The world’s best winter Olympic athletes meet in PyeongChang. Alpine skiers Vonn, Shiffrin, Ligety, Nyman and their teammates have a job which is basically to get from the starting gate to the finish line with a few obstacles to navigate in between. They face conditions they cannot control – weather, visibility, and snow to name a few. However, they can focus on the things they can control including the line or track they’ll take. And we’ll root them on their way to hopefully gold and joy.
Managing personal finances, and life, have similarities. We’re trying to get to where we want to be, with life’s surprises helping or hindering our progress. Either way, we adapt and adjust course and tactics. One area of change currently is tax reform (Note: there are plenty of other commentators talking about shifts in investments). Tax rates have been reduced. What if Congress hikes future tax rates? Thus, Roth IRA conversions might be a smart conversation with your CPA and financial advisor.
There are two types of IRAs – traditional versus Roth IRAs. Generally, the decision to contribute currently ($5,500, or $6,500 if you’re 50 or older) to either a Roth or traditional IRA is largely based on current versus future expected tax brackets. If future brackets are higher, then consider a Roth, and if lower, then consider the other. In traditional IRAs, you may get a tax deduction up front for the contribution, the monies grow tax deferred, and future retirement withdrawals are taxable as ordinary income (Note: non-deductible contributions may be non-taxable). Roth IRAs are treated the opposite. You contribute money on an after-tax basis, monies grow tax deferred, and generally, if withdrawn during retirement, those retirement checks are non-taxable.
To summarize, Roth IRAs are generally better for people who are in low or relatively lower tax brackets while they’re saving versus when they later retire. (Please note, taxes are complex, I’m oversimplifying this for discussion purposes, and you should seek expert tax advice from your CPA relevant to your specific situation).
But wait, there’s one more thing – are you earning too much money that would prohibit you from making a Roth IRA contribution? For 2018, the phase out for Roth IRA contributions is MAGI between $189,000 and $199,000 for married, and $120,000 to $135,000 for single.
However, regardless of your income level, you may be eligible to convert a traditional IRA account to a Roth IRA. Consider the expected differential between current and future tax brackets as previously discussed. The conversion will trigger taxation of the IRA amount. If you convert a $100,000 IRA, then you’ll have an additional $100,000 of taxable income. In essence, you’re making a long-term bet for higher income tax rates and buying out Uncle Sam early.
There are two things about Tax Reform relevant to Roth IRA conversions. First is the elimination of the “do over” option after 2017 – you formerly could change your mind and “undo” a Roth IRA conversion as late as October 15th of the following year. Second, the tax brackets are lower under Tax Reform. If you are high income and are considering Roth IRA conversion, the amount may have been taxed at rates ranging from 28% to 39.6% – under Tax Reform, it might “only” be taxed at 24% to 38.5%. And consider future tax policy. If nothing is done, the old tax brackets return in 2026. And if, the US deficit widens due to insufficient revenue (taxes) or higher expenses (more services, higher interest expense on government debt, etc.), what’s the bet for higher tax rates?
This is one more planning “what if” to consider – a window of potentially lower income tax rates. But save yourself, and your CPA, the bother if you’re one of the fortunate savers who will be passing wealth on to your heirs. If that’s the case, why are you paying taxes for your kids’ inheritance?