t have a lot of control over those and the timing of those. You’re going to have to pay them as they come. But with charitable gifts, you’ve got the ability to really control when and what calendar year you make those payments. So, a real good candidate for the bunching strategy is somebody who does a lot of charitable giving.

Another person who might be good at this or who would benefit from this is somebody who is just always falling shy of or just going over the standard deduction to where they’re not quite getting a benefit for their charitable gifts or maybe getting a very small one. By combining those charitable gifts into one calendar year, you can alternate between taking the standard deduction and then itemizing and really getting more of a tax benefit for those charitable gifts, especially for married couples, less so for singles because it’s easier for a single person to itemize because their standard deduction is relatively low. But for married couples, this is a particularly strong benefit, something we’ve been talking a lot about.

Benz: You mentioned charitable giving, that it is often tied in with this bunching strategy. And I know people often use a donor-advised fund in this context. I’m hoping maybe you can talk about that and also talking about the role of contributing securities to that donor-advised fund, so maybe picking up an additional tax benefit still. Maybe you can walk us through that and also what types of securities the donor-advised funds can typically take in?

Steffen: So, a donor-advised fund is in and of itself doesn’t provide any unique tax advantages. Giving to a donor-advised fund from an income tax standpoint is no different than writing a check or giving securities to your church or school or any other charity that’s out there. What it really does though is it helps facilitate these bunching strategies. Because what a donor-advised fund is, is the way for you to contribute money to a charitable entity, get your tax deduction right away while still controlling the funds, investing them and then over time doling them out to the charities as you feel appropriate with no requirement to do so within any time frame. So, it gives you the most flexibility.

From a tax standpoint, giving to a donor-advised fund, as I say, is no different than giving directly to a charity. But for those who want to do a bunching strategy and want to make double or triple even the gifts in one particular year, donor-advised fund is a great vehicle for doing so. Put the money in the fund and over time you can spread out the gifts to the various charities you want to support.

In terms of what you can give to a donor-advised fund, most donor-advised funds these days will take most anything you’re willing to donate. Certainly, cash gifts and appreciated securities, giving those to a donor-advised fund can be a great way to avoid paying tax in the gain because we’ve given appreciated stock to the donor-advised fund, you don’t pay tax on the gain when the fund sells the stock to reinvest it. It doesn’t pay tax in the gain either. So, appreciated securities have always been a wonderful way to contribute to either to a charity directly or through the donor-advised fund.

Nowadays we’re seeing donor-advised funds even be more and more flexible in the types of things they can take. So, depending on the fund you’re going with, they may be willing to take things like collectibles, artwork, precious metals, maybe even physical assets like real estate or vehicles. And now more and more of them are getting into accepting things like cryptocurrencies and that and are the electronic assets, so to speak. So, more and more of these funds are becoming more flexible in the things they can take. So, just shop around and see what the different donor-advised fund products offer. Be aware there may be some added expenses for some of these more unique or hard to value or hard to liquidate assets. But in general, more and more of these funds are accepting all kinds of assets.

Ptak: We could see some more big changes to the tax code at the end of 2025 when the provisions of the Tax Cuts and Jobs Act, which is the TCJA for short, are scheduled to end or in legislative parlance to sunset. First, let’s talk about some of the key provisions of TCJA. Is it safe to say that it generally lowered taxes for most taxpayers and a repeal would cause taxes to rise?

Steffen: Yeah, I think if we go back to 2017 when this was passed and we look at what happened in 2018 and compare the two years, most individuals probably saw some form of tax cut. So, the Tax Cuts and Jobs Act had a unique combination of things. It famously eliminated a lot of deductions. So, it put more caps on our ability to deduct our state income and property taxes and our mortgage interest and some other things. And it got rid of things like miscellaneous deductions and personal exemptions for your kids. But it also then lowered the marginal tax rate. So, while for many people their taxable income went up as a result of the Tax Cuts and Jobs Act, the actual tax they paid went down. So, more income subject to tax but tax at lower rates. So, it generally meant a cut for most people.

Certainly not universal. People at very high-income levels, those who lived in very high-tax states like the ones on each coast or elsewhere around the country, they tended to be more likely to say a tax increase in this because of the loss of some of the state tax deductions. But generally, people around the country saw tax cuts as a result of this. So, if we look ahead now to where many of these provisions are set to sunset, we would see a reversing of that. And many of those who saw cuts back in 2018 could be looking at increases in 2026 assuming their situations are the same. Between 2018 and 2026 is a long time. If you retire during that window or your nature of your income shifted or the amount of your income shifted, it’d be hard to compare. But all things being equal, the people who saw cuts back in 2018 will probably see increases in 2026.

Benz: So, do you have a take on how likely it is that Congress will allow these provisions to sunset? And when would Congress need to take action in order to maintain the status quo that’s part of TCJA?

Steffen: So, as we said, there are a lot of provisions within that are set to expire at the end of 2025. And if nothing happens in Washington—there’s literally no legislation that’s passed that addresses this—all of those sunsets will come to pass. Now, I don’t think anybody fully expects the sunset to happen exactly as it’s scheduled. There’s like to be some legislation that happens that will maybe extend some of the existing provisions, let others go away and probably change some other things. So, we’ll see a whole new big tax bill that will come.

In terms of the timing on that, presumably what happens sometimes toward the latter half of 2025, December seems to be a popular time for Congress to finally pass things that will apply for the next calendar year. It’s possible it could even drag into 2026 and then be made retroactive to the beginning of the year. What we’re all fairly confident on is that nothing is going to happen in 2024, with it being an election year, I think everybody just wants to ride out the election, see who is in charge in Washington come January of 2025. And from there, we’ll have a better sense of exactly what might happen with this. The one thing we can all agree on is that no one wants to be the party in charge when a large tax increase happens. So, presumably, regardless of how the election works out, there will be some sort of compromise on these sunsetting provisions and not everything will happen exactly as it’s planned.

Ptak: Which taxpayers stand to be the most adversely affected by the sunsetting of TCJA? And conversely, who, if anyone would benefit from its sunsetting?

Steffen: Well, again, we think we go back to 2018 and we look at all the people who benefit or were harmed, so to speak, from the changes done and we just reverse that. So, most individuals, as I said, received a tax cut in 2018. So, most of your average taxpayers are going to continue to receive an increase then. I think in particular it will be those who aren’t tending to be itemizers. So, if you’ve been benefiting from the very large standard deduction we’ve had for the last several years, and if the sunset happens and that number falls by roughly half again, and you don’t have other deductions to move you into an itemizer, you’ll feel more of an increase there because you’re going to basically be losing some of your deductions.

On the flip side, those who most benefit from large state tax deductions and property tax deductions, maybe those who paid a lot in advisor fees, tax-rep fees that have not been deductible but would be again in 2026, those individuals might be more likely to see a tax cut as a result of this. And we haven’t talked about the estate tax things, but there’s some fairly significant estate provisions that would roll off after 2025 that could mean some pretty significant liabilities for those who don’t do planning ahead of time. So, I think those are the ones, the ultra-high-net-worth, very high-income people are the ones who are going to be most affected by what might happen with the Tax Cuts and Jobs Act.

Benz: Let’s stick with the estate tax, Tim, which you just referenced. That is a big piece of this and to the extent that I’ve read about sunsetting strategies that’s been one of the key things that gets emphasized is this change in the estate tax. So, can you discuss what potentially would go on there and who that would affect?

Steffen: So, the main estate tax provision in the Tax Cuts and Jobs Act was to take the lifetime exemption amount—this is the amount that you can pass to anyone other than a spouse or charity at your death—completely estate-tax-free. That number was effectively doubled as a result of the Tax Cuts and Jobs Act, and in the ensuing years with an inflation adjustments that we’ve had, we’re now looking at an exemption in 2024 of over $13.6 million per person. For a married couple, you’re looking at a combined amount of over $27 million. Give it another couple years of inflation adjustments as we head into 2026 and that number could easily approach $30 million for a couple or $15 million per person. If the sunsetting happens as is expected, that number falls in half. So, you’ve got this situation where you’ve got a lot of people who today are not subject to the estate tax but in a couple of years could be severely impacted by it. For example, let’s assume a high-net-worth couple with a net worth of say $30 million. Their net worth is large enough. They are always going to be on the estate-tax cusp. It’s unlikely the exemptions are ever going to get large enough for people with more than $30 million to completely escape the estate tax. Those are the folks that absolutely should be taking advantage of this exemption now before it potentially goes away and looking at some of the planning strategies that are out there.

The flip side is the couples with maybe $15 million, which admittedly is a very high percentage of the population. It’s the vast majority of the people in the country with net worths below $15 million, they’re not likely to be impacted by an estate tax even if we do get a change in the exemption amount. Their net worth is not going to be high enough where they’re really going to be a target of the estate tax. The ones that are the most to be concerned about right now are the ones in the middle—so a married couple with a net worth between say $15 and $30 million. Right now, that couple wouldn’t pay any estate tax effectively. In a couple of years, they might be subject to the tax of 40% on any assets over $15 million. So, you take that married couple who’s got say $20 million, they could be looking at a $2 million tax bill come 2026 that they don’t have today. So, there’s a pretty meaningful impact there. So, you’ve got a group of people that really aren’t too concerned about it. You’ve got another group that should always be concerned about the estate tax. And then, this group in the middle that really is not sure what to do right now but needs to be thinking about it.

Ptak: You alluded to strategies that some of the affected groups you mentioned might want to consider. What are some of those strategies that should be under consideration in the event they think they’re likely to be hit by the estate tax if the TCGA sunsets or do you think that’s such rarefied air that tax planning strategies are just necessarily quite customized to the situation and therefore it’s hard to speak in generalities?

Steffen: Well, there certainly are a lot of nuances available in the planning world for those ultra-high-net-worth families but there are some easier things to consider, the easy one being charitable giving. For example, if you’re a charitably inclined person and you plan to leave much of your estate to charity, state taxes probably aren’t going to be an issue, or maybe you choose to do more to charity at your death in order to help avoid the estate tax. There are little things you can be doing now like taking advantage of the annual gift tax exclusions. Admittedly, for somebody with $30 million making $18,000 gifts may not seem like a big hit to the estate tax. But over time, with enough of those gifts, that can be material. So, take advantage of the larger gift-tax exemption. I mentioned $18,000. That’s the number for 2024. It’s going to be going up again next year.

There are liquidity things you can think about perhaps using life insurance to help provide liquidity to pay the estate tax so you’re not digging into your actual assets to pay that. One of the more common techniques out there or common things that’s being talked about anyway among the ultra-high-net-worth is a thing called the SLAT, or a spousal lifetime access trust, where spouses actually make gifts to each other to help avoid the estate tax. That’s a fairly advanced technique. It’s certainly not for the vast majority of people, but it is a way to take advantage of the larger exemption while also still maintaining a high degree of control over the assets. So, those are some of the things we’re talking to people about.

Benz: Tim, you mentioned the SALT tax cap and that is one provision of TCJA that I think a lot of people would be happy to see go away. The question is if we don’t have that SALT tax cap would the sunsetting of all the TCJA provisions negate or undo the benefits that people would get from being able to fully deduct their property tax and their state and local tax?

Steffen: Yeah, it’s important to think of it that way because you can’t look at any tax legislation in a vacuum and just say look at this one component of this bill and how this is going to impact me because each one of those provisions is part of a larger bill. And while some may work against you, others may work for you, and you have to look at it in totality. Just like we said in 2017 with the original Tax Cuts and Jobs Act, some things may be negative, other things may be positive. The net impact for most people is positive. The same applies here with the SALT deduction. So, that’s a $10,000 limit on your state income and property taxes that you can deduct today. In 2026, that cap would theoretically go away if sunset happened, so meaning you can now deduct an unlimited amount of those income and property taxes.

But one of the other things that would likely come back if the TCJA does sunset is something called the Alternative Minimum Tax, or AMT, everybody’s favorite three-letter word. One of the provisions in AMT is that your state taxes and your property taxes are not deductible. So, yes, you may be able to deduct a larger amount of them under the regular tax system. But with AMT potentially becoming a more prevalent issue in 2026, that deduction might just go away for you there anyway, and you might find yourself back in the same situation you are now where your state taxes don’t provide you much of a federal tax benefit. So, it’s important to look at how all of these things work together. I know a lot of people in those high-tax states are anxious for that cap to go away, but that doesn’t necessarily mean they’re going to get an increased tax benefit for those taxes.

Ptak: We’d like to discuss some of the strategies that should be under consideration for people in expectation of the end of TCJA at the end of 2025. But before we do, can you discuss how much people should try to be preemptive with tax planning when the laws haven’t changed yet?

Steffen: Yeah, I think we have to break at least the provisions of the TCJA into two broad categories. We talked about the estate provisions a bit. Those are ones that I think if you find yourself in that north of $30 million net worth, somebody who is always going to have an estate tax liability, you really ought to be trying to take advantage of this exemption before it potentially goes away. And again, those in that $15 million to $30 million window, they’ve got more planning and considerations to do. Maybe you do some planning for one spouse, but not the other.

When it comes to the income tax things, as we sit here in late 2023, it’s going to be a little bit trickier to plan for income tax changes in 2026 right now. I think we start thinking about some of those things, maybe look at maybe the timing of our deductions, making sure we’ve got more deductions in 2026 when they may provide more value to us than in 2024 or 2025, that bunching strategy we’ve talked about. Maybe if you’ve got income that may be coming due or that you have to recognize in 2026, you maybe look to find ways to bring that into 2024 or 2025. But in all honesty, most people don’t have a lot of control over their income and the timing of it. So, the business owners, maybe some retirees, that’d be about it.

So, the estate stuff, I think you absolutely have to be focused on for those who are going to be impacted by that. The income tax things, we’re probably a little bit premature. And then we always caution people don’t try to front-run the news on these things. Just because these things are scheduled to expire, doesn’t mean they will or that they will in the way that we expect them to. So, understand what’s being talked about, be prepared to react if they do happen, but don’t jump the gun too soon or you can find yourself having a little bit of buyer’s remorse on how you’re handling some of those strategies.

Benz: Well, yeah, speaking of that, I’ve been seeing a lot about how Roth conversions might be more advisable pre-sunsetting, something to consider. Where do you come down on that? And we have some more specific questions about conversions, but how about related to this TCJA sunset?

Steffen: Yeah. So, one of the best times to do a Roth conversion is when you can pay tax at a lower rate than you otherwise might in the future. So, if you just look at the provisions of TCJA that say tax rates are going to go up in 2026, you could easily make the jump that it makes sense to do a conversion now before those rates increase versus in the future.

When you look at the potential increases, each of the brackets would go up between 2% and 3%, maybe in a couple small cases, 4%. We’re not talking gigantic increases in the tax brackets, a couple of percentage points at each level, maybe or so. So, yes, rates might be a little higher in the future. Are they substantially higher? Maybe not, depends on your situation. I would be more concerned about where is your income going to fall in the future and how might that influence your tax rates. Projecting future tax rates is really difficult. Especially when we’re talking, if you’re a younger individual who is saying, I know what my tax on the conversion would be today, but what might it be in retirement? Impossible to predict. As I’ve been reminding people, even if this TCJA expiration does happen or we get some other bigger legislation late in 2025 that impacts 2026, it’s very unlikely that that’s the last tax legislation we’re ever going to see. We know how these things work. These things kind of ebb and flow. The last big bill we saw was tax cuts. The next one might be increases. The next one after that might be cuts again. These things come and go over time. So, to assume that the increases we might see in 2026 will be there forever, I think that’s a mistake. So, you don’t want to make too many big lifetime decisions off of what might be just a temporary increase in rates.

Ptak: Now that levels of investment income are higher thanks to higher yields, is asset location important again in a sense? What are some key principles to bear in mind when it comes to siloing asset types in various accounts in an effort to limit the tax drag?

Steffen: I don’t know that tax location or asset location is any less or more important than it’s always been. It’s always been a hot topic and something you need to focus on. As we remind people, it’s not about the return you earn, it’s about the return you get to keep. And so, that’s where taxes really come into play. So, you look at the types of investments you have that are right for your portfolio, what is your overall asset allocation. And then, you look at some of those different asset classes. Fixed income, for example. Are you purchasing fixed-income investments because you want the income off of it, or because you want the diversification in your portfolio? If it’s for the income, then you probably want to hold those outside your retirement accounts. If it’s for strictly the diversification and you don’t want the income necessarily, those are ideal to keep in your retirement accounts. And that’s always been the case.

On the flip side, on your equity portfolio, if you’re a buy-and-hold individual, those are great investments to hold outside of your retirement accounts. If you’re somebody who wants to be more of an active trader and could be triggering lots of gains and losses over time, maybe then it might be better to shelter some of that inside a retirement account, at least the gains anyway. So, really, the location matters, but it also matters on how you’re structuring your portfolio and why you’re investing in certain things. But yes, asset location is always an important thing. And general rule of thumb is you put your fixed income and those higher-income investments inside a retirement account, your more growth-oriented investments outside the retirement account. And then again, you tweak that based on what your specific needs for the portfolio are.

Benz: Sticking with the topic of tax-efficient portfolio management, I really like your point about how the use of the funds really is an important consideration. It seems like a lot of people from a practical standpoint hold safer assets because they want the liquidity. They expect to actually need the money for something. So, are municipal bonds usually the right thing to look at, especially for people with higher taxable incomes?

Steffen: There’s a couple of reasons people get into municipal bonds. One is just the diversification factor. You want to have a bond component in your portfolio. If those bonds are going to be outside of a retirement account and you’re in a higher tax bracket, municipals can make a lot of sense in that case because you can get the income without having to pay tax on it. I do think people sometimes are maybe too quick to jump into municipals because they like the idea of tax-free income. But there is a point when you’re looking at your tax rate where paying tax on a higher-yielding Treasury or a taxable bond of some kind can provide you more net income than getting a lower yield on a tax-exempt municipal bond, for example. So, we see this a lot with individuals as they transition from working years into retirement. During their working years, their income is very high, municipal bonds make sense for them because they don’t want to pay the higher tax rates on those coupons. Then, all of a sudden, they retire, their income falls off because they don’t have the wages anymore. Now they find themselves in a lower bracket but still holding those municipal bonds. That would be the time to start transitioning, at least as those bonds mature anyway, into maybe higher-yielding taxable bonds. Yes, they may create a tax liability, but you’ll end up with a higher overall net yield in those cases. So, yeah, municipals make a lot of sense, but they’re not right for everyone.

Ptak: We’ve discussed direct indexing with you before and it continues to be very much in vogue because of the ability to limit taxes on taxable holdings on a year-to-year basis. Before we get into the topic, and I suppose in the interest of full disclosure, does Baird have a direct-indexing solution that it offers clients?

Steffen: Like a lot of firms, we have a few different ones that we offer, some third-party ones, some internal ones. So, yeah, it’s a topic that’s of interest to our clients and we’re offering some products to help meet that need, for sure.

Ptak: Can you maybe discuss the basic tax strategies in play at most of the direct-indexing platforms, including those that you offer to clients? Is it mainly realizing losses and using them to offset gains?

Steffen: That’s the primary thing, yeah. Compare, for example, to going on and buying an index mutual fund or ETF that maybe tracks a large index, say the S&P 500, for example. If you buy into one of those funds or ETFs, you own on your balance sheet, so to speak, one position. Inside that, though, there are lots of positions—some are rising, some are falling, some have gains, some have losses, but you’re not really trading any of those. You’re not capturing any of those losses because they’re all inside the mutual fund wrapper and changes only happen in there when there’s a change to the broader index. So those losses that may be occurring in there are going uncaptured or untaken advantage of.

Direct indexing says instead of buying a mutual fund or an ETF, for example, that has this wrapper around all the positions that you can’t penetrate, we’re just going to buy the individual positions and you’ll have the same things in your individual account that you would have if you had bought the mutual fund. And now, now that we own all those individual positions, if there’s something that does fall in value, we can sell that, capture the loss, move into something very similar to it—we’ve got to be very careful about the wash sale rules, but eventually move back into that original position—having captured the loss and using that loss, then offset maybe gains we realized also in the portfolio. Where we see people getting into these a lot is those who come to us with a concentrated position that’s got a lot of gains in it that they’re hesitant to sell because they want to avoid paying the tax on it, but they know that they should be moving away from that position or diversifying it some. So, we take another part of their portfolio, we put that into a direct-index product where they can capture some of those losses, allows us to sell some of the concentrated position and offset the two and minimize the net tax cost.

Benz: We touched briefly on the advisability of Roth IRA conversions in the context of TCJA sunsetting, but we’d like to discuss it more broadly. One thing we sometimes hear is that Roth is always a good choice, whether for contributions or if you need to make conversions because tax rates are low relative to history. Is that correct? Would you share that view?

Steffen: Well, I try to avoid absolutes. I don’t know that any strategy is always right or always wrong. There are lots of opportunities, lots of times when doing a Roth, either contributions or conversions, can be the absolute right thing to do and there’s times when it’s maybe not quite as appropriate as it would be otherwise. So, yeah, I think there are windows for both of those, for both either a direct contribution to a Roth when you have the opportunity, as well as conversions. And so, it’s a matter of identifying which is the right one at that particular moment and how your planning in the future might work around that. So, yeah, there are definitely things we consider for both of those.

Ptak: For Baird’s younger clients who are many years from retirement, how do you help them decide whether they’re better off making traditional or Roth contributions? Especially to their company retirement plan—it has to be hard to make a judgment about what tax rates might be in the future, both at the individual level and on a more secular basis.

Steffen: Yeah, you’re right, Jeff. It’s really hard to predict future tax rates. We try not to focus on what do you think rates are going to be in the future and focus more on where do you see your income going in the future? Because we don’t know what the rates are going to be. But you might have a sense of the trajectory of your income over time. For those younger employees, they tend to be early in their career maybe at some of the lowest income levels they’ll have in their career, maybe until retirement even—we tend to have them focus more on contributing to a Roth 401(k), reason being is that they are maybe at a lower marginal tax rate. The tax deduction you get for putting money into a traditional 401(k) isn’t going to be that significant. And you’ve got many years, perhaps decades of time to let that grow tax-free. And when you take it out in retirement, even though you may be in a higher income level during your working years over time, when you get to retirement, things tend to fall off. You might find yourself back in that lower tax bracket or something, so they are maybe even a little bit higher still than when you were working. But we do find that the Roth contributions are great for those who are early in their career at low-income levels. As income starts to climb, then maybe you start to shift into the traditional plan as well and taking advantage of the deductions that are available to you then.

Benz: We’ve been seeing that more plans are offering aftertax 401(k) contributions. Many are now offering those in-plan conversions. Can you discuss what those are, who should consider them, and whether there are any pitfalls to bear in mind? Are there any situations where they wouldn’t be advisable?

Steffen: So, if you think about the two more common types of retirement plans of your employer, you’ve got the traditional plan where you get a deduction for whatever you put in there, it grows tax-deferred, and when you take it out, it’s fully taxable. And then, you’ve got the Roth-style plans where you don’t get a deduction when you put the money in. So, there’s no immediate tax benefit, dollars in there grow tax-deferred, and when you hit retirement and it comes out, it’s all completely tax-free. So, these are two very clearly defined silos of deductible going in, taxable coming out; nondeductible going in, nontaxable coming out.

The aftertax plans fit in the middle of those two. So, they’re generally a traditional plan, but that provides you no tax benefit up front, but taxable income in retirement. So, you don’t get a deduction for putting in money in the plan—it grows tax-deferred, just like your traditional plan would, like the old 401(k) we’re all used to—and then when it comes out, the earnings on that will be fully taxable. Your contributions will always come back out tax-free because you didn’t get a deduction when you put it in there, but the earnings on that are going to be taxable. So, it’s more like the traditional plan in that you’re going to have a future tax liability, except you don’t get a tax benefit for it up front.

What a lot of people then are doing who are taking advantage of this is… Well, first off, the people who are doing this are those who probably already maximized their contributions to the regular plan, either the traditional or the Roth. The limit for 2023 is $22,500, another $7,500 if you’re age 50 or more. If you’ve made that full contribution to either the traditional or the Roth plan, you’re looking to put additional money into the plan, your employer may offer that as an option for you. What we see a lot of people do then is, once the money inside that aftertax traditional plan—it’s typically a separate account from everything else—is if the employer offers this, and many of them do, is then doing an immediate Roth conversion of it, and getting those dollars out of the traditional plan into a Roth, no extra tax cost. It’s kind of the mega Roth. We’re all familiar with the term of the backdoor Roth. This is another version of the Roth called the mega backdoor Roth or something like that, where it allows people to get many thousands of dollars, in some cases, into a Roth account. So, like some of the other provisions we’ve talked about, it was slow in the early years, but we’re seeing it happen more and more, be offered more and more, and more and more people taking advantage of it because it’s a unique opportunity that you couldn’t do outside of a retirement plan, outside of an employer plan. It can only really be done within the employer plan itself.

Ptak: Everyone seems to love health savings accounts for their tax benefits. One strategy that you sometimes hear is to pay healthcare expenses out of pocket and save your receipts that you can take tax-free withdrawals from the account for nonhealthcare expenses later on. That makes sense, but do you have a suggestion about how people should store and track those receipts?

Steffen: Yeah, I do. You may not like it, but I do, because I do this very thing myself, and that is, I’ve got an Excel spreadsheet that I’ve kept track of the expenses on, and I’ve got a folder in a drawer that’s got all the receipts. It’s not very elegant and maybe a little cumbersome at times, but it will work as long as I’m good at keeping my records, which I try to be. If you use a personal finance tool like a Quicken or something like that, and there may be ways to track that in those tools as well. But the old Excel spreadsheet with an envelope of receipts works pretty well for me. We’ll see what happens when I get into retirement, and it’s time to start digging through that again, but that’s the process I’m using right now, and hopefully it will work well for me in the future.

Benz: We wanted to ask about retirement planning, focusing on people who have just retired or about to retire. We often hear that that period in life right after retirement but before any required minimum distributions are online with tax-deferred accounts, that’s a good season in life to consider IRA conversions. Can you discuss why that might tend to be, and I guess do you agree that that’s something to explore once you’ve retired?

Steffen: Yeah, I absolutely agree on it. I think that’s an ideal window of time to do a Roth conversion. We refer to that as the trough period, a period of time when you’ve stopped working and your wages have gone away, but you haven’t started Social Security benefits yet. You aren’t subject to required minimum distributions yet, which thanks to the Secure Act, those have been pushed out a couple of years further now, so 73 and 75. This window of time is bigger than it was before. So, you’re just going back to the idea of a Roth conversion. As you look at factors that make for a really successful conversion, one of those is doing it at a time when your tax bill is going to be a lot lower than what it would be if you just took those moneys out of a retirement account later in retirement.

So, we look for windows of time when your tax cost is artificially or temporarily lower than it otherwise might be. This trough period that we’re talking about—the period of time after retirement and before other income starts—is a really great opportunity, a great window to do this because as a retiree at that point, you generally have complete control over the source and amount of your income. So, you really get the ability to control how much tax you’re going to pay during this period of time. So, it can be an ideal time to maybe consider a Roth conversion. A similar period like this may have been, and I know it sounds kind of weird to say it in hindsight, but during the pandemic, and we look at business owners who are maybe dealing with shuttered businesses and revenue falling. As strange as it might seem, that might have been an ideal time for those business owners to consider a Roth conversion because their income was really low. They could have done a conversion at a very low tax rate, and now that things are back up and running again, that income is growing on a tax-free basis for later in life. So, yes, that period of time after retirement is an ideal window for doing Roth conversions.

Ptak: The qualified charitable distribution has gotten to be a very popular strategy for people over 70.5 to make charitable contributions from their IRAs. Are there any situations when it’s not advisable to make those qualified charitable distributions from IRAs?

Steffen: Again, like we said earlier, there’s not very many absolutes in this world, especially when it comes to tax planning. So, I don’t know if I’d say there’s windows where it’s just absolutely not the right thing to do, but a couple of things that I would consider if the alternative in most cases to doing a qualified charitable distribution would be donating appreciated stock. So, if you hold shares of an investment of some kind—a stock, or mutual fund, an ETF, whatever it is—in a taxable account, and it is highly appreciated, something you’ve had in your family for many years, stock you bought when you first started working at a company and now you’re in retirement and you still own it, those highly appreciated positions, those cases you might be better off donating the stock rather than doing a qualified charitable distribution. You still get the same net tax benefit for giving appreciated stock versus the IRA withdrawal, plus you can make that capital gain go away. So, if you’ve got some of those highly appreciated positions in your portfolio that you know you should probably diversify out of, but you don’t want to pay the tax cost on it, using those for gifts can be ideal. But if you’re not an itemizer to begin with, then going back to the qualified charitable distribution is probably going to be your better option. So, I would say the best argument for not doing a QCD would be somebody who does itemize and has very highly appreciated positions that they know they don’t want to keep.

Benz: There seems to be quite a bit of confusion about gifting appreciated assets to individuals, say, family members versus giving to charity. Can you discuss how that works? So, say, I have this highly appreciated equity position, and maybe you can discuss the advantages and lack of advantages if my goal is to give it to a family member.

Steffen: The two big differences when giving appreciated stock to charity versus to a family member, one is when you give it to charity, you get a tax deduction for it. When you give something to your kids or grandkids, you don’t get a tax deduction. As much as we might want to think of our kids or grandkids as a form of charity of some kind, IRS code doesn’t see it that way, so you don’t get any kind of income tax deduction for giving money to your kids, like you would if you gave it to charity.

The other big difference is, if you give that appreciated stock to the charity, you don’t have to pay tax on the gain, and neither do they when they sell it because they don’t pay tax. You give that highly appreciated stock to your child or grandchild or somebody else, again, you don’t have to pay the tax on it, but they inherit your basis. Your basis carries over to them, and then any gain that was in your name now carries to them, and when they sell it, they’re going to have to pay that same tax that you would have. They don’t have to pay it right away. There’s no immediate taxation, but the gain carries over, and it’s going to get taxed by somebody at some point. So those are the two big differences.

There are some nuances when you give things that have depreciated in value, so you want to be really careful about giving something to somebody that has fallen in value. You really don’t want to do that at all if you can avoid it. But giving appreciated securities to family members can be a great way to move things out of your estate, and if they’re going to sell it and they’re maybe in a lower tax cost than you are, it might make some sense to have them do it rather than you.

Ptak: A lot of older adults have concluded that they’re better off paying for a long-term care out of pocket rather than purchasing insurance. Can you discuss which account type people should use to save for long-term care?

Steffen: Well, you’ve really only got two options, or maybe three, I guess, if you include retirement accounts. You can always use your IRAs or your retirement accounts to pay for out-of-pocket medical expenses, but the money you take out is going to be fully taxable. Yes, you can likely get a deduction for some portion of that expense that you’re paying to a nursing home, for example. But medical expenses are subject to some unique rules that limit their tax value. So, it’s probably not the best strategy. The other two spots would be just your regular taxable savings account. So maybe you sell a position to generate some cash to pay a bill, or maybe you’ve got some other liquidity around where it doesn’t cost you anything to sell it to pay the bill. And then the third option would maybe be your health savings accounts. We talked about those earlier. Health savings accounts are fantastic tools for paying medical expenses in retirement.

When it comes to long-term care, especially if you’re going to do insurance, but also just out-of-pocket stuff, maybe not the entire amount you pay is going to be considered a qualified expense out of the HSA. You’ve got to be careful. When you’re writing that check to the nursing home, for example, make sure they give you an idea of how much of this is for healthcare and how much of this might not be a deductible expense. You can only use the HSA for the portion that would otherwise be deductible, which in nursing home cases is going to be the vast majority of the expense, maybe a very high percentage of it. But just be careful that you use the HSA to pay an expense that would otherwise be tax deductible. That’s the key rule on those.

Benz: I wanted to ask about state taxes. We’ve been talking mostly about federal tax-related things. It seems like state taxes are often left out of the discussion about tax planning, but they can be significant, especially in the estate tax realm, where you can see big differences from state to state. If someone has more than one home and is considering becoming a resident of another state, what are the key items that should be on the dashboard as they make that tax assessment about where is the right place to be a resident?

Steffen: Let’s take the typical example. You’ve got somebody who lives in a high-tax state like in New York, New Jersey, or California, or something like that and is thinking about relocating to a no-tax state like a [Florida] or a Nevada or Texas, one of those states. If you sell your home in the current state and purchase a home in the new state, it’s pretty clear you’ve moved, and you don’t have any residents in the old state. It’s clear you’ve made that move. But if you plan to own homes in both states and yet you want to call yourself a resident of the state that you’re not in now, you’ve got to be prepared to make some real life adjustments. Most people focus on the, well, as long as you’re in the other state for six months and a day, you’re going to be fine. I would call that absolute bare minimum when it comes to trying to relocate or change your residency from one state to another.

The way days are counted can be a little tricky. To just target six months and one day is probably not going to do it. You’re going to want to maybe shoot a little higher than that. So be prepared to be in that other state for probably well more than your six months and a day, just to make sure you’re not cutting it too close. As you think about moving to that state, you’re going to be spending more time there, so think about cost of living in that state. We know income taxes, that one you’re pretty familiar with, but what about the cost of other things: sales taxes, property taxes, the cost of living, what does housing cost there? Food and dining out?

If you’re going to relocate to another state but your family is all staying back where you came from, are you going to find yourself traveling back and forth more to go see them? And are those added expenses for traveling, perhaps going to negate the tax benefits of moving to another state. The house you have in the second state may be a much smaller one and you say, well, if we’re going to spend more time here, we’d like to get a little nicer house. Now you’ve got a bigger house and more expenses and more furnishing to do in that house and more upkeep. Again, all those expenses can offset the tax advantage you have by claiming a new state as your residency.

So, it’s easy to focus on the income tax benefits of moving, but there’s a lot of other things you need to think about before you make that final decision. And be aware, states are onto this. Those high-tax states, they know the people who are trying to make that move and leave their state and go to another one. You have to tell them that you’ve moved, so they’re going to be watching you. And states have gotten very aggressive in fighting people on that and saying, we don’t think you’ve really made the move. We think you’re still a resident here and therefore we’re going to continue to tax you as a resident. So, again, the six months and a day thing, don’t cut it too close and do all the other things you need to make sure you’ve really proven that you have severed ties in the old state and established them in the new state.

Ptak: Do you think that some of the population trends you’ve mentioned are only going to worsen the tax burden for people in states that are losing population like Illinois, for instance?

Steffen: Well, it would certainly seem to be the case. Those states that tend to be the higher-tax, more expensive states are losing people. Their revenue is going down, which means they either have to find ways to replace that revenue, which means more tax increases of some kind, or cut back on their spending. And just like any of us do with our own households, you’ve either got to increase income or reduce the spending to make the numbers match.

What you might see is some of those states that are traditionally considered higher-tax states, making some changes to try and entice people to stay or even come back to the state. We’ve seen that recently in, say, for example, Minnesota, which has traditionally been a higher-tax state. It isn’t always thought of one because you think of more on the coast, but Minnesota has traditionally been a higher-tax state. They enacted some changes this year to reduce the tax costs for retirees in the hopes of getting those who are up there to stay or maybe even bring some of those who have left to come back to the state. So, the states have some options, it’s just a matter of which lever are they going to pull to try and make ends meet.

Benz: It seems like a lot of financial advisors are leaning heavily on tax planning as an area where they add value. Do you have any advice to consumers about how to assess an advisor’s skill level on tax planning? I think it’s generally a good trend that advisors are saying, this is a good place for me to focus. But how do you tell what should you be looking for?

Steffen: I think in some ways, it’s the designations those advisors have earned. Most people are familiar with the CFP, certified financial planner designation, but there are others out there now, the CPWA, Certified Private Wealth Advisor. One we’re seeing a lot of interest in is something called the EA, enrolled agent. It’s a designation sponsored by the IRS that shows that somebody’s taken some coursework and done some studying and passed some exams to become familiar with how the tax code works. Obviously, CPA is a very highly recognized one as well.

So maybe start with the designations that your advisor has earned. Secondly, ask them some questions. How might they handle this situation? Or if this case were to come up, how might they respond or what kind of advice could they give? I will say you don’t necessarily need the advisor themselves to be the expert on these things. Most advisors at bigger firms have a whole team of people behind them that they can lean on. So, the advisor may say, “This is not my area of expertise. I know enough on this to know who to talk to. So, I’ve got a whole team of people that I can call that can help us with that.” That may be tougher for smaller firms or independent advisors to do, but they’ve got resources as well. So, it’s not just your advisor. They typically have a whole team of people they can rely on as well. It’s important to ask because as we remind our folks all the time, there is a tax angle to every planning strategy and everything we do out there. So, if you have an advisor who is just saying, “Taxes aren’t my area, I don’t get into that, I don’t want to talk about it,” that alone might be a bit of a red flag. You probably need to find somebody who is a little bit more aware of these issues and has the resources available to help them and to help you.

Ptak: A related question is the number of CPAs is declining. What are the key reasons that’s happening and what are the implications?

Steffen: I’ve seen some of those numbers too where they have fallen off. The number of graduates in the accounting program seems to be slowing down a little bit. I can’t put my finger on exactly why that is. I can say, and having talked to some CPAs out there, I’m a CPA, I was in public practice for a long time, but it’s been a number of years since I did that. I think a lot of other CPAs I’ve talked to are heading down that same path. They’re saying, we like doing the tax work, but it’s difficult. It’s a grind.

I think the COVID period was especially rough on CPAs with the constantly changing tax laws and the late changes in laws and all the provisions they had to deal with. Advisors have decided that they’ve just burned out. CPAs have said they’ve just burned out and they’re looking to get into something different, moving more into the planning side and even the asset-management side. We’re seeing a lot of CPAs moving out of the direct, I just do tax return and tax compliance work and do more broad-based overall planning and asset management. Just like in our business, we’re moving a little bit more toward the tax-planning side. I think the two industries are coming together. It is an issue. We hear from clients all the time that they’re struggling to find a good, reliable CPA that they can lean on. There’s lots of them out there, but the really good ones tend to be overworked and maybe not eager to take on a lot of new business. So, it’s definitely a struggle out there right now.

Benz: Well, Tim, this has been such a great download of tax-related information, as always. Thank you so much for being here.

Steffen: Thanks Christine and Jeff, for having me, and I look forward to doing it again.

Ptak: Thanks again.

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. While this guest may license or offer products and services of Morningstar and its affiliates, unless otherwise stated, he/she is not affiliated with Morningstar and its affiliates. 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 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.)

Correction: This transcript was corrected to insert "Florida" instead of "California" as a no-tax state.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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