Part 1 of our Tax Reform article series discussed how to bunch deductions to get the most from your Schedule A Itemized Deductions in light of the changes to the standard deduction and Schedule A deduction limitations imposed by the 2017 Tax Cuts and Jobs Act. 

Part 2 of our Tax Reform article series reviewed how the spread between ordinary income tax rates and long-term capital gains rates has narrowed and how this might offer more opportunities to sell appreciated assets.

Today’s article focuses on how to take advantage of your lower tax bracket and convert some of your tax-deferred accounts to tax-free accounts. 

You, like many investors, accumulate wealth by making tax-deferred contributions to your employer-sponsored retirement plans such as 401ks, 403bs, and TSPs.  This is a common and successful way to build your assets.   When you change jobs or retire, you may choose to rollover these retirement accounts to an IRA.   All these plans:  401ks, 403bs, TSPs, IRAs allow you to contribute pre-tax dollars to an investment account.  These accounts grow tax-deferred.  Any distributions after age 59 ½ are treated as ordinary income and taxed based on your marginal income tax bracket.

When you reach age 59 ½, you may still be working and don’t need the extra money so you, like many, choose to keep your money in your tax-deferred account where it can continue to grow. 

Fast forward 11 years.   At age 70 ½, the IRS requires you to take a minimum distribution from your tax-deferred accounts.  These required minimum distributions (RMDs) must be taken for the remainder of your life or until the account is depleted.   All these distributions will be taxed at your ordinary income tax rate. 

Before you sit back and wait for 70 ½ to sneak up on you, consider how the current tax law change can benefit you now and in the future.  One of the benefits of the 2017 Tax Cuts and Jobs Acts is that income tax rates have been reduced across the board.   And, the income tax brackets have broadened.   

Let’s talk real numbers.  If you are married, filing jointly, you will only pay 24% income tax on income between $165,001 and $315,000.     Under the old tax rates, income between $153,101 – $233,350 was taxed at 28% and income between $233,350 – $416,700 was taxed at 33%.   If your income falls between $165,001 – $233,350, you are paying 4% less in taxes.   If your income falls between $233,350 – $315,000, you are paying 9% less in taxes. 

Remember these tax rates are only effective through 2025.  Why not take advantage of that tax reduction now by paying taxes on your IRA distributions before you reach age 70 ½.   If you don’t need the money, go one step further and convert those IRA distributions to a Roth IRA that can continue to grow.  Roth IRAs have no required minimum distributions and all withdrawals are tax-free.

Let’s review.  We know that you must take distributions from your tax-deferred accounts at age 70 ½ and pay taxes, at your current tax rate (whatever it will be), on these distributions.    There’s no changing that.  

But, if you convert a portion of your tax-deferred account to a Roth IRA now, when tax rates are lower, you have now positioned some of your retirement money into a tax-free vehicle.    Some real-life application might help.

We’ll assume the following:

Current income:  $275,000

Current tax bracket:  24%

Value of IRA:  $700,000

You don’t want to pay more taxes than your current tax bracket of 24%.   We know that income up to $315,000 is taxed at 24%.    You can convert $40,000 ($315,000 – $275,000 = $40,000) of your IRA to a Roth IRA and only pay 24% tax on that conversion.     That $40,000 will still be invested for growth, but you will never pay tax on it again.   Your IRA is now worth $660,000.   Your Roth IRA is now worth $40,000.

If you continue doing this annually while tax rates are low, you could effectively position a good chunk of your IRA into a Roth IRA before you reach age 70 ½.   At age 70 ½ you are only required to take a distribution from your IRA not from your Roth IRA.   Because the total value of your IRA has been reduced, the required taxable distribution is also less, saving you taxes during your retirement years.

What are the pitfalls?   First, you need to be at least 59 ½ before taking distributions (or Roth conversions) from your IRA to avoid an early withdrawal penalty.   The funds must stay in the Roth IRA for at least five years before making withdrawals from the Roth.    When determining your income bracket you need to be sure to include all sources of taxable income like wages, bonuses, dividends, interest, etc.  You don’t want a Roth conversion to push you into a higher tax bracket. 

With any tax strategy, you will want to work with your tax advisor to ensure that this strategy is right for you.   Give us a call if you want to run some preliminary numbers to see the impact of a Roth conversion on your bottom line.

Securities offered through The Strategic Financial Alliance, Inc. (SFA), Member FINRA/SIPC. Advisory Services offered through Strategic Blueprint LLC. and The Strategic Financial Alliance, Inc. SFA and Strategic Blueprint are affiliated through common ownership but otherwise unaffiliated with Keen & Pocock.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary.  The SFA or Keen & Pocock do not provide tax or legal advice.