Year-End Planning Strategies

November 26, 2019

It always seems hard to believe, but another year is nearing a close and the holiday season is upon us.

Now that we are in the final months of 2019, The Fiduciary Group team is hard at work helping our clients address a variety of year-end planning considerations.  The end of the year is a natural time to pause and reflect on the year’s accomplishments and challenges, and to revisit plans for the coming year and beyond.  Here are some of the common planning considerations we are helping clients evaluate.

Retirement Savings Strategies
The window for establishing and, in some cases, contributing to many types of tax advantaged accounts closes with the end of the calendar year.  With that in mind, it’s a good time to revisit your current retirement savings strategies and to determine how they align with longer term goals.

Maximizing contributions to employer sponsored retirement plans, such as a 401(k) plan, is a good place to start.  Often, however, these contributions are not enough to provide sufficient cash flow for retirement or other goals.  Defined contribution plans, like 401(k) plans, limit the annual employee deferral to $19,000, with $6,000 additional “catch up” contributions allowed for those 50 and over.  The total defined contribution plan limit, including employer contributions, is $56,000 in 2019.  Defined benefit plans, by contrast, have much higher contribution limits, $225,000 in 2019.  These plans don’t work in all circumstances, but they can be a great tool when a plan calls for significant additional retirement savings.

Even if a defined benefit plan doesn’t work for your situation, you can consider additional contributions to an IRA.  These contributions may not be deductible, depending on income level and coverage by an employer sponsored plan, but the assets do grow tax deferred which yields a nice compounding benefit over time.  The IRS allows up to a $6,000 contribution in 2019, along with a catch-up contribution of $1,000 if you are over age 50.

The conversion of a traditional IRA into a Roth IRA is another strategy many clients have been interested in in recent years.  This strategy has wide-ranging implications, not only on a client’s current income tax, but also future retirement cash flow as well as estate planning.  The strategy involves taking pre-tax contributions and tax-deferred earnings in a traditional IRA, which are taxable upon distribution, and transferring those funds into a Roth IRA, which allows tax-free growth and also tax-free distributions.  This transfer is considered a taxable event, and income taxes are due on the converted balance.  When an IRA owner elects for this option, they are choosing to pay taxes on their traditional IRA now in exchange for not paying taxes on the converted Roth IRA in the future.

When an account owner converts from traditional to Roth, the tax liability is recognized in the year of conversion, with tax due the following year when the account owner files their personal tax return.  Many clients who do not need to draw assets from their IRA for their own retirement find this strategy particularly attractive for its wealth transfer benefits.  Roth IRAs are not subject to Required Minimum Distributions, like traditional IRAs.  A Roth IRA enables the owners to let the assets continue to grow tax free for their lifetime.  This benefit makes Roth IRAs an efficient asset to pass on to the next generation.  The tax bracket which applies to the IRA conversion now — compared to the future tax bracket which would apply on future distributions — is an important factor.  It’s impossible to know what the income tax rate will be in the future, but it is interesting to note that although our current top marginal income tax rate has been stable for the past 25 years, it is relatively low today by historical standards.  The top marginal bracket was 70% during the 1970s.  The top marginal rate was as high as 91% in the 1960 and as high as 92% in the 1950s[1].

Rising health care costs are another concern for many.  In fact, the health care inflation rate, with a long-term average of just over 5.29%, is significantly outpacing the 3.76% long term average of the CPI-U inflation rate, which is a broader measure of inflation[2].  This fact makes it even more important to plan carefully for health care costs in retirement.  Individuals still in their working years who have access to a Health Savings Account may want to consider max funding these accounts and letting the funds grow instead of using them for current health care costs.  Distributions from Health Savings Accounts are not taxed if used for qualified medical expenses, thus a well-funded HSA can be a particularly valuable asset to help manage health care costs during retirement.

Education Savings Strategies
Whether as a parent or a grandparent, setting aside funds to provide for the education of future generations is an important goal for many of our clients.  Again, the elevated inflation rate of education costs plays an important role in savings strategies.  From 1995-2013, college tuition rose at an annualized pace of 7.4%.  During this same time period, the CPI-U rose at a pace of 3.7%[3].

Given this backdrop, saving early and often for future education expenses is as important as ever.  There are a handful of tax-advantaged education vehicles such as the Coverdell Education Savings Account and 529 Plan accounts.  These accounts allow for after tax contributions to grow tax free and distributions for qualified educational expenses to be withdrawn tax free.  The passage of the Tax Cuts & Jobs Act of 2017 has made 529 accounts even more flexible, as account owners may now distribute up to $10,000 for qualified K-12 education expenses.

Charitable Strategies
The impact of the Tax Cuts & Jobs Act of 2017 didn’t stop with education savings vehicles; the law significantly increased the standard income tax deduction, which is now up to $24,400 in 2019 for married filing jointly taxpayers.  This in turn has a significant impact on charitable giving strategies our clients consider.

Gifting funds directly from an IRA is gaining popularity among retired clients who are required to take annual Required Minimum Distributions.  This strategy enables the donor to avoid income tax on the gifted funds, regardless of whether they itemize or claim the standard deduction.

Gifting low basis stock instead of cash is another consideration.  Additional strategies include bunching charitable donations and other itemized expenses normally made annually over several years into a single year in order to exceed the standard deduction amount in the bunch years and claiming the standard deduction in the non-bunch years.

Estate Strategies
The Tax Cuts & Jobs Act of 2017 also had a major impact on the estate tax exemption amount.  The 2019 exemption amount is currently $11,400,000 per individual, and although many people with estates under this limit may not perceive that they have an “estate issue,” changes in estate law can sometimes have unintended consequences that may be unrelated to estate tax itself.

For example, a client’s will may direct an Executor to fund a certain trust up to the maximum exemption amount, with the remainder of the estate assets to fund other purposes.  If such a clause was designed with a much lower estate exemption in mind, the client’s estate may not be distributed as originally intended.  Even with a much larger exemption currently in effect, the estate exemption amount will fall to around $6,000,000 in 2026, which makes it worthwhile to revisit your longer-term estate strategy today.

As we move closer to year end, amidst holiday celebrations with friends and family, we encourage clients to also make some time to review their financial plans.  Our team at The Fiduciary Group is always glad to work in concert with our clients’ broader advisory teams, including estate planning lawyers and CPAs, to help clients take stock of their current situation and plan for the future.  If you would like help in evaluating your own financial plan, please reach out to us.

[1] https://www.taxpolicycenter.org/statistics/historical-highest-marginal-income-tax-rates

[2] https://ycharts.com/indicators/us_health_care_inflation_rate

[3] https://www.edvisors.com/plan-for-college/saving-for-college/tuition-inflation/

AUTHOR:

MICHAEL McLEOD, CFP®