Never Simple

Adam M. Grossman

WHEN ROSS PEROT RAN for president in 1992, a pillar of his campaign was tax reform. Federal tax rules, he pointed out, had grown to more than 80,000 pages. His proposal: Start over and replace everything with a simple flat tax.

Perot’s campaign for tax reform didn’t make much progress, but many can sympathize with his frustration. Because of the complexity of tax rules, financial planning often ends up feeling like the children’s game Operation—with penalties for even the slightest misstep and confusion around every corner.

I recall, for example, speaking with a fellow who was approaching his 70th birthday. He noted that his plan was to defer Social Security to increase his monthly benefit. That made sense. But then he mentioned in passing that this would entail waiting two more years, until age 72.

I was glad he mentioned this, because Social Security benefits hit their maximum at age 70, not 72. If he’d waited until 72, he would have unnecessarily surrendered most of the two years of benefits he could have received. It’s a common point of confusion. Age 72 represents another financial milestone: when we’re required to begin taking distributions from tax-deferred accounts, such as 401(k)s and IRAs. Retirees live in fear of this particular deadline because the penalty for missing a required minimum distribution (RMD) is unusually harsh: a full 50% of what should have been distributed.

The RMD and the Social Security deadlines used to be much closer together. Until 2018, the deadline to begin RMDs was age 70½. While that was an odd deadline, at least it coincided more closely with the Social Security deadline.

In the world of personal finance, there are many similar pitfalls. Below are six that, in my view, are most important from a planning perspective.

1. The “still working” exception. As noted, the new RMD deadline is age 72. But there’s an exception: If you’re still working and a participant in your employer’s retirement plan, you can typically delay RMDs until you retire. But there’s an important wrinkle: This exception applies only to your current employer’s plan. If you have an IRA or a 401(k) from an old job, the exception doesn’t apply to those accounts. You could roll over the assets in those old plans into your current plan to bring them under the umbrella of the exception. But if they remain separate, then the usual age-72 deadline applies.

2. Qualified charitable distributions (QCDs). This is a popular strategy to tamp down the tax impact of required minimum distributions. Gifts to charity that are made directly from a tax-deferred account help satisfy your RMD while also sidestepping income tax on the sum donated. But for whatever reason, when Congress changed the RMD rule in 2017, it didn’t change the rule applying to QCDs. Under the new rules, RMDs aren’t required until age 72, but QCDs are still permitted after 70½. If you’re looking to reduce the size of your IRA before RMDs kick in, this provides an additional window. Keep in mind that QCDs are limited to $100,000 per year.

3. Tax rates. Search online, and it’s easy to find tables clearly mapping out the tax brackets. The problem, though, is that these brackets apply only to your “ordinary income.” This includes W-2 and self-employment income. It also includes interest earned from bonds and bank accounts. Short-term capital gains and some dividends are also taxed at the same rate as ordinary income.

A different, and usually more favorable, set of rates applies to long-term capital gains and to qualified dividends—dividends from stocks that had been held for at least 60 days. Capital gains rates are either 0%, 15% or 20%. But in addition, a 3.8% surtax applies to married couples with adjusted gross income (AGI) above $250,000 and single filers with incomes over $200,000. Result? Depending on your total income, capital gains might be taxed at the federal level at anywhere from 0% to 23.8%.

A final point on capital gains: Keep in mind that some states have special tax rates for short-term capital gains. Massachusetts, for example, taxes short-term gains at a punitive 12%, while long-term gains under current rules are taxed at just 5%.

4. The backdoor Roth IRA. This is a tax strategy favored by those with incomes too high to contribute directly to Roth IRAs. It consists of two steps. First, an investor contributes to a traditional IRA. Then, he or she completes a Roth conversion to move those dollars into a Roth IRA.

It’s not too difficult, but there’s a wrinkle to be aware of: If you have any other tax-deferred IRAs, you’ll want to be careful about completing that second step. Because of something called the “aggregation rule,” this second step can end up being taxable—something you want to avoid. This isn’t a problem if you have other tax-deferred accounts, such as a 401(k), and indeed that presents a potential solution. In a lot of cases, IRAs can be rolled over into 401(k)s, but this needs to be completed before the end of the year if you’re planning to complete a backdoor Roth contribution.

5. The once-per-year rollover rule.  If you’re completing a rollover from an IRA to a 401(k)—either because you’re getting ready for a backdoor Roth contribution or simply because you’ve changed jobs—​keep in mind that there are two ways to complete a rollover, and one of them carries risk.

The first is called a direct transfer. That’s when your old employer’s plan makes a check payable directly to your new plan. That’s the method I recommend. The second is riskier. When you leave your old plan, the provider might make a check payable to you, rather than to your new plan. You can then deposit this check in your bank before writing a check to deposit the funds into your new plan. This is risky in two ways. First, this process must be completed within 60 days. Otherwise, it will be treated like a liquidation of your old account, making the balance fully taxable—a disastrous result.

The second risk: Even if you successfully complete a distribution within 60 days, the IRS limits rollovers like this to just one in any 12-month period. If you’re trying to consolidate old 401(k)s—a worthy goal—it’s important to tread carefully. It would be easy to inadvertently run afoul of this limitation.

The safest route: Always opt for a direct rollover or transfer, sometimes referred to as “trustee to trustee.”

6. Deductions for charitable gifts. Suppose you make a gift to charity. Can you claim a tax deduction? Assuming you itemize your deductions, the simple answer is yes. But at least four different limits apply—depending on both the type of charity you’re donating to and the type of asset you’re donating.

The first distinction is based on the type of charity. Two types of organizations are eligible for deductions. The first includes the most common types of nonprofits, including schools and religious institutions. It also includes donor-advised funds. The second, smaller group includes veterans’ groups, fraternal organizations and a handful of other types of charities.

Gifts of cash to the first type of organization are currently limited to 60% of a taxpayer’s adjusted gross income, while gifts of cash to the second type of organization are limited to 30% of AGI. In 2026, these rules will change, but for now these are the limits.

Gifts of appreciated securities—for example, a stock that has gained in value—are subject to different limits. For the first type of charity, it’s 30% of AGI and, for the second, it’s 20%. For both types of organizations, it’s important to note that the appreciated security must have been held for more than one year to receive a deduction for the current market value of the asset, which is what you’d want. If the asset has been held for less than one year, only the cost basis of that asset can be taken as a deduction, thus defeating the purpose of donating an appreciated asset.

In all cases, if one of these AGI caps limits a deduction, the unused portion of the gift can be carried forward and deducted in a future year—but you only have five years to take advantage of the unused sum.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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