MIKE TOWNSEND: Another tax season has come and gone. Tax time has always felt to me like a little bit of a personality test. Are you a planner? Someone who filed their taxes a month ago and has already received a refund?
Or are you a procrastinator? Someone who was scrambling last weekend to find those receipts you were sure you saved?
Me, I'm in the latter category—I sent the IRS a check on April 17 this year, one whole day ahead of the deadline.
But as we close the books on the 2022 tax season, it's worth taking a breath and thinking about the 2023 tax environment—because there are some big changes that investors can be taking advantage of.
Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.
In today's episode, since we are literally recording this on Tax Day, we thought we would honor the end of the 2022 tax season by looking ahead at how the tax landscape is changing this year and discussing how investors can plan for those changes. In just a few minutes, I'm going to talk taxes with Nancy Murphy, a senior wealth strategist here at Charles Schwab who specializes in estate planning.
But first, a quick update on a couple of the issues making news in Washington right now.
Congress returned to Washington this week after the two-week Easter recess to begin one of the busiest stretches of the year. The House of Representatives will be in session eight of the next ten weeks, and the Senate will be in session nine out of the next ten. And the big focus of this next stretch is going to be the debt ceiling. In fact, I expect we are all going to get pretty sick of hearing about the debt ceiling over the next ten weeks.
This week, the rhetoric on the debt ceiling finally got a little more serious. On Monday, House Speaker Kevin McCarthy delivered a speech at the New York Stock Exchange, during which he said that House Republicans will vote in the coming weeks on a bill that would resolve the debt ceiling for a year, until roughly May of 2024. That would be coupled with a plan to cap federal spending at 2022 levels and limit the growth of spending over the next ten years to 1 percent of annual growth, all "without touching Social Security or Medicare," McCarthy said. Several other Republican priorities would also be attached to the package.
Now, McCarthy's plan is a non-starter in the Democrat-controlled Senate. But the main purpose of this week's speech was to shift the pressure back to the White House to come to the negotiating table. The president and Congressional Democrats have not wavered from their position that the debt ceiling should be raised without conditions, with any discussion of federal spending levels shifted to a separate conversation. McCarthy, however, said this week that a clean debt ceiling increase "cannot pass" the House.
While negotiations with Democrats have barely started, McCarthy's first and perhaps biggest challenge, will be to wrangle the votes for his plan from within his own party. With a narrow majority, McCarthy can only afford to lose four Republican votes in the House and still pass a debt ceiling bill. But there are 16 House Republicans who have never, under any circumstances, voted for a debt ceiling increase. That means McCarthy's path to getting a debt ceiling bill through the House is going to be incredibly difficult―and that's before the issue even gets to the Democrat-controlled Senate.
I also thought that McCarthy's choice of a venue this week was important—speaking at the New York Stock Exchange was clearly an attempt to reassure Wall Street that Republicans are taking the debt ceiling debate seriously. McCarthy did reiterate that "defaulting on our debt is not an option," but a path to a solution remains as murky as ever.
One thing that lawmakers are waiting for is a more specific deadline for when the debt ceiling debate must be resolved. Estimates for the default date have ranged from late June to early September—a range so wide that it has perhaps contributed to a lack of urgency on Capitol Hill.
Treasury Secretary Janet Yellen indicated recently that she would be better able to pinpoint the default date once April tax receipts were in. A strong tax receipt season, the thinking goes, would push the default date out toward late summer. Weaker-than-expected tax receipts would likely mean the default date falls more in that late June to early July timeframe.
Bloomberg recently did an analysis of the Treasury's cash balance and found that it had dipped to about $87 billion last week. That's the lowest level since December of 2021—which just happens to be the last time the country was bumping up against the debt ceiling. Bloomberg estimates that a strong April tax receipts season would push the Treasury's cash balance up to above $200 billion, while weaker receipts would leave the level at around $150 billion. So those are good numbers to watch to see how this might play out.
No matter where the date falls, though, Congress is a long way from reaching a resolution. Expect the tension on Capitol Hill—and in the markets—to creep upwards over the next few weeks.
Elsewhere, SEC Chair Gary Gensler touched on several important issues for investors during an appearance on Tuesday before the House Financial Services Committee. It was the first time Gensler had testified before the committee since Republicans took over the House majority in January, and it featured several contentious exchanges during more than three hours of questioning.
As I have noted on the podcast before, the SEC's regulatory agenda touches on a lot of issues with direct impact on individual investors. From cryptocurrency to climate risk disclosure to an overhaul of the system for retail trading to significant changes to mutual funds, the SEC has a long list of proposals in the queue. At this week's hearing, Republicans and some Democrats pressured the chairman about whether he's trying to do too much, too quickly. Gensler said it was the responsibility of the SEC to promote efficient markets and protect investors and that the regulatory proposals the agency has made are designed to do just that.
The most intense exchanges during the hearing focused on cryptocurrency. In the wake of last fall's collapse of FTX, the cryptocurrency exchange, the SEC has stepped up its efforts to crack down on misbehavior in the crypto space. But there is a lack of clarity about who has regulatory authority over different kinds of digital assets, some of which behave like securities, others of which are treated as commodities, which are regulated by a different federal agency. Gensler has long been outspoken in his belief that the crypto space is rife with fraud and abuse and that there are inadequate protections for investors from scams. Congress, however, has struggled to find consensus on legislation that would create a better regulatory framework for cryptocurrency.
There was also significant discussion around the SEC's controversial climate-risk-disclosure proposal, which would require public companies to disclose more to investors about their impact on climate change and the risks they face from climate change in the near future. Gensler noted that the proposal received more than 15,000 public comments, an extremely unusual number for an SEC rule. Republicans on the committee questioned whether climate change is even an issue that the SEC should be involved in regulating. Businesses have pushed back against the complexity of reporting the information to investors. The SEC intends to finalize the rule later this year, but a legal challenge is virtually certain to follow.
My big takeaway from the hearing this week is that there continues to be a significant disconnect between what the SEC is doing and what Congress thinks it should be doing, and investors are caught in the middle, with potentially big changes to the markets on the horizon. I'll continue to follow these key issues as they make their way through the regulatory process in the months ahead.
On my Deeper Dive today, I want to look at how investors should be thinking about taxes over the next year and beyond. I'm pleased to welcome to the podcast Nancy Murphy, a senior wealth strategist here at Charles Schwab who specializes in estate planning. Nancy, thanks so much for joining me today.
NANCY MURPHY: It's a pleasure to be here, Mike.
MIKE: Well, Nancy, you're on the front lines with investors every day, helping them plan for their futures, taking into account taxes, estate planning strategies, and the like. And in that role, you get an opportunity to really get to know clients, understand what their goals are, what their hopes are for their own legacies. But no matter where you are on your investing or planning journey, taxes are an ever-present concern. So let's start there, particularly because taxes are kind of on everyone's minds this week.
As we look ahead to 2023, there are a lot of big changes coming, many of which are a direct result of inflation. While none of us like inflation, at least when it comes to the IRS, there is maybe a bit of a silver lining. So before we dive into some of the specifics, perhaps you could just explain the connection between inflation and taxes.
NANCY: Sure, Mike. Basically, when inflation goes up, the IRS makes certain adjustments to both the value of the federal tax credits and standard deductions, as well as to the tax brackets to prevent bracket creep, which could push you into a higher tax bracket even if your income didn't increase that much.
MIKE: Well, so what are some of the specific changes that we're going to see in 2023? Who benefits?
NANCY: Well, the standard deduction increased by $900 for a single taxpayer and $1,800 for married couples filing jointly, which reduces the taxable income. And while the seven tax rates don't change, the tax brackets those rates apply to do expand. Not only does it help prevent bracket creep, but with the highest inflation in decades, the tax brackets have been expanded such that even if your income did go up in 2023, you may find you still pay the same rate you did in 2022. Limits on what can be contributed to 401(k)s are also indexed for inflation. For 2023, contribution maxes to 401(k)s jumped to $22,500 with an increase in the catch-up contribution to $7,500 for those over 50. And contribution limits for IRAs were also increased by an additional $500, to $6,500 for 2023. And the income ceiling for contributions to Roth IRAs was also raised to account for inflation.
But when it comes to paying taxes on capital gains, the income thresholds for long-term capital gains tax rates are also adjusted for inflation. If your income essentially stays the same, you may be able to avoid bracket creep here, as well, and stay out of the 20% capital gains tax bracket.
MIKE: What about changes for things like Social Security?
NANCY: One of the first things that was affected by higher inflation was Social Security increases. Everyone was thrilled to see the higher benefits until the letter with the higher cost of Medicare benefits arrived. The Social Security wage base also rose to $160,200, though, which means that taxes will be collected on more of your salary.
And along with the increase in the tax brackets comes the increase in the brackets for the Income-Related Monthly Adjustment Amount, or IRMAA, surcharges on Medicare. These brackets are just slightly different than the tax brackets. For example, while the 22% tax bracket is maxed at $95,375 of income for a single taxpayer, the first surcharge for Medicare starts with incomes over $97,000 for that same taxpayer. Unlike the income tax brackets which are marginal, the IRMAA brackets are a strict reading of the modified adjusted gross income, and if you exceed the limits for each bracket, you may be subject to higher Medicare expenses for the following two years.
The estate exemption also jumped from 12.02 million to 12.92 million, which gave couples almost $2 million more of their estate protected from that transfer tax. It's important to note, though, that 12 states and D.C. still have some form of estate taxes. However, unlike the federal exemption, states generally do not allow portability of the personal exemption amount, which essentially doubles the federal exemption amount for couples. And many clients miss the opportunity to reduce the amount of their estate subject to those state estate taxes because they neglect to consider the impact of transferring all of their accounts to their spouse through titling assets "joint with right of survivorship" and naming their spouse as beneficiary on all tax-deferred accounts. Passing everything to the surviving spouse doesn't utilize any of the exemption amount at the first spouse's death.
And, finally, the annual gifting exemption increased to $17,000 this year, and contribution limits for the health-savings accounts were increased to $3,850 for individuals.
MIKE: Well, that's a lot of changes that you've described. So what ideas are you sharing with clients about taking advantage of some of these changes?
NANCY: Well, inflation of those brackets makes a difference for lots of clients. If they're retired, it can give more space for Roth conversions or drawing down IRA assets without hitting those IRMAA charges for Medicare. Many tax advisors used to encourage clients to delay paying taxes as long as possible, but we're seeing more tax advisors suggesting a more proactive approach because of the potential changes in both tax brackets and tax rates in the future. Market volatility can be a partner in this scenario by taking advantage of lower market values on the conversion side and, hopefully, enjoying the rebound in growth on both the tax-deferred and tax-free side. Roth conversions, unlike Roth contributions, are available to anyone if you're willing to pay the taxes due. You can convert as much or as little as you wish. And you can continue to convert to Roth even as you're taking required minimum distributions, as long as you're converting amounts above those RMDs.
MIKE: What about people who are still working?
NANCY: For those who are still working, increasingly the conversation we're having is whether it's best to try to reduce income today by contributing to every possible tax-deferred account pre-tax, or whether it makes sense to consider contributing to Roth versions in 401(k)s and other taxable brokerage accounts. That, again, depends on the timeframe for working and the need for creating income in retirement. We see many clients that have lopsided tax buckets. Their entire wealth is in tax-deferred accounts, which leaves them very few options once they retire and in their estate planning, as well. Those clients often just hate to take money out of their accounts because it creates taxable income. They can't buy a car without crossing a tax bracket border. They're also going to be subject to whatever the IRS demands in required distributions once they get to the required withdrawal age, which is now 73, regardless of what their income needs are.
MIKE: Nancy, another tax issue that's already getting a lot of attention here in Washington, and this is one I get asked about literally every time I speak to investors, and that's the looming expiration of the 2017 tax cuts at the end of 2025. If that happens, it would mean big changes to individual income tax rates, the alternative minimum tax, and the estate tax. And I can tell you from the Washington perspective, those tax cuts are not going to be extended with the current divided Congress. In fact, I don't think we're going to have any idea whether they will be extended until after the elections of 2024. So how do you plan for something when you won't know what you're planning for, for at least the next two or three years?
NANCY: Well, I'll jump on the estate tax because that's the one I deal with every day. The federal exemption is so large that it has lulled a lot of people into thinking they never have to worry about it again, and that often means that they also take their eyes off their estate tax exposure at the state level. I've talked with other clients that are just planning to wait until 2026 to create their estate plan once they know the new rules, as though they have some guarantees about how life is going to treat them in the meantime. Even if the exemption amount reverts to the 2015 levels, it still will allow individuals a personal estate exemption of somewhere around $7 million and around $14 million for couples. We speak with many clients that have a net worth of $10 to $12 million to see if there are any opportunities to reduce their potential exposure without impacting their lifestyle needs or other goals. For example, annual gifting is one way to reduce the estate gradually over time. Charitable giving is another way to spend down tax-deferred money and keep the estate balances under the limits. For clients with $20 million and above, more-complex solutions might be appropriate. And here time is not on our side, although we aren't yet in the situation we had back in 2010, when the estate tax was eliminated for one year.
It can be challenging to balance taking advantage of the current personal exemption environment while maintaining flexibility to adjust to changes in the future. And it's important to confirm that gifting significant amounts away doesn't impact the donor's lifestyle and other needs and opportunities. Luckily, there are resources and tools to help explore the options and solutions that can potentially preserve access to money, if needed, while taking advantage of those higher exemptions.
MIKE: Nancy, you've talked about some retirement savings, contribution limits, and other elements of retirement savings, but there is also a brand new retirement savings law, SECURE Act 2.0, that's now on the books. As a result of that new law, the age at which individuals must begin taking required minimum distributions from their retirement accounts was raised from 72 to 73 this year. So that means that people who turn 72 in 2023, well, they now have an additional year before they're required to begin drawing down their retirement savings. But the SECURE Act 2.0 has 92 different provisions, most of which don't go into effect until 2024 and 2025. So looking ahead, what are some of the elements of this new law where you see there may be opportunities for investors?
NANCY: Yes, getting a whole extra year to start required distributions was like a Christmas present, wasn't it? But to me it was kind of like those toys you used to get for enormous amounts of tickets at Chuck E. Cheese—you know, big eyes, big dreams, small reality. Getting an extra year can help with getting in one more Roth conversion, but, ultimately, waiting one year doesn't change the equation for how the RMD is calculated, and that calculation will be using the life expectancy factor for your attained age that year. So for example, the RMD for a taxpayer age 72 is about 3.65%. For age 73 it's about 3.78%. Not a whole lot of difference, is there? While that increased flexibility to delay may be helpful to some, not all retirement savers will benefit from deferring taxes to a later age.
Interestingly, in my conversations with clients, it's pretty clear that the impact of the original SECURE Act still isn't understood in how radically it changed the ability to pass wealth on to the next generation, while still enjoying the benefits of tax-deferred growth, not to mention the ability to control that distribution using trusts. Now, with the exception of the spouse and a few special categories of beneficiaries, anyone inheriting an IRA has ten years to take distributions and pay taxes, and by the end of that tenth year, the account must be fully distributed. Originally, in 2020 when it went into effect, attorneys, CPAs, and everyone connected to financial services understood the new rules to suggest that the inheritor could pick and choose when to take distributions as long as it was fully distributed by the end of the tenth year. The SECURE 2.0 woke everyone up, when the IRS kindly said that they wouldn't penalize those who had failed to take RMDs for accounts inherited in 2020 and 2021. The proverbial jaws dropped with a thud when it was made clear that what we understood and what the IRS intended were not the same. We are still waiting for clarification on whether one can safely begin RMDs for inherited traditional IRAs in 2023 or whether the previous years should be taken, as well.
It had the effect of taking a simplified version of RMDs, one that anyone could understand, to complicating it even more than it was before. Now it depends on whether the deceased was taking RMDs or not, whether the account is an IRA or a Roth, whether the trust named as a beneficiary has the appropriate language to pass the test, who the beneficiary is, how old they are, and so on. When I started in this industry, there were about eight different ways to calculate RMDs, and I believe we're back to that now with these updates. This is an issue to add to the list of questions best explored with an advisor who can help integrate these accounts with your goals and your needs, because the consequences of naming the wrong beneficiary can reduce those ten years to five years with substantial and unintended tax impact on the beneficiary.
MIKE: Yeah, there's no question that the rules around an inherited IRA certainly have undergone some serious changes, and it's caused some consternation here in Washington where a lot of analysts feel like the IRS sort of changed the rules in the middle of the game. But are there any positive changes from SECURE Act 2.0 that we can be looking forward to?
NANCY: Oh sure, one or two. One that took me by surprise was the new provision that allows you to do a rollover of up to 35,000 of 529 assets to a Roth account for the beneficiary of that 529 plan, if certain requirements are met. The account has to be opened for 15 years, the beneficiary has to have earned income, the rollover is subject to the IRA contribution limits each year, and there are many other rules. And, frankly, with the way the cost of higher education has gone up, most of us are lucky to have saved enough in the 529 plan to actually cover those costs. But, still, it's a lovely option if your child or grandchild got a scholarship or chose not to pursue more education.
Another thing that was clarified, that has some really positive consequences, is that previously, if you named a special needs trust as the beneficiary of an IRA, you could not name a charity as the beneficiary of the inherited IRA or it would cause the five-year rule, which stipulates that the non-designated beneficiary must take out the remaining balance over the five year period following the owner's death, to be applied. A non-designated beneficiary is best thought of as a non-living entity, such as a charity, a trust, or an estate. The new SECURE 2.0 allows a charity to be named as the beneficiary of an inherited IRA owned by a special needs trust, and the trust can continue to take distributions based on the life expectancy of the special needs person. That was huge for the special needs planners and families and the organizations that support them.
And when it comes to retirement savings, as I mentioned earlier, there were substantial increases in catch-up contributions for retirement accounts. An increase of $2,000 for 401(k)s, with the catch-up contribution increased $1,000. That's a total potential contribution amount of $30,000 for those over 50. IRA contributions were increased by $500 for both traditional as well as Roth IRAs. And starting in 2024, those IRA catch up limits will be indexed for inflation, too. And kudos to the lobbyists for the age 60 to 63 crowd, since they got the biggest contribution changes. Beginning in 2025, they will be allowed to make a larger catch-up contribution of either 150% of whatever regular catch-up amount is for a given year or $10,000, whichever is greater.
MIKE: Yeah, that was a quirky part of the SECURE Act 2.0 debate. At one point, there was a counter proposal that the catch-up contribution increase should apply to people ages 62 to 64. And there were like dueling proposals between 60 to 63 and 62 to 64. Ultimately, the 60 to 63 crowd, as you pointed out, won out.
Well, a lot of people are looking at Roth conversions, and I guess I'm wondering if that makes sense for most people. How do you go about helping clients determine when's the right time to do a Roth conversion, how much to roll into a Roth, all these different considerations that go into that decision-making process?
NANCY: Roth conversions are all the rage, aren't they? All the really cool kids are doing them, and that's because so many of our listeners did such a great job of using tax-deferred accounts, making consistent contributions to the max every year, and being disciplined and prudent in their investment strategy. But they find themselves in a very different place than they expected in retirement. When they finally decide to retire and lift their heads from the grindstone and peer into the future, it does not seem to include the mythical lower tax brackets they were promised long ago. Tax-deferred accounts required minimum distributions that may be more than what people need for their lifestyle. Add in that those distributions may bring the unpleasant companion of higher IRMAA charges on Medicare premiums. And for married couples, when one spouse dies, the surviving spouse will have to continue taking those RMDs and paying the income taxes that are due but now as a single taxpayer.
So the solution seems to be to make Roth conversions today as prevention for the tax ugliness down the road. Roth conversions can also help with reducing a taxable estate and creating wealth that can be potentially controlled through a trust for generations. Time is of the essence because even with that additional year before RMDs start, it still can leave relatively little time to make headway against a large IRA. You can convert as much as your appetite for paying taxes allows. Again, it depends on what your goals are. Are you trying to reduce taxes for yourself, your surviving spouse, or your kids? I have worked with a few clients who converted millions in one huge, glorious, and extremely painful tax year, and they also had two years of paying the highest IRMAA on Medicare, too. And then they spent the rest of their retirement blissfully living their life without worrying about RMDs or IRMAA. But they all had specific reasons for doing it that way and they all had enough taxable money in accounts to pay the taxes due, as well.
The question really is, then, how much? We can't give tax advice here at Schwab, as you know, so listeners should talk with their tax advisors for specific guidance. However, before we get to a number, again, it's important to understand why and for whom you're taking the tax pain today. It's not needed by absolutely everyone. Sometimes clients can pair qualified charitable distributions, QCDs, with their RMDs and reduce their taxable income while doing good. And sometimes they can pair those QCDs with Roth conversions for amounts over their RMDs, even once they cross the bridge into the IRS's control.
MIKE: Well, Nancy, you can't really talk about retirement savings without talking about Social Security. So how does determining the right time to begin taking Social Security go into your planning? And what do you tell younger investors who are increasingly worried that Social Security won't be there for them when they retire? Do people who are either retired or approaching retirement need to be concerned?
NANCY: Well, Mike, it wasn't long ago that you could make a living, just helping people calculate the various strategies they could consider in claiming Social Security. But like all good things, that came to an end, and the last people to benefit from the more exotic strategies are all turning 70 this year. However, that hasn't changed the concern and anxiety clients have about when to claim, and, naturally, the answer for each person depends on a lot of factors. I used to joke with clients that if we knew our expected date of death, we could do a great job of calculating the best age to claim our benefits. But some things to consider do include life expectancy, but not just for the primary worker, but the spouse, as well. After all, the surviving spouse will continue to receive the larger benefit for the remainder of their life. So if you're the primary earner and you claim early, that is the most your spouse will be able to collect if you predecease them. If you wait until your full retirement age or longer, that means your surviving spouse will continue to enjoy the benefits of that decision for the remainder of their life.
Other issues to consider include Roth conversions, again. Here we're looking at delaying Social Security as a way to reduce taxable income and allow more to be converted from the IRA. Or perhaps there's deferred comp paying out early in retirement, or the sale of a business, or some other issue that creates greater taxable income for a specific period of time.
MIKE: At the same time, sometimes there are reasons people want to claim early.
NANCY: There are, of course. Sometimes it's just plain needing income or health issues that might impact longevity. Sometimes market volatility creates such anxiety that claiming Social Security is a way to offset emotions that might trigger poor investment decisions. This is when working with an advisor really helps, not just in supporting you through those rough markets, but in creating a strategy that might include starting to take the lower worker's benefit and taking a wait and see approach to the higher worker's benefit. For all of us, it isn't a quick or easy decision, or one that should be made on the fly or because your brother-in-law told you to do it. It's one that really benefits from talking with an advisor and understanding how to integrate it with other goals and elements in your financial lives.
MIKE: Well, Nancy, this has been a great conversation. And I really think that last point is an important takeaway, which is that none of these things that you've talked about today have a one-size-fits-all solution. That's why it's really important to talk to somebody.
Well, I really appreciate the time you've given us today, and thanks so much for joining me.
NANCY: My pleasure, Mike.
MIKE: That's Nancy Murphy, senior wealth strategist at Charles Schwab.
That's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks. Take a moment now to follow the show in your listening app so you won't miss an episode. And if you like what you've heard, leave us a rating or a review—those really helps new listeners discover the show.
For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.
I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.
