Tag Archives for " income tax "

Mar 15

Is the new Tax Law an opportunity for Roth conversions?

By Chris Chen CFP | Financial Planning , Investment Planning , Retirement Planning , Tax Planning

Is the new Tax Law an opportunity for Roth conversions?

The New Tax Law, known as the Tax Cuts and Jobs Act (TCJA) was passed in December 2017. Its aim was to reduce income taxes on as many constituencies as possible. One of the well known implementations of that desire has been the temporary reduction of individual income tax rates. That provision of the law is scheduled to sunset in 2025. Starting in 2026, individual income tax rates will revert back to 2017 levels, resulting in a significant tax increase on many Americans, following 8 years of reduced tax rates.  

Assuming Congress doesn’t take future action to extend the tax cut, how can the damage of the TCJA’s scheduled tax increase be mitigated? One way to mitigate the damage of the TCJA scheduled tax increase could to switch some retirement contributions from Traditional accounts to Roth accounts from 2018 to 2025 , and switching back to Traditional accounts in 2026 when income tax bracket increase again.  

Another way to blunt the impact of theTCJA is to consider effecting Roth conversions between 2018 to 2025 .

The TCJA has a tax increase built into it

It’s well known that contributions to and withdrawals from Roth IRAs and Roth 401(k)s are taxed differently than their Traditional cousins .  One of the major factors to consider when deciding between a Roth IRA or a Roth 401(k) and a Traditional IRA or Traditional 401(k) are income tax rates during working years and in retirement.  

Generally speaking, Roth accounts are funded post tax, whereas a Traditional accounts are funded pre-tax .  As a result, funding a Traditional 401(k) account reduces current taxable income , usually resulting in lower current taxes. Similarly, you may be able to deduct your contributions to a Traditional IRA from your current tax liability depending on your income, filing status, whether you are covered by a retirement plan at work, and whether you receive social security benefits.   Income taxes must be paid eventually, so retirement distributions from Traditional IRAs and 401(k)s are taxed in the year in which they are withdrawn. In fact, the Internal Revenue Service so wants retirement savers to pay income taxes that it mandates Required Minimum Distributions (RMD) from Traditional accounts after age 70 1/2 . RMDs are taxed as ordinary income in the year they are distributed.

On the other hand Roth accounts are funded with post-tax money and result in retirement distributions that are tax free, provided all requirements are met.  

Roth IRAs and Roth 401(k)s

When working year taxes are lower than projected tax rates in retirement, it usually makes sense to contribute to a Roth account . In this situation, paying taxes upfront results in lower projected lifetime taxes. For instance, assuming that Vanessa is in the 24% tax bracket, she will need to earn $7,236 to make a $5,500 contribution to a Roth IRA. That is because, she will owe federal taxes of $1,736 on her earnings (not counting state taxes where applicable), leaving her with $5,500 to contribute. However, Vanessa’s distributions in retirement would be tax free.  If her marginal tax rate in retirement is greater than 24%, she would have saved on her distributions.

 

Traditional 401(k)

It’s important to note that you can only contribute to a Roth 401(k) plan if your employer offers one as a company benefit . Married individuals filing jointly and  making over $196,000, married individuals filing singly and making over $10,000, and single filers making over $133,000 cannot contribute to a Roth IRA, but may contribute to a Roth 401(k).

Traditional Accounts

When working year tax rates are higher than projected tax rates in retirement, it usually makes sense to contribute to a Traditional IRA or Traditional 401(k) .  Contributing to a Traditional account in that situation generally results in a reduction in taxes in the year of contribution; taxes will be due when the assets are withdrawn from the account, hopefully in retirement. For instance, If Vanessa contributes $5,500 to a Traditional IRA can result in a reduction in taxable income of $5,500. If she is in the 24% federal income tax bracket, Vanessa would save $1,320 in federal income taxes (not counting potential applicable state income taxes).  If Vanessa is in the 12% marginal federal tax bracket in retirement, when she takes $5,500 in distribution, she would then owe federal income taxes of $660.

Traditional IRA

 

Most working people are in higher tax brackets while working than they will be in retirement; hence it usually makes sense for them to contribute to Traditional accounts . That is not true for everyone, of course, as individual circumstances can significantly affect taxes owed.

The New Tax Law

The new Tax law, aka the Tax Cut and Jobs Act or TCJA, passed in December 2017, comes with a number of features, including a permanent reduction in corporate taxes. Most important for individuals and families, it significantly reduces individual tax brackets starting in 2018.  

Roth 401(k)

Table 3: 2018 Federal  Tax Brackets

 

However, while the tax decrease for corporations is permanent, the TCJA tax decrease for individuals and families is temporary. Starting in 2026, individual tax rates will be back to their 2017 levels .

Roth IRA

In practice this will result in a large tax hike in 2026 for many individuals and families.  For instance if Susanna and Kevin make $150,000 and file “Married Filing Jointly”, they might be in the 22% marginal tax bracket in 2018.  With the same income in 2026, Susanna and Kevin would be in the 25% marginal tax bracket. Of course, there are several other factors that will impact their final tax bill, but most people in that situation will stare at a higher tax bill.

So what if Susanna and Kevin project that their retirement income would place them in today’s 22% bracket? Most likely that would put them in the 25% federal bracket in 2026, resulting in a possible tax increase. In fact, depending on the exact situation, a large number of Americans will see their taxes increase in 2026 as the result of the sunset of the TCJA individual tax cuts .

Consider a Roth Conversion while working

Susanna and Kevin could also take advantage of the temporary nature of the TCJA tax cuts to convert some of their traditional tax deferred retirement accounts to Roth accounts.  In so doing, they would take distributions from the Traditional account, transfer to the Roth, and pay income taxes on the conversion. This way Susanna and Kevin would create themselves a source of tax free income in retirement, that could help them stay in their tax bracket and partially insulate them from future tax increases.

Now is the time to take steps to manage your taxes

Because Roth conversions increase current taxable income, many people will find them a limited possibility as only so much funds can be converted without jumping into the next tax bracket.  However, working people can also think in terms of changing their current contributions from Traditional 401(k)s to Roth 401(k)s. That would have the similar impact of increasing current taxable income and income tax due for the benefit of creating a reserve of future tax free assets.

Consider changing from a Traditional 401(k) to a Roth 401(k)

In the case of Susanna and Kevin, they could be in the 22% marginal federal tax bracket in 2018.  If they retire in 2026, and their taxable income in retirement does not change, they may be in the 25% marginal tax bracket. For this couple, it may well be worth switching current contributions from a Traditional 401(k) to a Roth 401(k) from 2018 to 2025 , thereby increasing taxes due from 2018 to 2025, and potentially reducing taxes in retirement.

Of course, it is not always clear where Susanna’s and Kevin’s taxable income would come from in retirement.  That is because their sources of income will likely change significantly. While they would no longer earn income, they may then have social security income, pension income, and retirement plan income which are all taxed as ordinary income. They may also take income from other assets with different tax characteristics, such as savings or investments.  That might make the projection of their taxable income more difficult.

It is possible that Susanna and Kevin’s income needs will influence the tax characteristics of their income when they retire in 2026 or later; that may place them in a different tax bracket altogether. For instance Wealth Managers routinely advise clients to postpone Social Security income as late as they can, preferably until 70 in order to maximize lifetime social security income.  When that happens it is possible that income between retirement and 70 could come from other sources, such as investments. When that happens taxable income could be significantly lower as investments are usually taxed at a lower capital gains rate.

This may sound self serving, but I’ll write it anyway: the best way to know what Susanna and Kevin’s income would look like in retirement, and how it might be taxed, is for them to check in with a skilled Certified Financial Planner. Otherwise they would just be guessing.

Considering a Roth Conversion in Retirement

So what about people who are already retired?  The situation is similar. Take David and Emily, a retired couple with social security income, state pension income, and retirement plan income.  From 2018 to 2025, their $100,000 taxable income places them in the marginal 22% federal tax bracket. With the same income in 2026, they would end up in the 25% tax bracket.  Through no fault of their own David and Emily will see their income tax increase in 2026.

One of the ways that David and Emily can fight that is to convert some of their Traditional retirement accounts to Roth between 2018 and 2025, pay the income taxes on the additional income, and then use distributions from the Roth when their taxes go up in 2026 to stay within their desired tax bracket. In this way, David and Emily could potentially reduce their overall taxes over the long term.

Conclusion

The new Tax Law, aka the TCJA, reduces individual and family income federal tax rates substantially starting in 2018. However in 2026 individual federal income tax rates will go back up resulting in a significant tax increase for many American families .  Roth conversions could help many plan to avoid the pain of this planned tax increase by balancing current lower taxes against future higher taxes. To do this successfully requires careful evaluation of current and future taxable income. Planning Roth conversions from 2018 to 2025 could pay significant rewards by lowering taxes after 2026.

The key challenge for retirement contributors would be to calibrate the right amount of Roth conversion or Roth contributions so as to minimize current and overall taxes owed.

Because each situation will be different, it will pay to check with a Certified Financial Planner to estimate future income and tax rates, and to plan a strategy that will maximize your financial well being.

 

Check out our other posts on Retirement Accounts issues:

Rolling over your 401(k) to an IRA

7 IRA rules that could save you time and money

Doing the Solo 401k or SEP IRA Dance

Tax season dilemna: invest in a Traditional or a Roth IRA

Roth 401(k) or not Roth 401(k)

 

 

Note 1: this post makes assumptions regarding potential individual tax situations. It simplifies the many factors that enter into tax calculations. It omits many of the rules that are applicable to Roth accounts and Roth conversions. It also assumes that the TCJA will be unchanged.  None of these assumptions may be correct. Please check with the relevant professionals for your individual situation.

Note 2: Insight Financial Strategists LLC does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Insight Financial Strategists LLC cannot guarantee that the information herein is accurate, complete, or timely, and  makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

Jan 16

Is 2018 the Year of the Roth 401(k) or the Roth IRA?

By Chris Chen CFP | Financial Planning , Investment Planning , Retirement Planning , Tax Planning

Is 2018 the Year of the Roth 401(k) or the Roth IRA?

Much of the emphasis of the Tax Cuts and Jobs Act (TCJA) passed in December 2017 affected individual income taxes. However, there are also impacts on investment strategies.

From an individual standpoint, the primary feature of the TCJA is a reduction in income tax rates.  Except for the lowest rate of 10% all other tax brackets go down starting with the top rate which drops from 39.6% to 37%.

2018 MFJ Tax Table

 Table 1: 2018 Tax Rates for Married Filing Jointly and Surviving Spouses

Even then, not everyone’s income taxes will go down in 2018 . That is because some of the features of the bill, such as the limitation on State And Local Taxes (SALT) deductions,  effectively offset some of the tax rate decreases.

However, in general, it is safe to say that most people will see a reduction in their federal income taxes in 2018. Of course, this may prompt a review of many of the decisions investors make with taxes in mind.

Retirement is one area where reduced income taxes may have an impact on the decision to invest in a Traditional or a Roth 401(k) or IRA . The advantages of tax-deferred contributions to retirement accounts, such as Traditional 401(k) and IRAs, are also tied to current tax rates. In Traditional retirement accounts, eligible contributions of pre-tax income result in a reduction in current taxable income and therefore a reduction in income taxes in the year of contribution.

Most people expect to make the same or less income in retirement compared to working life, and thus assume that their retirement tax rate will be equal to or lower than their working year tax rate. For those people, contributing pre-tax income to a Traditional retirement account comes with the possibility of reducing lifetime income taxes (how much you pay the IRS over the course of your life).

Most people are pretty excited to see their taxes go down this year! However, the long-term consequences of the tax decrease should be considered.  While the TCJA was passed with the theory that it would stimulate growth such that tax revenues would grow enough to make up for the increased deficit created in the short term by tax cuts, few serious people believe that.  The most likely result is that we will experience a small boost in growth in the short term and that federal deficits and the National Debt will seriously increase thereafter.

In the opinion of the non-partisan Committee for a Responsible Federal Budget, not even the expectation of additional short-term growth is enough to temper the seemingly irresistible growth in the federal debt.

TCJA impact on the National Debt

Increased deficits will make it more difficult to fund our national priorities, whether it is defense, social security, healthcare, or investment in our national infrastructure.  Therefore, I expect that we will initiate another tax discussion in a few years, most likely resulting in tax increases, in addition to the automatic tax increases that are embedded in the TCJA.

With federal income tax rates down in 2018 and our expectation that individual taxes will start increasing after 2018, now may be the time to consider a Roth instead of a Traditional account. The consideration of current and future tax rates remains the same. It just so happens that with lower tax rates in the current year, it becomes marginally more attractive to consider the Roth instead.

Consider the case of Lisa, a married pharma executive, making $225,000. This places her in the 24% federal tax bracket. In 2018, her $10,000 Traditional 401(k) contribution reduces her income taxes by $2,400. In 2017, Lisa would have been in the 28% tax bracket. Her $10,000 Traditional 401(k) contribution would have resulted in a $2,800 reduction in income taxes. Hence, Lisa’s tax savings in 2018 from contributing to his 401(k) goes down by $400 compared to 2017.

Federal income tax impact on a $10,000 Traditional 401(k) contribution Table 2: Tax savings on a 401(k) contribution with $180,000 taxable income

From a tax standpoint, contributing to a Traditional 401(k) is still attractive, just a little less so.  To optimize her lifetime tax liabilities, Lisa may consider adding to a Roth 401(k) instead, trading her current tax savings for future tax savings. If Lisa were to direct the entire $10,000 to the Roth 401(k), her 2018 income taxes would increase by $2,400 compared with 2017. Why would Lisa do that? If she expects future income tax rates to go back up, she could save overall lifetime taxes. It may be an attractive diversification of her lifetime tax exposure.

For instance, suppose now that the national debt does grow out of hand and that a future Congress decides to increase tax rates to attempt to deal with the problem. Suppose that Lisa’s retirement income places her in a hypothetical future marginal federal tax rate of 30%. In that case, she will be glad to have invested in a Roth IRA in 2018 when she would have been taxed at a marginal rate of 24%: she would have saved on her lifetime income taxes.

Of course, if Lisa’s retirement marginal tax rate ends up being 20%, she would have been better off saving in her Traditional 401(k), saving with a 28% tax benefit in her working years and paying retirement income tax at 20%.

Note also that Lisa would not have to put the entire $10,000 in the 401(k). She could divide her annual retirement contribution between her Roth and her Traditional accounts, thus capturing some of the tax advantages of the Traditional account, reducing the tax bite in the current year, and preserving a bet on a future increase in income tax rates.

Another possible course of action to optimize one’s lifetime tax bill is to consider a Roth conversion. With a Roth conversion, you take money from a Traditional account, transfer it to a Roth account, and pay income taxes on the distribution in the current year.  As we know, future distributions from the Roth account can be tax-free, provided certain conditions are met . A distribution from a Roth IRA is tax-free and penalty free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you have reached age 59½, become disabled, you make a qualified first-time home purchase, or you die. (Note: The 5-year aging requirement also applies to assets in a Roth 401(k), although the 401(k) plan’s distribution rules differ slightly; check your plan document for details.)  Because tax rates are lower in 2018 for most individuals and households, it makes it marginally more attractive to do the conversion on at least part of your retirement funds.

Consider David, a single pharma marketing communications analyst. With $70,000 in taxable income, he is now in the 12% marginal federal income tax bracket, down from the 25% federal income tax bracket in 2017. He is working on his part-time MBA in 2019 and expects his income to jump substantially as a result. Additionally, David, a keen student of political economy expects his taxable retirement income to be higher than his current income and overall tax rates to go back up before he reaches retirement.  David now has a sizeable Traditional IRA.

For David, the opportunity is to convert some of his Traditional IRA into a Roth IRA. To do that, David would transfer some of his Traditional IRA into a Roth IRA. He would pay income taxes on the conversion amount at his federal marginal rate of 22%. David would only convert as much as he could before creeping into the next federal tax bracket of 24%. If he feels bold, David could contribute up to the 32% federal tax bracket. Effectively this means that David would stop converting when his taxable income reaches $82,500 if he wanted to stay in the 22% tax bracket, and $157,500 if he wanted to stay in the 24% tax bracket.

In this example, if David were to convert $10,000 from his Traditional IRA to his Roth IRA, he would incur $2,200 in additional federal income taxes. If David expects to be in a higher tax bracket in retirement, he would end up saving on his lifetime income taxes.

David could combine this strategy with continuing to contribute to his Traditional 401(k), thus reducing his overall taxable income, and increasing the amount that he can convert from his IRA before he hits the next tax bracket.  If he were to contribute $10,000 to his Traditional 401(k) and convert $10,000 from his Traditional IRA to a Roth IRA, you could view this as a tax neutral transaction.

Federal tax impact on a $10,000 Traditional 401(k) contribution and $10,000 Roth conversion

Table 3: Balancing a Traditional 401(k) and a Roth Conversion

This strategy may work best for people who expect to have a reduced income in 2018. Maybe it is people who are back in graduate school, or people taking a sabbatical, or individuals who are no longer working full time while they wait to reach the age of 70 and start collecting social security at the maximum rate.

It is worth remembering that Roth accounts are not tax-free; they are merely taxed differently . That is because contributions to a Roth account are post-tax, not pre-tax as in the case of Traditional accounts. You should note that the examples in this article are simplified. They do not take into account the myriad of other financial, fiscal and other circumstances that you should consider in a tax analysis, including your State tax situation. The examples suppose future changes in taxes that may or may not happen.

If you believe, as I do, that tax rates are exceptionally low this year and will go up in the future, you should have additional incentive to analyze this situation. The decision to contribute to a Roth IRA or 401(k) works best for people who expect to be in a similar or higher tax bracket in retirement , and have at least five years before the assets are needed in order not to pay unexpected penalties. Is that you? The financial implications of whether to invest in a Roth instead of a Traditional account can be complex and significant . They should be made in consultation with your Certified Financial Planner.

 

Check out out other retirement posts:

Seven Year End Wealth Management Strategies

Is the new tax law an opportunity for Roth conversions

Rolling over your 401(k) to an IRA

7 IRA rules that could save you time and money

Doing the Solo 401k or SEP IRA Dance

Tax season dilemna: invest in a Traditional or a Roth IRA

Roth 401(k) or not Roth 401(k)