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EXPERTS OFTEN ARGUE that tax-avoidance strategies shouldn’t drive our financial plans, especially as Congress is forever fiddling with the tax rules. And yet many of us end up making decisions based on federal tax policy, which is loaded with incentives designed to change behavior and advance social goals.
That’s certainly true for my wife and me. Despite the tax code’s many provisions—and its 75,000 pages of complexity—four big-picture tax considerations have largely shaped how our financial lives have turned out, and perhaps that’s true for you, too.
Homeownership. Tax policy has long encouraged homeownership through the deductions for mortgage interest and property taxes. Before the standard deduction doubled in 2018, some 30% of taxpayers claimed these two deductions.
Homeownership was such a strong pull for my wife and me that we bought our first house in 1979, when we were both age 23, just 10 months after we married. We finagled our finances so we could amass (just barely) the house down payment and meet the monthly mortgage payment.
Subsequently, we bought homes in 1991 and 2022, both of which we still own. Each was a colossal stretch, leaving us cash-strapped for a time. In past decades, buying “the most house you can afford” was common advice to capture both big-dollar tax deductions and the potentially outsized gains from leveraged home-price appreciation.
The 2017 tax law trimmed the use of home-related tax deductions. Today, just 11% of taxpayers take the mortgage interest and property tax deductions. That’s why most financial pundits now recommend against stretching to buy housing. This could change, though, should the 2017 tax law be allowed to sunset as scheduled in 2026 and the standard deduction revert to its earlier, lower levels.
While we now forgo the twin housing tax deductions, we have no plans to change our overweighted real estate holdings, particularly since the latest house purchase is near our children—life’s best tax deduction.
Contributions to 401(k)s. Income saved in our 401(k) plans—along with the subsequent growth of those dollars—are tax-deferred until withdrawn. This led us to accumulate nearly 90% of our financial assets inside tax-deferred accounts by the time we retired. Our lopsided allocation arose because we contributed the maximum to our 401(k) plans each year, while maintaining a 100% stock allocation and never trading in these accounts.
Our retirement savings blossomed, but our finances lacked tax diversification. All this money will be taxed as ordinary income upon withdrawal, not at the lower capital-gains tax rate. The upshot: We have a large pending tax obligation that’ll be paid as we tap these accounts. We’re also handcuffed to the ever-changing rules on required minimum distributions and withdrawals from inherited IRAs.
Unfortunately, our required minimum distributions will be taxed at higher rates than we would have paid when we deferred taxes on contributions during our early working years. We naïvely followed the conventional wisdom that “your tax bracket will be lower in retirement.” We and our advisors never contemplated the potential for tax bracket creep in retirement, the result of decades of inflation and investment appreciation.
Young workers in their lowest tax-rate years are now advised to favor Roth contributions over traditional tax-deductible retirement accounts. Roth and health savings accounts can slow tax-bracket creep for those likely to have higher retirement incomes as a result of career growth, stock appreciation, business income or an inheritance.
Retirees also shouldn’t lose sight of the possibility that their nest egg might double in value should they delay withdrawals for the 10 or 15 years between retirement and the onset of required minimum distributions, currently set at age 73. This could push them into a higher bracket just as the time comes for mandatory taxable distributions.
Step-up in basis. The chance to get embedded capital gains forgiven upon our demise has resulted in our death-grip hold on 19 individual stocks, which we purchased decades ago within our taxable accounts. These highly appreciated stocks are our only remaining after-tax holdings. Each has an unrealized capital gain of between 300% and 10,000%, and together constitute about 12% of our financial assets.
Over the years, we sold all losing stocks to offset realized taxable gains. We also sold any stocks and funds having modest gains to raise cash for, among other things, our 2022 house purchase.
The step-up in cost basis is also one of the main reasons we’ve retained our 1991 house. It’s a complicated situation, but this house has now become an unanticipated furnished rental property. We helped a military family displaced by a fire with a brief emergency rental, which extended into an 11-month stay.
Roth conversions. The lower income tax rates created by the 2017 Tax Cut and Jobs Act prompted us to undertake significant Roth conversions in recent years. Our conversions have been taxed at a 24% federal rate, rather than the 28% or 33% hit that would have been triggered before the 2017 law.
After we cover normal living expenses and help our children a bit, paying the taxes on Roth conversions, plus the resulting higher Medicare premiums, has soaked up every spare penny of after-tax income. Thus far, we’ve converted around 14% of our portfolio to Roth accounts.
Our tax-deferred balances now comprise a less-lopsided 74% of assets, not 90% as before. We plan to continue Roth conversions until the Tax Cut and Jobs Act sunsets in 2026, and possibly until our required minimum distributions start in 2028.
As I look back on the four big tax influencers, tax incentives drove us to overspend on housing and over-save in tax-deferred accounts. Both are considered desirable outcomes from a federal policy viewpoint.
So, too, are our Roth conversions, which have helped fatten the Treasury Department’s tax collections. The anticipation of a step-up in cost basis in our estate has led us to be “forever owners” of stock winners in our taxable account. Yes, despite what the experts advise, we are behavioral slaves to the tax code.
John Yeigh is an author, coach and youth sports advocate. His book “Win the Youth Sports Game” was published in 2021. John retired in 2017 from the oil industry, where he negotiated financial details for multi-billion-dollar international projects. Check out his earlier articles.
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Of course, we all are influenced by different tax rates we face on different forms of behavior. Not only in our investment decisions, but also in our every-day purchases. We face high taxes on purchases of alcohol and cigarettes. We face incentives, in the form of deferral of taxes, to save through individual retirement accounts. Our leaders — whom we elect — set up such programs because they think we will be better off if we buy less alcohol and cigarettes, and if we put more of our earnings in savings for our retirement.
The idea of using the tax code to influence us to make better decisions is not new. But the extent to which Congress has gotten into the business of building explicit behavioral incentives into the code has increased in recent years. Now, many people like us readers of Humble Dollar are trying to figure out what is the best way to take advantage of all those special tax incentives. I, too, have money in a traditional IRA, and I have moved some to a Roth IRA. But not all, for doing so would put me in a high tax bracket now just to avoid a high tax bracket later. Would that be smart? Probably not. The answer depends on anticipating future tax rate schedules.
We all want to take advantage of special incentives when they benefit us. But we have to be careful about what lies at the other end of those incentive programs. Trying to outsmart (or just out-guess) the next Congress is a difficult game.
Another way of looking at tax incentives is to seek to pay the lowest lifetime taxes, not the lowest taxes this year. While this is still tax-driven, it shifts the decision-making toward long term gain rather than short-term gains. A few consequences:
1) It may be good to have some investments in taxable accounts paying lower long term capital gain rates rather than paying ordinary income tax rates later on gains in tax deferred accounts.
2) Since charitable contributions count against the highest tax rate income, making larger charitable contributions in years with higher incomes and making charitable contributions that offset ordinary income tax (rather than capital gains) can make sense along the way, rather than waiting to give once more wealth is accumulated.
3) It may never be too soon to convert available tax-deferred dollars to roth dollars if this is an available option, unless you have other concerns, like what your income will qualify you for in college financial aid for those wonderful, but expensive children.
This is such a great article. I am in the same boat on many fronts concerning tax deferred accounts. Also I am POA on my widowed 96 year old mother’s account that holds stocks that I would rather be out of but holds enormous capital gains subject to step-ups in value at death. On one hand she could die at anytime at her age but on the other hand I feel that she could very well go way pass 100. I feel that there are better ways to invest the money but worry I will cause a large tax situation that would not happen if she dies shortly after the sale.
Good article John! Thanks for sharing.
When I retired in 2010 at age 66, 89% of our savings was pre tax in TIRAs. I considered Roth conversions but opted not to do so. I read an article a few years ago talking about the impact of the sunset of the 2017 tax law. That really got my attention.
I began doing large Roth conversions each year since. These triggered IRMAA penalties and pushed me into 24% tax bracket. I have reached the point where my QCDs exceed my RMDs, so will only do a small Roth conversions up to the point just before IRMAA penalties began.
The net of all this is our TIRA allocation will only be 15% at the end of the year. Everything else is in Roth and taxable.
I do not intend to use any of the Roth but it will be a great inheritance for our children.
I have no idea whether the 2017 tax law will expire or continue. But I am glad we did all of these Roth conversions.
John, thanks for an excellent article. I find we are also overweighted in pre-tax savings and real estate. We used much of our after-tax savings in the past few years on our beach home, and our new home in Monmouth County. We have equity in both, but there are ongoing costs. These real estate moves also complicated a finicial plan that I had greatly simplified. Oh well. I spend a lot of my time thinking about was to optimize our plan. High interest rates and a soft rental market at the Jersey shore this summer are working against us. With regard to home ownership, the $500,000 CG exclusion on the sale of a primary residence can be a big driver in behavior. The 5-year clock on that is running for us since we moved in fall of 2023. If we choose not to sell in that window and claim the exclusion, it might make sense to hang on to the beach house to get the step-up in basis for our kids. But we hope that won’t be for a while! Lots to consider.
i often wondered if there is an age at which it does not make sense doing the first Roth conversion given the five year waiting period for the tax benefits.
Given the taxes to be paid, the possible bump in tax brackets, even IRMAA premiums, I wonder when there may not be time to recover?
A surviving spouse single tax status brackets are typically approximately 1/2 of the married filing joint brackets beginning the year after the first spouse dies under current tax rules for most of the lower tax brackets. I expect those tax attributes will continue after 2025 regardless of the TCJA sun-setting or not.
For my tax situation using Roth contributions (when I have earned income) and/or Roth conversions to fill up the lower MFJ tax brackets while we are both alive makes tax sense for us. I expect the survivor’s lower tax brackets as a single filer will be fully used and thus current Roth contributions/conversions should help which ever one survives to better control their future tax burden.
Like most things tax everyone needs to plan based on their own circumstances.
Thanks for your article John.
Would please explain what you mean by MFJ tax brackets?
Married filing jointly, as opposed to filing as a single individual or head of household.
Question: for someone at least 59 1/2 years old isn’t the 5 year waiting period on a Roth conversion only on the earnings? My understanding is that the money actually converted is available for no penalty immediate withdrawal if you’re over 59 1/2. A bit of a bookkeeping burden, but not much as long as someone is aware of it beforehand.
Dick, this is an excellent question. My older brother and I have discussed it at length. One consideration if someone has a large pre-tax balance that they expect to pass on to their heirs. Even if they don’t have time to break even on taxes, they might consider Roth Conversions as an estate planning tool. You are effectively pre-paying the taxes for your heirs. I believe Jonathan has written extensively about this.
The arbitrage from today’s especially low tax rates is perhaps the key driver for Roth conversions, and tax rates have a decent likelihood of increasing in 2026. For me personally, a lack of tax diversification in asset buckets is another benefit.
The five year holding period is probably not much of an issue since Roth monies will typically be the last used. Also, Roth’s can continue to appreciate for your heirs for another 10 years after death.
I agree with you as those are valid questions. I did my first conversion at 52 and am now at 57. I can’t touch my 401k for two more years, but them plan to do as big of a conversion as I can within my bracket up to age 63. At that point I’ll have to consider IRMAA and decide the path going forward.
You can’t touch your 401(k) because you’re still employed?
I believe you cannot convert your 401k to an IRA while you are still working for the same employer. Now however many 401k and 403b plans have a Roth option, so you can invest money going forward there. Whenever you leave an employer or thereafter, you can then convert all or any part of your 401k to an IRA. Once it’s in an IRA, you can convert all or any part of the traditional IRA to a roth IRA, while you’re still alive.
And some 401(k)s allow in-plan Roth conversions.
John, this is a great look at the prods and pulls of the tax code on our behavior. It gets my mind to wondering about other ways policy shapes my life…
Thanks Ed – indeed 40% of my articles have something to do with taxes.