Last year brought higher yields, changes to retirement and 529-plans, high inflation, and hopefully discussions with your clients around how the sunsetting of the Tax Cut and Jobs Act (TCJA) will impact income and estate taxes. Expect similar themes to continue this year. It is unlikely that 2024 will bring any significant tax changes, which makes it a good year to focus on planning with few surprises.
The biggest planning news this year is preparing for the sunset of the TCJA at the end of 2025. Although this is still relatively far off, wealth transfer strategies take time to design and implement. We recommend a “sooner rather than later” timeline, which we’ll discuss more in a bit.
First, it’s important to note the backdrop all this is playing out against.
Bonds and cash are paying the highest rates in over 15 years, and minimizing taxes on interest income requires thoughtful planning. This year, a Roth conversion may be worth exploring, especially if most of a client’s retirement assets are in pre-tax IRA accounts. Additionally, the 529-to-Roth rollover option is available this year, and the strategy may make sense for some.
Here are some points to explain to clients.
Fixed Income
As of January 2024, the 10-year U.S. Treasury yield is hovering around 4%. Last year, investors shifted to bonds to take advantage of higher yields. Although it’s tempting for investors to look at bonds to earn a reliable income, we should remind clients to view bonds as part of a diversified portfolio with a long-term horizon that supports planning objectives.
Clients eager to buy bonds may benefit from understanding that, historically, U.S. fixed income has returned less than U.S. equities on an absolute basis. Encourage your clients to think of fixed-income allocations within the context of an entire plan rather than for the purpose of chasing yield for a couple of years. By overweighting fixed income, clients may be giving up higher returns over the long term for potentially safer but lower performance.
You can also help clients consider the tax consequences of interest paid on bonds and how asset allocation matters — holding them in certain accounts will minimize taxes.
Let them know that pre-tax retirement accounts can serve as ideal vehicles to keep taxable bonds. The interest in these accounts is tax-free until it is withdrawn. Keeping the interest sheltered from tax allows for greater compounding. In contrast, withdrawals from Roth IRAs are not taxed. That’s why a Roth is typically better suited for high-growth assets held over the long term since their gains are never taxed.
Government-issued debt
Investors typically locate municipal bonds in taxable accounts because the interest is exempt from federal and sometimes state taxes. However, investors should be aware that interest from certain “private activity” municipal bonds is subject to the alternative minimum tax (AMT).
Over the past year, many investors have invested in money market funds to take advantage of higher interest rates. Still, it’s important to understand the tax implications. States do not tax most income from federal debt, including Treasurys, savings bonds, and bonds issued by certain agencies. However, income from Treasury repurchase agreements (“repos”) is subject to state income tax. Repos are commonly held in money market funds, and certain investors may want to steer clear of them, especially if they reside in a high-income tax state such as New York or California.
However, funds that exclude repos may have higher management fees. It’s recommended to weigh the benefits and costs of various cash alternatives.
Retirement-Plan Considerations
On the retirement front this year, pre-tax retirement accounts continue to act as both a blessing and a curse. Clients can benefit from tax deductions and decades of tax-free growth. However, the true value of pre-tax accounts is lower because they are subject to ordinary income tax when funds are withdrawn. Some IRA owners are disappointed to learn that their pre-tax IRA accounts aren’t worth what they believed them to be.
Required minimum distributions (RMDs) can also negatively impact retirees who don’t need the annual distributions to fund their lifestyle but are nonetheless required to pay taxes on these withdrawals.
The Ins and Outs of Roth Conversions
As every advisor should know, Roth conversions may help reduce income taxes over the long run since distributions from Roth accounts are not taxed. When clients consider keeping assets in a traditional IRA versus performing a Roth conversion, they may focus on the fact that a conversion reduces assets due to the upfront tax bill. On the other hand, assets in a pre-tax IRA are not worth as much as they appear because distributions are taxed at ordinary income tax rates. Even beneficiaries pay income taxes on distributions. Clients may not realize that they must pay taxes on the appreciation in a traditional IRA, unlike with a Roth account.
Roth conversions have the highest long-term benefit when performed during low-income years. If a client’s income is expected to be high throughout their lifespan, a conversion avoids unnecessary RMDs and may provide an estate planning opportunity.
Many households will see their income tax rates increase when the TCJA expires in 2025, so timing a conversion before then may be wise. Suppose, though, that an IRA owner’s income is expected to meaningfully decrease as they age. In that case, a Roth conversion may not be beneficial during one’s lifetime but may be a good estate planning strategy. Here’s why:
Inheritors of Roth IRAs can keep assets in the account for ten years after the owner’s death. This extends the time these assets can grow tax-free. In contrast, those who inherit regular IRAs will likely be required to take distributions each of the ten years, and the funds will be taxed. There are exceptions to this rule for surviving spouses.
Additional Reading: Should You Leave an IRA to a Trust?
Ultimately, the decision to convert an IRA later in life is circumstantial and is based on the client’s estate planning objectives, financial position, future expected tax rates, and tax rates of heirs.
Sunset Considerations
When the Tax Cuts and Jobs Act (TCJA) sunsets at the end of 2025, the estate, gift, and generation-skipping transfer (GST) tax exemption will reduce by approximately half, from $13.61 million per individual in 2024 to around $8 million per individual in 2026. A couple can secure benefits from the current exemption by transferring any amount above $8 million using one of the spouse’s exemptions. The December 31, 2025 deadline is deceptive. Deciding on what to do, how to best do it, and drafting the legal documents can take six to 12 months. A good attorney may be hard to retain in 2025, so aim to have the documents drafted by the end of this year.
Estate-Planning Concerns
Clients who can benefit from transferring wealth ahead of the sunset may hesitate to execute a plan. One of the most common concerns is having enough assets after gifting to maintain a lifestyle and minimize the risk of depleting assets.
For this reason, the first objective of any gifting plan should be to determine a safe amount to transfer, leaving enough to cover expected expenses with an added margin of safety. Other strategies, including Spousal-Lifetime Access Trusts (SLATs) and flexible irrevocable trusts, can help clients take advantage of the exemption and still maintain access to funds.
For those concerned about prematurely giving too much to their children, some strategies offer significant controls over heirs’ access to the assets even from “beyond the grave.” Flexible irrevocable trust documents can include provisions and mechanisms that give the power to change or eliminate beneficiaries later, though the process may be arduous or less feasible depending on the language of the trust document.
New and Noteworthy
A new planning opportunity available this year is the 529-to-Roth rollover. The Secure 2.0 Act created the ability to transfer up to $35,000 of unused funds from a 529 to a Roth, but there are caveats. First, the 529 plan must have existed for 15 years, the Roth must be in the name of the beneficiary, and the beneficiary of the 529 plan must have earned income, among other restrictions. The ability to rollover helps parents overcome some concerns that they will contribute too much to a 529 plan.
Regardless of whether the 529 beneficiary completes their education, the 529-to-Roth rollover is a mechanism to help young adults save for retirement. The rollover may also act as a long-term strategy to grow assets on a tax-free basis and pass them to the next generation, though the amount is capped at $35,000 per child.
For those who need to transfer significant wealth and wish to pass on values around education, a “mega legacy 529” is likely a better strategy. Also known as a “dynasty 529”, these are accounts that can be used to hold generational wealth for the purpose of funding future education for grandchildren or other family members. With the inflating cost of higher education, providing support to future generations can incentivize them to attend college without having to worry as much about the cost.
A Good Start
There are plenty of opportunities to improve a client’s wealth plan in 2024 beyond what is summarized here.
Determine the most high-impact item and start there. This year is an election year, so expect the media to provide commentary on proposed tax changes that seem frightening. Keep in mind, however, that this is just noise. With the current and expected composition of Congress, major tax changes are unlikely to pass this year. Remember to stay on course and have a prosperous 2024!
Mallon FitzPatrick, CFP, is a principal and managing director at Robertson Stephens and heads the firm’s financial planning center. Alicia Denton, CFP, is a wealth planner at Robertson Stephens. For more information about Mallon, Alicia or Robertson Stephens, please visit www.rscapital.com or email info@rscapital.com. Advisory services are offered through Robertson Stephens Wealth Management LLC. Opinions presented are those of the author and not necessarily Robertson Stephens. Please read Important Disclosures.
