December 18, 2023

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TAX ALPHA: What is it, and why is it so important – #1 in Series

Taxes are the most significant drag on investment return – greater than inflation, transaction costs or management fees. Studies show that taxes reduced returns by an average of one to three percentage points making it important to manage “tax drag”.

The increased value created in an investment portfolio by using the tax saving strategies described below is referred to as “Tax Alpha.” Put another way, it is your after-tax excess return (after-Tax Alpha) minus your pre-tax excess return (pre-Tax Alpha) based on the appropriate benchmarks. Research indicates that many portfolios don’t consistently beat their benchmarks on a pre-tax basis, often producing negative alpha on an after-tax basis which is why creating Tax Alpha is important.  This paper will be the first in a series of strategies released in the next few months about creating tax alpha.

IRA AND ROTH IRA STRATEGIES – Roth IRA conversions to “fill-up brackets”

Roth IRA conversions have become a popular topic in recent years. The concept is you move funds in a given year from your IRA to a Roth and pay taxes on the amount you convert. 

There are specific situations or “sweet spots” where this makes the most sense.   Mostly this would be for those people who have low income in a given tax year and therefore have room to add income while staying in the lower marginal tax bracket. 

Benefits to converting:

1. Even though you pay tax on the amount you convert, the conversion amounts will lower the balance in your traditional IRA thus reducing the amount of your future Required Minimum Distributions (RMD’s).   Required Minimum Distributions are the minimum amount you are required to distribute from your IRA over your life expectancy when you turn either age 73 or age75 depending on when you were born.
2. If you don’t take any distributions from your Roth within 5 years after the conversion, you will not pay taxes on any future distributions. 
3. Beneficiaries that inherit your retirement accounts will not have to pay any taxes upon distribution.

Example of a “sweet spot” situation:

A 65-year-old retires but doesn’t plan on taking social security until age 70. The spouse is 62 years old and doesn’t plan on taking social security until age 67.

Assuming they don’t have to take money out of retirement accounts to live on for those 5 years, besides for investment income, the taxpayer will have no income for the 5 years prior to taking social security. 

In 2023, joint taxpayers pay 10% on their first $22,000 of income and then 12% on the next $67,000 of income.  The standard deduction is $29,000.  So, if their total income is less than $118,000, then they will be in the marginal tax bracket of 12%.  Assuming they have investment income of $33,000, they could convert $85,000 of their IRA to a Roth and pay tax at a very low rate. The next tax bracket which kicks in after $89,000 of taxable income has a 22% tax rate, so it’s important to not convert too much each year as to be pushed into the next higher tax bracket. 

A few more thoughts:

1. Some people are convinced taxes are only going to go up over time, so they are inclined to convert more money and pay at the 22% rate or even at the 24% rate. Even if this turns out to be correct and taxes do go up in the future, the likelihood of rates increasing on the lower end of the spectrum is minimal.  Most likely if rates go up, it will affect higher tax bracket taxpayers and therefore most retirees will not have to worry about this. 
2. Roth conversions are not just for people who retire early.  For those who have a period where they are out of work, that could also be a good opportunity to convert some IRA funds as well. 

As always, it’s best to consult a tax or investment professional before making these important decisions. If you do think you could be a candidate for Roth Conversion the best thing to do is talk to your CPA towards the end of the year and try to project your taxable income and see if there is any room to fill your brackets with a Roth conversion. 

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Important Disclosures:

Securities offered through IFP Securities, LLC, dba Independent Financial Partners (IFP), member FINRA/SIPC. Investment advice offered through IFP Advisors, LLC, dba Independent Financial Partners (IFP), a Registered Investment Advisor. IFP and Finspire, LLC are not affiliated.

The views and the other information provided are subject to change without notice. All reports posted on or via www.clearnomics.com or any affiliated websites, applications, or services are issued without regard to the specific investment objectives, financial situation, or particular needs of any specific recipient and are not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Independent Financial Partners and Finspire do not provide legal or tax advice. Any potential tax advantages or benefits will depend on your circumstances. Consult your tax professional about your individual tax situation and visit IRS.gov to learn more. Past performance is not necessarily a guide to future results.