Avoiding the 2026 tax surprise: The low tax rate party is almost over
In 2017, with much fanfare, the Tax Cuts and Jobs Act was signed into law. It provided Americans with lower federal income tax rates, a higher threshold for estate taxes and other changes to the tax code. In order to meet budgetary requirements, Congress was able to enact the lower rates but only through December 31, 2025. After that date, marginal income tax rates are scheduled to revert to their original, higher rates.1
While it is hard to know if Congress will be able to agree on an extension of today’s current tax rates, we think it is wise to plan based on what we know today.
For many higher income families2, making a plan today could serve them well. Here are 4 things you should consider:
Consider Roth IRA / 401(k) conversions
Traditional pre-tax contributions to IRAs and 401(k)s are great at providing reduced taxable income today. However, you are basically deferring the inevitable future tax bill that will be due when you retire. If you have $1 million in retirement assets, effectively this is really more like $650,000 or $500,000 after-tax because taxes will be due when you withdraw funds from these pre-tax accounts.
A Roth, on the other hand, is funded with after-tax money and qualified withdrawals are tax-free. The drawback is that you have to pay income taxes on the amount converted today.
With income tax rates scheduled to increase in the future, it may make sense to do a Roth conversion now while tax rates are lower.
The big IRA tax trap
If you are turning age 73 in 2024 and you have a IRA or 401(k) with pre-tax money, you’ll need to start taking Required Minimum Distributions (RMDs) from your account. If you have a lot of money stashed away in these accounts, you’ll have to take large distributions. This may not matter if you need all of the RMD to cover your expenses. But if you have other sources of income, receiving your RMD is going to add to your taxable income. For those with large IRAs, this could mean a surprise tax bill. For example, if you are 73 and have an IRA with a pre-tax balance on 12/31/23 of $2.5 million, your first RMD will need to be at least $94,340. Combined with $58,476 in Social Security benefits3 and earnings from investments, you could suddenly be
in a higher tax bracket than expected. Your RMD could also cause your Medicare Part B premium to increase.4
By converting some pre-tax IRA money into after-tax Roth money, you could smooth out and possibly reduce the tax impact of starting RMDs at age 73.
Another ticking time bomb: Leaving your big IRA to your kids
When you die, you can leave your IRA to your spouse and they can take RMDs based on their own life expectancy. However, if you are no longer married or your spouse is deceased, the non-spouse beneficiary can no longer stretch out RMDs over their life expectancy. This was often a significant benefit for children or grandchildren as those RMDs tended to be small because they could spread out distributions over a long time period.
No more.
Since the signing of the SECURE Act on December 30, 2019, non-spouse beneficiaries of IRAs must empty the IRA account by the 10th anniversary of the IRA owner’s death—that’s nine years.
Using the example above with the $2.5 million IRA, that means the non-spouse beneficiary (usually an adult child of the owner) must take an average of $367,555 per year.5 For some adult children who are working and already in a high tax bracket, this could cause push them into a significantly higher bracket.
Older IRA owners may want to consider doing Roth conversions and / or taking more out of their IRAs now while tax rates a little lower. This could help soften the tax impact their adult children will experience by having to take IRA distributions over a relatively short period of time.
The clock is ticking on the estate tax exemption
In 2024 estates worth less than $13.6 million ($27.2 million for married couples) do not have to pay estate taxes. However, these higher limits which were raised with the Tax Cuts and Jobs Act of 2017 are set to expire after December 31, 2025. It is expected that in 2026 the limits will decrease to $7 million ($14 million for married couples). For some individuals and couples, these decreases, coupled with appreciating assets will push their taxable estates above the lowered exclusion. Because the tax rate on estates is usually significantly higher than on regular income taxes, higher net worth individuals should be concerned.
Time is running out
There are a few strategies that can be used to avoid the effects of the falling estate tax exemption. However, I do not know of any estate planning attorney that wants to receive a phone call in December 2025 asking how to avoid the lower limits that will kick in on January 1, 2026. The time to plan is now.
There are several other tax provisions that are scheduled to expire on December 31, 2025. We recommend that you contact your tax or estate planning professional now so that you can review your options and have adequate time to make the best decisions.
If you have any questions about how you can avoid these tax surprises, give me a call. I’m here to help. You can schedule a quick call with me by clicking HERE.
Lyman H. Jackson
Lyman@PlanWithFPS.com
617-653-3303
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· Top 5 financial mistakes https://planwithfps.com/blog/top-5-financial-mistakes
1Unless Congress acts to successfully extend these tax rates. While both Presidential candidates have made various proposals to extend or cut taxes, that remains to be seen.
2Higher tax rates will likely have a greater impact on those with adjusted gross incomes of more than $191,950 (single) or $383,900 (married filing joint).
3The maximum individual Social Security benefit for 2024. Source: SSA.gov.
4 In 2024, Medicare premiums are increased for income over $97,000 (single filers) or $197,000 (married filing joint).
5 Starting with $2.5 million earning a hypothetical 6% rate of return for 9 years. Example does not include taxes which would apply to the distributions.
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