Thanks to the Tax Cut and Jobs Act of 2017, your tax bracket has declined this year, and that’s obviously a good thing. Many retirees still pay taxes on Social Security, annuity payouts, pensions, and perhaps earnings from a part-time job. This tab will decline.
And you might get even more bang for your buck if you think more expansively about the benefits of the tax cut. Specifically, this might be the time to convert part of your traditional IRA to a Roth IRA, which, unlike a regular IRA, does not require you to start making withdrawals at age 70 ½ and does not incur income taxes on withdrawals when you do make them.
Neither do the withdrawals count in the calculations for taxing Social Security benefits or determining Medicare premium surcharges.
These benefits, of course, are not free. To capitalize on them, you have to pay ordinary income tax rates on withdrawals when you make them. The Roth IRA is all about pay now, play later.
Conversion from an IRA to a Roth IRA makes particular sense if you expect your income – and hence your income tax rate — to rise in the future. This isn’t true for the vast majority of retirees, but conversion now makes sense for them as well because of the new tax law.
Locking in your current tax rate makes the most sense when taxes are low. While they have been historically low for some time, the new tax law drove rates down even further and broadened some brackets considerably. For example, a single filer with $80,000 in taxable income is now in the 22% federal tax bracket, down from 25% under the old structure.
The $1.5 trillion Tax Cut and Jobs Act is scheduled to sunset by 2026 and could be extended by a future Congress, but the odds of that are poor because of swelling annual federal budget deficits – heading their way toward a whopping $1 trillion – and other factors.
The federal debt is already about $21 trillion, and ballooning debt will not only make it difficult to extend the life of this law but pressure the government to boost taxes to levels higher than in past years. Retiring baby boomers are living longer and hence putting a huge strain on the already-stretched Social Security, Medicare and Medicaid programs. The government could choose to cut these programs rather than raise taxes. This would encounter enormous political resistance, however, and the benefit cuts, even if implemented, may not be sufficient to put the debt and deficits on a viable path.
“Settle your tax bill when it is the lowest it will ever be,” says one wealth management expert. “There will never be a better time than now.”
This way, you are also less likely to make a big conversion amid a sky-high stock market – as we have today. If you made the conversion in one fell swoop today, your tax hit would be based on these high valuations.
It’s also important to know that you cannot make withdrawals from a Roth IRA until you’re at least 59 ½ and have at least one Roth IRA open for more than five years. Lastly, bear in mind that the new tax code makes conversions from traditional IRAs to Roth IRAs a one-way street. You are no longer allowed to characterize the conversion back to a traditional IRA if you change your mind.
So, make doubly sure you want to do the conversion before doing so and can afford the tax tab.
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