The tax- and retirement-planning expert discusses SECURE and CARES Act implications for charitable giving and estate planning, the pause on RMDs, and why 2020 is shaping up as an ideal year for Roth conversions.
Our guest on the podcast is retirement and tax expert, Ed Slott. He is president and founder of Ed Slott and Company, which provides retirement and tax planning education to investment advisors and financial institutions. Ed has written several books including the recently published Ed Slott's Retirement Decisions Guide: 2020 Edition and Fund Your Future: A Tax-Smart Savings Plan in Your 20s and 30s. PBS viewers may know Ed from his frequent appearances on public television. He also hosts the popular website irahelp.com, where The Slott Report blog regularly dispenses wisdom about retirement, tax, and estate planning. He provides a monthly Q&A column to AARP and is also a contributing columnist and media resource to Financial Planning, Financial Advisor, and InvestmentNews magazines. Ed is a certified public accountant.
Background
Ed Slott bio
The Slott Report blog
Books by Ed Slott
Ed Slott AARP articles
Ed Slott InvestmentNews articles
Ed Slott Financial Planning articles
IRAs and Conversions
Tax-deferred definition
A Comprehensive Guide to Tax Treatment of Roth IRA Distributions
Roth IRA Conversion Rules
“New Tax Law Provides the Opportunity for Tax-Rate Arbitrage on Roth IRAs,” by Ed Slott, InvestmentNews, Feb. 15, 2018.
“Seize the Opportunity to Convert to Roths,” by Christine Benz and Ed Slott, Morningstar.com, April 1, 2020.
“Rothification?” by Sarah Brenner, Irahelp.com, Oct. 16, 2017.
“The Definitive Guide to the Back-Door Roth,” by Jeffrey Levine, Irahelp.com, Aug. 12, 2015.
“Backdoor Roth IRA Conversions Alive and Well,” by Christine Benz and Ed Slott, Morningstar.com, Aug. 14, 2018.
“Am I Too Old for an IRA Conversion?” by Christine Benz and Ed Slott, Aug. 21, 2018.
“When IRA Conversions Don’t Add Up,” by Christine Benz, Morningstar.com, June 1, 2020.
Required Minimum Distributions
Required minimum distribution definition
“The CARES Act and 2020 RMDs,” by Ian Berger, Irahelp.com, Aug. 6, 2020.
“The 411 on RMDs for 2020,” by Christine Benz, Morningstar.com, April 22, 2020.
“SECURE Act Targets Minimum Distribution Rules,” by Natalie Choate, Morningstar.com, Jan. 8, 2020.
Charitable Giving
“QCDs: Still Available in 2020 and Still a Good Strategy,” by Sarah Brenner, irahelp.com, April 20, 2020.
“How Charitable Giving Is Changing in 2020,” by Christine Benz, Morningstar.com, April 20, 2020.
"Morningstar’s Guide to Donor-Advised Funds," Morningstar.com, Nov. 20, 2018.
Modified adjusted gross income (MAGI) definition
Estate Planning
“Did the SECURE Act Kill the Stretch IRA?” by Ed Slott, AARP.com, Feb. 27, 2020.
“10 Things to Know about the SECURE Act’s 10-Year Rule,” by Sarah Brenner, IRAhelp.com, Feb. 26, 2020.
Step-up in Basis definition
Stretch IRA definition
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar, Inc.
Ptak: Before we get start our conversation, we wanted to share some exciting news. The Morningstar Investment Conference for investment professionals will be held virtually this year on September 16th and 17th. We're offering the same research, analysis, and insight you'd get at the live event for a reduced price of $149. And the best part is you can join us from wherever you are. For more information or to register, visit go.morningstar.com/mic. Again, that website is go.morningstar.com/mic.
Now, let's start our conversation. Our guest on the podcast today is retirement and tax expert Ed Slott. He is president and founder of Ed Slott and Company, which provides retirement and tax-planning education to investment advisors and financial institutions. Ed has written several books, including the recently published "Ed Slott's Retirement Decisions Guide: 2020 Edition,” and “Fund Your Future: A Tax-Smart Savings Plan in Your 20s and 30s.” PBS viewers may know Ed from his frequent appearances on public television. He also hosts the popular website irahelp.com, where The Slott Report blog regularly dispenses wisdom about retirement, tax, and estate planning. He provides a monthly Q&A column to AARP and is also a contributing columnist and media resource to Financial Planning, Financial Advisor, and InvestmentNews magazines. Ed is a Certified Public Accountant.
Ed, welcome to The Long View.
Ed Slott: Great to be here. Thanks.
Ptak: It's hard to start anywhere but with this pandemic. The federal government has already spent trillions of dollars to help stave off a depression. What do you think the repercussions of that will be for tax rates in the future?
Slott: Well, somebody's got to pay the bill at some point. I mean, we've written--with the CARES Act, we wrote a $2 trillion check on a bank account with no money in it. And probably by the time anybody's listening to this we'll have spent trillions more. So, it's just plain math, really. At some point, the bill is going to come due. And I think it's going to hit the people hardest with the most money that has not yet been taxed. In other words, tax-deferred savings, like your 401(k)s and IRAs. That's what tax-deferred means. Many people look at their 401(k) statements and say, “Oh, look the market’s up,” or their IRA statements not realizing a big chunk of that may be owed right back to IRS. But you don't know how much is owed back until you know the tax rates.
So, this has kind of always been the low-hanging fruit for Congress. Easy to tax, because they know that was the deal everybody made. They said we got a tax deduction upfront, and that was kind of like our deal with the devil, right? That we got the tax deduction upfront. But as with any deal, there's a day of reckoning and the day of reckoning is when you take that money out. But the problem now is the uncertainty of what future higher taxes could do to your standard of living and your purchasing power in retirement.
Benz: So, you've always been bullish on Roth IRAs and 401(k)s. Walk us through your thinking and particularly in light of what you envision will be a higher tax situation in the future.
Slott: Well, first, everybody has a different situation. We're giving general advice here, a 30,000-foot view. But some people may say, you know what, I really will be in a low bracket or maybe my beneficiaries will, and that's fine. But still, we don't know what the low bracket will be. The low bracket can be higher than today's low bracket, much higher than today's highest bracket. Remember, we're in the lowest tax rates we've seen in this country in our lifetime. I mean, you can be in the 24% bracket married, filing, joint up to $300,000 of taxable income. That's incredible. So, I've always been a big Roth fan, because it's all a tax rate arbitrage game, buying low and selling high like they say with stocks. It's the same thing with IRA distributions or 401(k) distributions. You want to get the deduction while rates are high to get more bang out of that. But when you pick it up as income, you want low rates. So, it's really buying the tax rate.
You know, there's a funny saying from years ago, the old comedian, I may be dating myself, but he was even well before me, so I'm not that old--Henny Youngman. He had a great saying. Now, he used it as a comedic line, but it's true. He said, “I'm putting all my money in taxes, the only thing sure to go up.” That's exactly how I feel. This is an investment in the tax rate. So, if you believe your rate will be higher or even the same or higher in the future, then I'm a big Roth fan. Roth IRA removes the uncertainty of what future higher rates can do to your retirement savings when you have to take them out.
The other big benefit of the Roth is no lifetime required minimum distributions. You never have to take that money out. It grows tax-free forever, including after you die, even under the new SECURE Act, even though there may be a 10-year payout for most of your non-spouse beneficiaries. Still, they'll pick it up income-tax-free because you paid the tax now at low rates. Now, some people say, but you're still paying money upfront that you could have had invested. I call that the opportunity--or the opportunity cost argument, or the time value of money. A lot of accountants ask me about this, and financial advisors and consumers. They say, “If I'm spending all this money to pay the tax on a Roth conversion, I could have invested that money. Isn't that lost? Isn't that a lost opportunity?” And the mathematical answer is no, not if the rates are the same and you use the same assumptions for investing earnings. You end up in exactly the same place. If you compare the investment return percentage and the tax rate, you end up in exactly the same place. So, the bet really is, if you want to call it a bet, is that you believe your tax rate will be the same or higher in retirement.
But here's the good thing. This is why I'm a big Roth fan. If you lose the bet, and everything I said is wrong, here's your worst downside: You have a 0% tax rate in retirement as a consolation prize. That's a pretty good result in anybody's game. You can't beat a 0% tax rate. So, that's your worst risk, really.
Benz: So, we have a lot of questions about specific strategies that someone could incorporate if they are thinking about going Roth. But before we get into that, I just want to follow up on a comment you made about required minimum distributions not being in place for Roth IRA assets. Do you think it will stay that way? I get that question a lot. I'd like your take.
Slott: Here's the question I get from consumers. I do a lot of consumer programs, actually, all virtually now and advisor programs. But consumers in particular, whenever I talk about Roth IRAs at a consumer program, I always get some version of the question you just asked but not as nice as you asked it. Usually, they say, “Can I trust the government to keep its word that Roth IRAs will always be tax-free?” And the answer is absolutely not. You cannot trust them. The accountants like me have a saying that's gone on forever, that tax laws are written in pencil. So, you have to act with the laws we have now.
Now, yes, if you get it in now, you lock in today's rates, and it will grow tax-free. And hopefully, if a law ever changes, and I don't think that part will change for conversions where you paid the tax already, otherwise, it'd be a double tax. So, I'm saying, get it while it's here. Take advantage of it while it's here. And I don't think that the government is going to do that, because that would dry up a huge source of their revenue. If you remember Christine, that maybe about a year or two ago there were proposals that some called “Roth-ification” because the government needed money, and now they need more money than ever. The government needed money and they were going to do away--there was a proposal; I think it was in the negotiations for the Tax Cuts and Jobs Act, the 2017 law--to do away with all 401(k) deductions and have everybody go Roth. Why did the government want that? Because with the Roth they get all their tax money upfront and they desperately need money.
So, what they did--the proposal said, let's have everybody go Roth. And if you look at the Roth IRA over time, even though the answer to the question, “Can you trust the government?” No, but you can always trust them to find new ways to bring in revenue and whenever they needed revenue, they went to the Roth. If you look at the history of the Roth IRA, remember back about 10 years ago, you couldn't even convert to a Roth if your income exceeded $100,000. Then in 2010, they removed that restriction and the floodgates opened up, and the Congress saw how much money came in from Roth converters. I was in that group. I took advantage of that two-year deal. And they've opened up the Roth over time to fill in revenue gaps, budget gaps. They look at the Roth IRA as a moneymaker. So it's highly unlikely they're going to kill the golden goose because it produces money. Remember, the only money that can get in a Roth IRA is already taxed money. You pay the tax upfront. So, I don't think they're going to kill that so fast.
Ptak: Maybe sticking with Roths, even if the math favors Roth contributions for young people just starting out, what about the psychological boost that young savers might get from seeing their balance grow faster because they're making pre-tax contributions? Is that or should that be a factor?
Slott: Well, the balance grows the same anyway. It's just a matter of what they pay tax on. For example, let's just back up a second. For young people, Roth is the way to go. There's just no question about that. They have--the greatest money-making asset any individual can possess is time, and that's what they have. And they have more years to capitalize on it. Imagine people listening to this now in their 50s or 60s or 70s thinking, wow, what a magical thing that would be if I could just snap my fingers and all my money in my retirement account, my 401(k), my IRA magically is tax-free. Well, young people can start out from dollar one building tax-free so they never have to worry about future higher rates. So, the same amount goes in. For example, whatever you put in your 401(k) or your IRA is going to be the same amount. It's just that you get a tax benefit upfront if you get a deduction, which you have to give back later. And remember, younger people are generally in the beginning of their working and earnings years, are in lower brackets. So, the deduction isn't worth as much. That's what I was talking about earlier. Deductions are worth more at higher rates. So, the deduction isn't worth as much. So what they're doing is they're getting the deduction at a lower rate and possibly paying it back at a higher rate. That's the opposite of what most people should be doing.
Benz: So, you referenced the lifting of the income limits on conversions, and that was the beginning of the backdoor Roth IRA. So, a question is, do you think that Congress at some point will just totally legitimize that and lift the income limits on Roth IRAs altogether?
Slott: I hope they do. There's no reason for it. Why are the rules different for IRAs and Roth IRAs? And going along with the same theme I've been talking about, when the government's looking for revenue, they'd rather have more people doing Roth because they get their money up front. Now, as an accountant, if I was the accountant for the government, I would say kill the whole Roth program. And the Congressmen would say, but look at all the money it's bringing in. And I would say to them, but look, that's only for this year and next year. If everybody in America did this, you'd have a bunch of Roth IRA millionaires, and you'd never be getting any tax revenue. They'd all be tax-free millionaires. And the Congressmen would say, but I don't care about that. I only care about this year and next year, because those are our budget cycles. So, they don't see things like that. So, you have to take advantage of that.
If I was the accountant for the government, I'd say Roth is costing you a fortune. Have people do deductible IRAs. Even though they get a deduction, you're building a receivable, “you” being the government, for future years. So, I think they probably--when they start looking for revenue sources, lifting the cap would be brilliant. First of all, you don't have all these shenanigans of this backdoor Roth, and then it's on the same scale as a traditional IRA. It would be a simpler system. And there's no reason for an income limit on the Roth, except some people--and this may be a political thing, I don't know--will say, well, that just favors wealthier people who can afford to put more away. But then you could make the same argument for the same people putting in, in a deductible IRA, which they're allowed to do, and getting a big deduction. So, I think that would be a welcome change. But I don't think it's at the top of anybody's list until Congress goes searching for revenue again.
Benz: So, it sounds like you would favor conversions or that people at least consider conversions. So, let's walk through the…
Slott: Well, I'll back up on that a little.
Benz: Okay.
Slott: Because, again, I'm giving general advice. Everybody's situation is different. And when I talk about conversion, I'm not talking about converting everything. Remember, many people miss this. It's not an all or nothing. I think probably in the middle somewhere is your best solution, is your best course of action, because it's probably best to do a series of annual smaller conversions over the years. So, over the years, you use up those low brackets, take advantage of those while they're here. They may not be here that long--you don't know what's coming in the future. But they're here now, using up the lower brackets each year and over time, taking down your IRA balance at low rates, and building up your Roth at the same time. And remember, the foundational principle, which is kind of a corollary to what I said before, is to always pay taxes at the lowest rates. That sounds simple, but most people miss that. Now are the lowest rates probably because I don't see them getting lower. I think everybody agrees on that. But I can see them getting higher.
And another thing you have to consider is, even if you're thinking about a Roth based on what you're hearing here and elsewhere, I wouldn't do a Roth conversion in 2020 until after, I'd say, Thanksgiving, towards the end of the year. You may recall that Roth conversions for the last couple of years are permanent. You cannot undo them. There's too much uncertainty right now. You don't know the economics, what your own situation might be. Once you convert, you're committed to the tax bill--and you don't really know what that tax bill is till you have a somewhat accurate projection. That won't happen, I'd say, till maybe the first week of December, when capital gains are thrown off, or maybe you have a bonus or an income increase at work or decrease, or maybe there's a situation where you had a business loss and can take advantage of Roth conversions at very low cost. As a matter of fact, we're seeing some of that. Some of the silver lining of people having tough situations with business is creating losses. If that's the case, that's when a Roth conversion should be done at almost no cost. So, I would look at that closer to the end of the year. What you should be doing now is starting the evaluation process to see if it's right for you, yes or no, and how much, and then somewhere, maybe first week of December, that may be the optimum time to do the conversion.
Benz: So, in the context of conversions, you often hear that those post-retirement years may also be a good time to consider a conversion, so pre- required minimum distributions, but after you've retired. Do you agree and if so, can you walk through why you think that is a really opportune time for people to take a look at converting?
Slott: Well, there's two areas there. When you say post-retirement, if you're talking about somebody who has an IRA, let's say, and now they're say over 72, the new age to begin required minimum distributions, those RMDs, I would be careful on converting at that point because the RMD itself cannot be converted. So, to convert, while you're subject to RMDs--which nobody is now for 2020, they're all waived. It's an optimum window right now of opportunity for everyone. Because there are no RMDs, so everything can be converted now. But once you're in retirement, to convert, you first have to take your RMD, pay tax on that, and then if you want to convert, you can convert part or all of the remaining balance. But it costs you more to convert because the first dollars out have to be the RMD and that can't be converted. But if you do that and you're in a very low bracket, then it could still pay.
The sweet spot for converting is really in your 60s probably, but you may still be working, too. So, it all comes down to tax rates. If you can convert in the years before you start your RMDs, that would be the optimum time because maybe rates are lower and you don't have to take the RMD. But there are other factors, too. Lots of people look at their Medicare IRMAA charges, those Income Related Monthly Adjustment Amounts that are based on income; a conversion can spike that. But for those people who constantly complain about that, by the way, when they convert that their Medicare surcharge went up, I always tell those people if that makes you angry that the conversion caused your Medicare surcharge to spike, increase, then convert anyway and they look at me, what? I say, well, I rather have you angry for one year than angry for the rest of your life because if you don't convert, at some point, you'll have required minimum distributions from your IRA and you'll be angry every year, because every year those things will increase your adjusted gross income, which increases Social Security, Medicare charges and a host of other tax benefits that can be phased out because of increased income.
Ptak: There have been a number of other changes affecting RMDs over the past two years. Most recently, the CARES Act put a pause on RMDs for 2020. The market has recovered a lot since then though. Do you think Congress was perhaps too hasty?
Slott: No. Well, in my personal opinion, and this is totally opinion, but I've been saying this for years, and now I'm sure of it, I don't think there's any need for RMDs anymore, lifetime required minimum distributions. Now that you have the SECURE Act, which kind of puts an end date on how long an IRA can last, basically 10 years after death with most non-spouse beneficiaries, why even annoy seniors with RMDs? To me, that's all RMDs are at this point, an annoyance. By the government's own numbers, they say 80% of the people take the RMDs for that RMD amount or more because they need the money. So, you're only talking about 20% of the people that might stockpile it and not take it. But there's no need for it anymore. The money is going to come out eventually anyway, and they may find they'll get the same revenue, “they” being Congress, because 80% of the people are going to continue taking money they need, but at least they don't have the annoyance of calculating, and RMDs, and what age, and what if I miss it, 50% penalty, and to make the calculations each year. It just seems like a total waste of time. So, I'm glad they waived RMDs for this year.
You may be right. They jumped the gun. But that's always the way. People were panicking. The market was in freefall. It's easy to look back now, in March and say, you know, it wasn't as bad. When you see your account in freefall, it's bad. Even if you know in your heart that it will probably come back, you never really know. So, it was probably a good move. But I would like to see them eliminate RMDs, lifetime RMDs for all seniors. They're going to find it's not going to have that much of a dent in the revenue the government gets. And even for people that may not take as much, the beneficiaries are still going to have to force all of that out, probably at higher rates in future years. So, I think that's one--along with what Christine was talking about eliminating the cap on Roth contributions, the income cap--I think they should eliminate RMDs just in the name of simplicity and making it easy for seniors.
Benz: So, you referenced a couple of times at the change of the starting age for RMDs going out to 72 from where it had been at 70.5. So, do you have thoughts on what was the impetus for that? Was it longer life expectancies? Or was it lobbying from Wall Street and financial advice community? What's your take on that?
Slott: I don't know what it was. But it wasn't enough. It was something. But with all my complaining about the tax laws, this single provision was the best provision I ever saw enacted, for only one reason: Finally, they got rid of that half year. And that's been around, as you know, for decades, and that's been the most confusing part. Remember, it affects seniors. They didn't know if they were 70 or 71. Your age could be different for your starting year. When's my birthday? Six months after 70. People, they hardly remembered their 70th birthday, let alone 70.5. And they really were totally confused every year when they had to start. Getting rid of that half year was one of the best things that happened in the SECURE Act. So, now we know it's age 72. But as I just said, I think they should cancel them or end RMDs anyway. I don't know what the impetus was. Maybe it was life expectancy. But two years, it didn't do much. They acted like they found the cure for cancer when they were patting themselves on the back with that, and I'm thinking, you know, other than that half-year simplicity, what did they really do? Push it out for about a year and a half? That's not that much. And not only that, in the RMDs in that year and a half would be the ones that would be the lowest because they were the younger age. So, it's a lot of nothing except for the getting rid of the half-year. 72 is still better than 70.5 though.
Benz: Let's talk about the qualified charitable distribution. You've mentioned and we've discussed that there's this pause on required minimum distributions for 2020. So, what is going on with this QCD in that context?
Slott: I love QCDs and everybody should love them too, qualified charitable distributions. The best way to give to charity, no questions asked. The only negative about QCDs is that they don't apply to everyone. They only apply to IRA owners and beneficiaries who are 70.5. Here we go, the half-year again, that did not go away. Even though they raised, the SECURE Act raised the RMD age to 72, the QCD age stayed at 70.5. So, you have this little gap now, and even a little more confusing now since you don't even have RMDs; they were all waived for 2020. So, the questions keep coming up, “Can I still do a QCD even though I don't have an RMD?” All these acronyms--it's like we're talking a different language. The answer is, yes, you absolutely can. And if you normally give to charity, this is the way to give if you qualify, because most people are not getting any tax benefit for the money they give to charity, because most people no longer itemize. They take the standard deduction, that much-larger standard deduction made even larger if you're 65 or over, and anybody that qualifies for a QCD is 65 or over because you have to be 70.5 to qualify. So, that's the way to do it, and the reason it's much better than a deduction.
In fact, in essence, you do get a deduction. Even though you can itemize, you get better than a deduction. A QCD is an exclusion from income, which is way better than a deduction. It excludes income at the source, so it lowers your AGI, your adjusted gross income. There's another acronym. Soon on this program, we'll only be talking acronyms. But it lowers your AGI. That's a key figure on the tax return that determines, for example, whether you're going to get hit with the 3.8% net investment income tax, or like I said, Social Security, Medicare charges, other tax benefits and credits and deductions, all based on AGI.
Now, just because it does not offset an RMD, because there are no RMDs this year, if you're giving to charity anyway, this is the way to do it because you're getting money out of an IRA at zero tax. And that goes back to my golden rule of taxation: Always pay taxes on the lowest rates, and start whittling down that IRA, which if it's not taken down now could be subject to heavier taxes later. This is the way to do it. IRA money is the best money to give to charity because it's pre-tax money. This is money that would have been taxed if it stayed in there. So, in effect, you are getting a deduction, but you're getting better than a deduction. And you can do that with up to $100,000 a year per person out of your IRA. Now, most people don't give that much. But I'm just making the point that’s how valuable it is. Whatever you give, if you can do it through your IRA, and remember, it has to be a direct transfer from your IRA to the charity. You can't take the money out in your hands personally and bring it to the charity. It has to be a direct transfer.
And a common question we get: What about donor-advised funds? They do not qualify. Supporting organizations do not qualify. Private foundations do not qualify. It has to be a direct transfer from your IRA to what we call a regular charity. The technical term is one of these 501(c)(3) charities, the ones that you would get a tax deduction if you were itemizing. So, it's a much better way to do it. And people should still be doing it, even though they're not subject to RMDs this year, or they're in the gap--let's say next year when RMDs come back, they still may not be subject to RMDs because they didn't hit 72 yet, but they're over 70.5. And for this particular rule, you actually have to be 70.5 years old. If you're 70.5 years old tomorrow, you can't do it today. It's not the year. It's the actual birthday. So, you have to be careful there. What does it mean if you don't qualify for a QCD? It means the only other option to get a tax benefit is if you're itemizing and itemizing, most people--I think the numbers are something near 90% of the people are taking a standard deduction, so they're not getting any benefit of their charitable gifts.
Benz: So, I wanted to follow up on that, because it does seem like charities have felt a little bit of pain through this period, in part because there are fewer incentives for many taxpayers to give charitably. So, what are the strategies? The CARES Act, I know, had that small allowable above-the-line deduction, but is a donor-advised fund the main thing that people in that situation who aren't of RMD age should be considering?
Slott: If you have an IRA, that's the way to do it. You can do, like I said, up to $100,000. That should be enough for most people. Yes, you can do that. Plus the $300, which is I agree, it's small, but for a married couple, it's $600. And that's only for cash gifts. And again, that comes right off the top, an exclusion from income just like the QCD. Now, if you have much larger gifts, one of the things you might want to do if you're over the $100,000 is gifting appreciated stock, but I'd rather get the IRA money out because under today's rules, you're getting it out of the pre-tax money. And that means the more of your IRA that you give to charity--again, I'm not saying give more to charity for tax benefits--if you're giving anyway, if you're already charitably inclined, this is the way to do it. But if you're maxing out on that, that would be the first step, to max out whatever your giving level is through your IRA.
There are other ways to give large amounts to charity, like you can give appreciated stock, but I'm not a big fan of that if you already have an IRA. If you don't have an IRA, then yes, that might help. But the more you give of your IRA, then the less of that IRA will go to beneficiaries, and they may get more of other, better money, better property, property that gets a step-up in basis. So, like a stock portfolio, for example, your beneficiaries are way better off getting appreciated property because at death at least under today's law, they get a step-up in basis and all the gain is eliminated. Now you can do that by giving appreciated stocks to charity, if that's what you want to do, and that eliminates the gain, too. But what I'm saying is, at death, that gain will be eliminated anyway. So, there's no nice way to say it: People over 70.5 are closer to their life expectancy. And maybe if they hold on to that highly appreciated stock, if the step-up in basis holds, which I think it will--they're talking about, all the politicians who knows what's going to be--if it holds, that capital gain will be eliminated automatically anyway. So, you would want your beneficiaries to get that. It's a much better asset to inherit than an IRA. If you use the QCD, they'll get more of the better assets and less of the taxable IRAs.
Ptak: Maybe focusing on estate planning, one of the most notable aspects of the SECURE Act was the elimination of the stretch IRA. So, let's start by discussing what the stretch IRA was. Can you explain that?
Slott: Yes. It's funny you mentioned that, Jeff, because for years, not so much anymore but when it first came out, I would talk to clients about it and I would get this call. They'd say, “I'm at the bank. I asked them for a stretch IRA. They don't have them. I don't know what you're talking about Ed. They don't have them.” I said, it's not a product--it's a process. And what it was is the ability, which became known as the “stretch IRA,” the ability to name a beneficiary, say, a younger person, a child or a grandchild, and they could extend required minimum distributions over their life expectancy, over 70, even 80 years in some cases with a one- or two-year-old grandchild. And by doing that, the account would grow tax-deferred over that time and the RMDs, the minimum amounts would be really just crumbs, maybe 1% or 2% has to come out and be taxed. So it would significantly decrease the tax bill and it could stretch or extend out over many, many years.
That all went away starting in 2020, because Congress believed--you know, it's funny because Congress on the one hand says “Save, save for retirement, people are not saving enough.” And then people saved too much. So now Congress says, “Well, now you saved too much,” and Congress felt for years that the IRA or retirement accounts were for your retirement only, not as an estate-planning vehicle to pass on to your family, because they didn't earn it, you did. It’s for your retirement, not theirs. So, they put the brakes, they eliminated the stretch IRA for most beneficiaries, not all but most non-spouse beneficiaries, who will now be stuck with a 10-year rule, which is not the worst thing in the world.
The actual 10-year rule is not a bad deal because they've scrapped this whole RMD thing where you have to look up the RMD every year. There are no RMDs for most non-spouse beneficiaries, your children, grandchildren, anybody but your spouse. What happens is that there's an end date, as I said before, at the end of the 10th year after death, everything has to come out of that IRA and be taxed. Same thing with a Roth IRA, too, except it won't be taxed at that point because it will be tax-free. But even the Roth, the inherited Roth has to come out by the end of the 10th year after death. But there are no RMDs during that 10-year period. So, it gives beneficiaries tremendous flexibility. Maybe they have a low year in year two and they take more out, or then they don't take out any till year seven, or with a Roth IRA, it pays for them to hold it till that last day of the 10th year, accumulating all those earnings for 10 years. So, the 10-year rule is not a bad deal. But some people are exempt and still get the stretch, but not many. And that's where there's some confusion.
Generally, the spouse is the one that benefits. The spouse is exempt. The spouse is unchanged in the SECURE Act. In other words, whatever benefits--and the spouse had many, they could roll over, stay as a beneficiary--all those remain. The spouse is unaffected until obviously that second spouse dies, then it goes to a beneficiary and probably be the 10-year rule. And then, there's a few other exceptions, but it's not most people. There's one exception that people are misunderstanding. There's an exception if you leave an IRA to your to your minor child, and many people think that means grandchildren--it does not. It would have to be your minor child. A minor child is somebody that hasn't reached the majority, which is age 18 in most states, or under the SECURE Act, you could go up to age 26 if the child is still in school. That person, that minor child still gets the stretch IRA, but only until they reach the majority. But the reason people think it applies to their grandchildren like before, is because they only saw a minor child, but it has to be your minor child.
If the average IRA owner, say, dies at 80, what is the likelihood they're going to have a 12-year-old child? Unlikely, unless maybe a Tony Randall, or I think even Billy Joel--he just--I think he turned 72 this year, has to start RMDs soon, and I think he has teenage or very young children. But other than those sensational examples, that's not most people. The only people that will qualify for that are minor children. Let's say, a young IRA owner dies at age 40 and has a minor child, then they could stretch it. But at 40, you're probably not going to have that much to stretch anyway. So, the bottom line is, the spouses are okay. But most other non-spouse beneficiary, including most trusts--and many people leave their large IRA to trusts--will have to pay out and the money will have to be taxed unless it's a Roth. There's another benefit for the Roth, to pay the tax that beneficiaries would have had to pay. That money will have to be taken out of the inherited IRA and taxed if it's not a Roth by the end of the 10th year after death. So that was the big change. Congress wanted people to only use IRAs for retirement and put an end date for everyone else, for beneficiaries. And they did.
Benz: So, just to follow up on that, this really only applies to a pretty rarefied subset, right? This is partly why Congress decided to do away with this because most people do not stretch out or did not stretch out under the old tax laws?
Slott: Well, no, the subset is people with the largest IRAs. People can say, those are the one-percenters and maybe they're right. The reason it only affects the largest IRAs, because if you have a million or more in an IRA, or 2 million or 3 million and there's people out there, this is who it affects, because there's a good chance there will be more of that IRA balance, that large IRA balance, passing to the next generation. So, that's who it affects. Smaller IRAs are going to be consumed pretty much during a person's lifetime, especially given today's life expectancy. So, not as much will be left to beneficiaries. It's kind of funny, because everybody's talking about, “Oh, the stretch IRA is gone,” you know, “The kids can't go out 30, 40 years.” I can't even count on my fingers--and I've been doing this a long time--clients that have actually, you know, where their kids or grandkids have actually used the stretch, and didn't decimate that account pretty much on the way to the funeral, before the body was cold.
So, most people, it sounded good in theory, and that's the way I taught it, and you and I talked about it for years, and everybody talks about it. But I don't think most beneficiaries stretch, especially ones that need the money. They're in their 20s and 30s. They have family. They have student loans and mortgages and everything. So, most of them took that money down. Actually, for most of those people, the 10-year rule is a much better deal. They probably won't even last the 10 years, but at least they have flexibility to take down whatever they want in those best years of the 10 years. But you're right. I don't think most people stretched anyway. So, while we made a big commotion about all of this, it was really just for the largest IRAs that would have the most financial impact. But the average beneficiary, I didn't really see stretching all that long. They might have started out on a roll, but a year or two in, they had something came up and they needed the money. It's hard not to touch money as a young beneficiary.
Ptak: We've been talking primarily about federal tax issues with respect to retirement savings, but what about state taxes? Given the state of municipal finances, they're probably going to be going higher in the future, too. So, how should people think about that in relation to their retirement and estate plans?
Slott: Well, state taxes obviously are special to the person's own state, but there's no question the states like mine and New York, every state that has a state tax, they're going to find new ways to tax money because they're desperate for revenue. But I have to say, even high tax states like New York are very favorable to retirees. Most people say, oh, it's such a high tax state. But in New York, the first $20,000 a year of your IRA if you're over 59.5 is not taxable, your Social Security is not taxable, state pensions are totally exempt. So, if you're a retiree that has maybe a state pension or something, and Social Security and some IRAs, you pay almost no tax in New York anyway. And lots of states have special provisions to exempt retirement income. So, you should look at that first. Don't just look at the state tax rates. Look at how they tax the income you'll have, and if a lion's share of that is retirement income, you may be pleasantly surprised how little of that--and plus the Social Security, many states don't tax that like the federal does--you may be surprised that you have almost no state income tax, even though you have a big federal tax. That's the case for a lot of retirees in New York and other states that are seen to be high tax states. It's the kind of income you have.
Benz: I want to ask a really general question to close, Ed, which is, why this all has to be so darn complicated. And you've given some great ideas about simplifying, notably, eliminating required minimum distributions. But what other ideas do you have, sort of, big picture for simplifying all of this for retirees?
Slott: Well, first thing is the things I talked about. Can you imagine how simple it would be if there were just the two things we talked about: getting rid of the caps on Roth IRAs and getting rid of lifetime RMDs, knowing there's the 10-year rule. That would make it so simple. But the other thing they should do is be more consistent. There are too many different types of retirement accounts. On the IRA side, you have IRAs, and then SEPs, and SIMPLEs. And some people still have these old Keogh plans, believe it or not. You may have heard of those back in the day. And then, on the 401(k) side, there's 401(k)s, there's 457(b)s, and then the other 457s, and then there's 403(b)s. It's too many types of retirement accounts, each with their own distinct set of rules, which makes it very complicated, their own distinct set of rollover provisions. It's not so easy. They did change a lot of that years back and made them more portable from one account to another. But really, you need more simplicity on all the types of retirement accounts.
I don't know if it's possible, but really, it should be like one type of retirement account, where the rules are the same whether your IRA, maybe expand the limits of the IRA to the same as the 401(k) limits. But then everybody would scream, well, then wealthy people can put more money away, but so can anybody. So, I think that would be--I don't know how that could be done. But I think that's something that has to be done. There's just too many different kinds of plans out there, each with their own rules, each with their own paydown provisions.
For example, the 10% penalty exception. Do you know that there's three different types of exceptions for people who want to take money early out of their IRA or plan? There's exceptions that apply to both if you take money out of whether it's a plan or an IRA, like death/disability/medical expenses. But there's also exceptions for people who take from their IRAs. There's exceptions for distributions only from IRAs, like for education and first-time homebuyer and people get confused. Many times they take out of their 401(k) for education thinking it's exempt from the 10% penalty and they end up with a 10% penalty because they didn't know to roll it over to an IRA first, where there wouldn't have been a penalty. And then, there are penalty exceptions just for 401(k) plans. There's just too much--the rules are just too different depending on the kind of plan you have. And I think they should make it easier and more consistent, especially that 10% penalty. A lot of people get tripped up because they take from the wrong account.
Even the ages are different. For example, you get a 10% penalty for withdrawing early from an IRA. But if you're in a plan, it's age 55. If you're separated from service in the year you turned 55 or older, there's no 10% penalty. And on a 457(b) plan, there's no 10% penalty at all, or if you're divorced and you have one of these qualified domestic relations orders, that's only from a plan. There's no 10% penalty. But let's say the spouse rolls it over to his or her own IRA and takes, then there is a 10% penalty. So, it just seems like there's so much going out in unnecessary taxes and penalties due to the confusion on all of these different type of accounts with their own rules, all retirement accounts, but all with different rules, too much.
Ptak: Well, amid all that complexity that you described, we're very thankful that we have an opportunity to tap your knowledge and expertise. Thank you so much for the illuminating insights that you shared with us today. We really appreciate it.
Slott: Well, me too, and I hope one day we look back at this and some Congressman says, “You know, I heard on that Morningstar about getting rid of lifetime RMDs. That's a good idea.”
Benz: That would be great. Ed, we always appreciate your perspective. Thank you so much for taking the time.
Slott: Okay, thanks.
Ptak: Thanks again.
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Benz: You can follow us on Twitter @Christine_Benz.
Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.
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