Opportunity Calls: Fill Up The Valley

On his way to winning ten National Collegiate Athletic Association (NCAA) national basketball championships in a 12-year period, John Wooden, was renowned for his short, simple inspirational messages to his players, many of which were directed at how to be a success in life as well as in basketball.

Coach Wooden was referring to the ups and downs of life when he said,

“All of life is peaks and valleys. Don’t let the peaks get too high and the valleys too low.” ~ John Wooden

We take it as a lesson on managing your lifetime tax bill through tax arbitrage, bracket management, and income smoothing.

Just like life, all of financial planning is peaks and valleys. Tax savings are significant when you don't allow the peaks to get too high or the valleys to get too low.

In this article we focus on how to recognize and capture the opportunity in the valleys.

The Opportunity in the Valleys

The basic idea is simple – the “opportunity in the valley” represents a relatively low-income tax year; a chance to pay less in taxes over a lifetime.

Here is what the valley might look like, with income on the left, age along the bottom, and different tax brackets arcing across as different horizontal lines:

Fill Up The Valley

Here’s what it looks like to capture that opportunity strategically and intentionally – to fill up the lower tax brackets in the Valley of Opportunity.

Once a valley is recognized, the opportunity can be captured by creating additional taxable income. This “fill” of taxable income targets the top of a favorable tax bracket, usually at the push of a button. Proactive action makes the most of lower tax brackets, saving the same dollars of income from being realized at a higher future tax rate.

Different Valleys, Same Opportunity

Looking out over a five to fifteen-year horizon, there almost always exists a valley of opportunity that can be filled with proactive bracket management and intentional income-smoothing strategies.

Tax savings are significant by seeking first to maintain tax deferral, then second, to avoid higher tax brackets and other “tax torpedoes”, like Medicare IRMAA and Net Investment Income Tax, at which your effective tax rate increases.

Devise your best, personalized approach to harvesting/accelerating income versus avoiding/deferring income.

All else being equal, the longer taxes can be deferred, the smaller the relative tax bill (in terms of present value, a dollar today is worth more than the same dollar tomorrow). But, life never leaves things equal, nor unchanged. Birth, death, new job, job loss, market downturns, higher taxes, even events linked to certain ages (age 62 for early/penalized Social Security, or age 72 for required distributions) – no matter the change – all of those events represent a similar valley of opportunity from an income tax planning perspective.

Our three favorite tax planning valleys include:

The Golden Ages (Ages 60-70)

The decade around ages 60-70 represents a golden opportunity for tax planning.

Ages 60-70 tend to be the years approaching full retirement, when earnings from work trend down, but before the same tax bracket valley is filled back up with mandatory income and benefits like Social Security and required distributions.

Consider your opportunity to fill up the valley when:

Approaching retirement, but before claiming your Social Security benefit (before ages 62-70)
Approaching retirement, but before claiming a Medicare benefit (ages 63-65+) or if still working with non-Medicare insurance as primary
Approaching retirement, but before receiving Required Minimum Distributions (ages 70-73+)

In recent years, required distributions and Social Security benefits have been delayed, sometimes by choice, other times by law. While this is relatively meaningless for many Americans who will access funds for living expenses regardless of the mandated age, for those that can afford to wait, a delayed distribution can create a potential issue.

Without proper bracket management around these valleys, future taxable income will spike, and the tax bill only grows thereafter.

The Bliss of Marital Brackets

A strong marriage takes work; the favorable tax brackets are free and represent a second opportunity for good planning.

Federal income tax brackets are more favorable for married couples filing joint returns than for single individuals. This benefit works in reverse for those facing a return to unfavorable unmarried brackets – perhaps through death or divorce – sometimes referred to as the “widow’s penalty”.

Consider that Social Security benefits are often continued to a spouse, as are mandated retirement account distributions – but those same income streams are now taxed at less favorable single/unmarried brackets. For instance, the illustration below shows a taxable income of $250,000 that was previously taxed in the 24% married bracket (“MFJ” for married filing jointly) and is now taxed in the 35% bracket (“Single”).

Consider your opportunity to fill up the valley:

To use your full married bracket at a lower rate as a married couple, even if distributing unneeded income to be reinvested.

Without proper bracket management each year and over time, the bliss of marital tax brackets devolves into the shock of single brackets, with the same dollar distributions but with less left over and a higher lifetime tax bill for the surviving spouse.

A Valley of Opportunity for the Next Three Years (2023, 2024, & 2025)

By law, tax rates are scheduled to increase in 2026.

Rates are set to increase by 3-4% nominally, equal to 13-25% proportionally.

A temporary valley therefore exists for most people – married filers with taxable incomes between $20,000 and $360,000, or, single filers with incomes between $10,000 and $180,000.

Consider your opportunity in the valley to make the most of your income brackets in 2023, 2024, & 2025.

Opportunity for Younger Tax Payers

For younger earners, this lower set of rates could be thought of as similar to the years before your earnings increase as your career progresses.

Opportunity for All Other Tax Payers

For others, this lower set of rates could be thought of as similar to a sabbatical or a “gap year” (intentional or otherwise due to life events including poor health, a new addition to the family, travel, caring for a loved one, etc.).

A Valley Since the Early 1990s?

Regardless of tomorrow's tax rates, today’s tax rates might be considered relatively low when compared to history.

The chart below illustrates the history of the top (marginal) U.S. tax rates beginning in 1913. The top income tax rate is illustrated in blue and the top capital gain rate is illustrated in orange.

Income tax rates peaked at 94% from 1940 to 1960, before decreasing to 70% in the 1960s and 1970s, 50% in the 1980s, then settling at around 40% in the early 1990s. Marginal income and capital gain tax rates have changed relatively little since the early 1990s.

Have we been in a valley since the early 1990s?

Where will tax rates go from here?

How to Fill the Valley

One easy way to pre-pay your tax bill and fill the Valley of Opportunity is through a Roth conversion.

Are you aware of the income taxes embedded in your traditional retirement accounts (401(k)s and IRAs)? Your name might be on the account, but the government owns a slice. These taxes exist as a silent liability. You (or your beneficiaries) will someday pay this tax bill. Your death does not eliminate the government's claim on your retirement savings. You or your beneficiary will pay this bill someday (unless you give the money directly to a qualified charity).

We've gotten pretty good at planning lifetime tax bills. Ask us to show you today. Call us now or schedule some time with us at www.openwindowFS.com/connection.

Roth Conversions Remove Uncertainty

When done right, a Roth conversion is a strategic choice to “fill up the valley” by pre-paying an inevitable tax bill today.

A Roth conversion removes future tax uncertainty by paying a known tax rate today, versus leaving an unknown rate for tomorrow.

When your inevitable tax bill comes due what will tax rates look like?

Where do you think tax rates be 5 years from now? How about in 50 years?

Even for those in today's top tax bracket, tomorrow's top tax bracket may be higher still.

Roth Conversions Create Flexibility

After meeting a few timing rules, all distributions from a Roth are tax-free. This can give you the flexibility to access funds whenever you need them without worrying about the tax consequences.

Roth Conversions Create Balance

If you’ve mastered the habit of saving a portion of your income, you might eventually notice that some accounts are easier to build than others. Many good savers find it is “easier” to save into a pre-tax account, like a traditional IRA or 401(k). Saving tends to occur automatically and comes right out of your paycheck, plus you get a deduction for contributions. This might be why many taxpayers are out of balance, overweight in pre-tax assets with relatively less in after-tax accounts.

Not all savings are created equal, as we explore in our Insight Article: Gold, Silver, & Bronze Medals of Tax Planning. Those overweight in traditional pre-tax IRA or 401(k) assets are also overweight future tax rates. The largest threat in their financial plan is the risk of future rates increasing and their savings decreasing at the stroke of a pen in Washington DC.

As tax planner Steven Jarvis says,

...holding an IRA [or 401k] is like having a variable-rate mortgage with the IRS where they have the ability to change the interest rate to whatever they’d like, whenever they’d like. An opportunity to take the IRS out of the picture by converting IRA dollars to Roth dollars is always worth considering. ~ Steven Jarvis, CPA

How do your savings stack up with the example below?

ASK US TO SHOW YOU WHERE YOU STAND.

Roth Conversions Avoid Beneficiary Bombs

Your IRA or 401(k) may have taken your entire life to build, but thanks to the 2022-SECURE Act, your entire account must be emptied within 10 years of your death.

While your spouse can absorb your IRA or 401(k) as their own, almost everyone else will face a 10-year clock. You received a tax deduction during life. Now your beneficiary foots the bill. Since each dollar distributed is taxed like income, this 10-year timeline creates a potential tax bomb for your beneficiary.

Consider a $1,000,000 account inherited by a beneficiary that wants to distribute the account equally over the 10 years so as to lessen the tax bite. The account will distribute at least $100,000 of taxable income each year, perhaps more with growth. $100,000 of income yearly makes it up into the 24% marginal bracket. For this beneficiary, the tax-aware timing of distributions will be key to keeping more after-tax money.

A Roth conversion can therefore be seen is a gift to your heirs – still subject to the 10-year SECURE Act rules but distributed tax-free, at 0%. Not only do you pay the taxes for them (gift #1), you remove the complexity of timing tax-aware distributions (gift #2).

Roth Conversions – Before Beneficiaries Can’t

Once inherited, IRA or 401(k) funds can no longer be converted to Roth. If a conversion is to be done, it must be done during the original owner’s life. Consider converting for them before they can’t (gift #3).

Roth Conversions Create Undisturbed Growth Potential

Roths don’t require minimum distributions at any age. For those that don’t need the income for support, the balance can grow tax-free for as long as possible.

Roth Conversions For Generational Wealth

As another benefit for beneficiaries that don’t need distributions, a Roth could be viewed more as a wealth transfer tool than as a personal retirement income vehicle.

Estate limits are set to fall by ~50% in 2026 to around $6,000,000 per person. Above this limit, a 40% tax is applied. Families threatened by lowered estate limits can consider Roth conversions as a way to decrease their overall taxable estate, thereby lowering (or in an extreme case, eliminating) the effect of estate tax rates.

Personalized Opportunities For Roth Conversions

In addition to a tool to fill up lower tax brackets in the Valley of Opportunity, there are many other factors that might favor a Roth conversion:

Experiencing a market downturn, or a downturn in one asset class
Those with offsetting charitable deduction carry-forwards
Those with offsetting investment tax credits
Those with offsetting net operating losses
The existence of high basis nondeductible balances in an IRA or after-tax 401(k)

Downsides of a Roth Conversion

Even if a Roth conversion makes sense, consider the downsides before proceeding:

Tax Bill - You're choosing to pay a tax bill today that won't be due until tomorrow. Tax rates may change, but not in your favor. Further, do you have the cash flow to pay an additional bill? Conversion tax bills will ideally be paid using funds outside of the IRA or 401(k), especially for those under age 59.5. In effect, choosing to pay the tax bill using outside funds packs more dollars, and more value, into the Roth. To submit a one-time electronic tax payment, go to www.irs.gov/etpay (and ask us to share additional instructions).

Medicare IRMAA - For those enrolled in Medicare, a Roth conversion may lead to higher Medicare premiums through IRMAA. This may increase the cost of a Roth conversion by one or a few percentage points temporarily. IRMAA is revised each year, looking forward two years. That is, a Roth conversion in 2023 will affect Medicare IRMAA in 2025. All other years are unaffected. Consider reading more about IRMAA here. Just don't let IRMAA appear by surprise!

Safe Harbor/Quarteries - Next year, in the year after the Roth conversion, don't be surprised if your tax preparer asks you to start paying "quarterlies". The IRS expects you'll have a similar income each year, and they see your Roth conversion income as no different than any other earned income. They expect that same income to repeat again next year, regardless of your plans, and they want their cut in a timely manner by requesting that you increase your "safe harbor" contribution through quarterly tax payments. There are often ways around this requirement, just don't let it catch you by surprise.

We Can Help You Fill Up The Valley

Tax savings can be significant by targeting the Valley of Opportunity that appears during lower-income tax years.

It makes sense to pay an inevitable tax bill at a relatively lower percentage rate when the bill is lower. You have an opportunity to do so each time you enter a valley. Bracket management and income smoothing over a five to fifteen-year horizon maintains tax deferral while avoiding higher tax brackets and thresholds at which your effective tax rate increases, including “tax torpedoes” like Medicare IRMAA and Net Investment Income Tax, all by strategically and intentionally filling up lower tax brackets whenever life presents a valley of opportunity.

To do so, you’ll need to look ahead.

Instead of reflecting on your tax bill each year after it comes due, plan your bill in advance and over many years and decades.

Life tends to present these valleys as predictable opportunities, occurring at certain times and even at specific ages.

Make sure you’re prepared to act by “filling up the valley” to avoid leaving your future self, or your beneficiaries, with higher effective tax rates.

Have questions? Want to talk this through? That’s what we’re here for!

Call (775) 827-0670 or schedule some time with us at www.openwindowFS.com/connection.