This is a golden opportunity for you to convert your traditional individual retirement account into a Roth IRA, financial professionals say.
That's because the GOP tax bill passed at the end of last year lowered the top individual income tax rate to 37% from 39.6%, and reduced many of the other rates as well.
That means if you convert your traditional IRA to a Roth and agree to pay taxes on those funds now, you will be paying at a lower rate than before. And of course, having to pay lower taxes also emboldens the case for opening a Roth from scratch.
Can't rates go lower still? In theory yes.
But for much of history, rates have actually been much higher: The top marginal rate hovered in the 50% range during much of the 1980s and was even higher at times before that. And it’s likely that income tax rates will rise — not fall — in the future, experts predict.
Part of that is because the ballooning federal debt will make it hard to lower taxes in the future. Plus, retired baby boomers will put a huge strain on already stretched Social Security, Medicaid, and Medicare programs. The government could choose to cut those programs rather than raising taxes. But it's likely that Washington will need to raise at least some additional money to address a federal debt that’s already around $21 trillion.
Rebecca Walser, a tax attorney and author of “Wealth Unbroken,” says you should consider paying taxes on your retirement savings now, as most people have an opportunity to lock in lower rates.
“Settle your bill when it’s the lowest it’ll ever be,” Walser says. “There will never be a better time than now.”
The case for converting your traditional IRA to a Roth
Remember how traditional and Roth IRAs differ.
In a traditional IRA, contributions you make are tax-deductible. So you don't pay taxes up front. But when it comes time to withdraw funds from your nest egg at retirement, the money that comes out will be taxed as ordinary income.
In a Roth, you get the reverse treatment. Contributions into these accounts are made with money you've already paid income taxes on. However, at retirement, funds can be withdrawn tax-free.
You need to fall under certain income limits to contribute fresh money into a Roth — for instance, married couples filing jointly with modified adjusted gross income of $199,000 or more are restricted from contributing in 2018.
However, people of all incomes can open a Roth and transfer their traditional IRA balances into it.
Why do that?
Well, you may feel that a Roth will be a better option — for instance because you're relatively young and you believe you'll be in a higher tax bracket later on in life. In that case, the recently passed tax cuts presents a real opportunity.
Also, if you enter retirement with your entire nest egg held in pre-tax dollars in traditional IRAs and 401(k)s, your money isn’t fully yours.
Say you’re single and in the new, 12% federal income tax bracket in retirement, and you collect an average amount of Social Security benefits each month.
If you withdraw an additional $10,000 from your traditional 401(k) or IRA, you’ll pocket only between $8,200 and $7,780, after paying between $1,800 and $2,220 in federal income tax, depending on how much of your Social Security benefits is subject to taxation, says Greg Geisler, professor of accounting at University of Missouri-St. Louis.
Subtract whatever you owe in state income tax on top of that, and you’ll keep even less. If income tax rates rise in the future, as many are predicting, the government’s cut will be bigger than it is today even if your own income doesn’t change.
Who shouldn't convert to a Roth?
Favorable climate aside, there are some groups of savers who wouldn't benefit from a Roth conversion.
For starters, people who don’t have sufficient funds outside of their IRA to pay the tax bill shouldn't make this move. “The number one rule is don’t use IRA money” to pay your Roth IRA conversion, says Jim Shagawat, a certified financial planner in Paramus, N.J.
Not only will you have to pay income taxes on any amount you withdraw — and a penalty if you do this before turning 59 1/2 — you’ll also remove that money from your nest egg and lose out on all future growth it could have earned.
And if you need to sell stocks from a taxable brokerage account to pay the taxes on the conversion, try to avoid selling securities that you've owned for less than one year, as you will incur short-term capital gains taxes on the sale, Shagawat says. These are taxed as ordinary income and do not receive the beneficial long-term capital gains rate, Shagawat says.
Another group of people who should be wary of conversions are those under age 65 who buy subsidized health insurance on the public exchanges. Because converting will increase your income for the year, it will also decrease the premium assistance you are eligible to receive from the government.
Also, if you plan to tap your savings in the near term, think twice about a Roth, as these funds lose certain tax benefits if withdrawn within five years.
Beware of the new Roth conversion caveat
There's a new rule you should know about: The GOP tax bill took away savers’ ability to re-characterize their Roth IRA to a traditional IRA. Until this year, savers who converted their traditional IRAs to a Roth had until Oct. 15 of the following year to change their mind and undo it.
This provision came in handy if the market tanked after you made the conversion. Say you converted $100,000 in January, but the market dropped 20% later in the year. Under the old rules, you could re-characterize your Roth so you wouldn’t owe taxes on the full $100,000 when your account is now valued at just $80,000.
Under the new rules, that $100,000 is added to your adjusted gross income for the year, and you’re taxed accordingly even though your account is now worth less.
Since the do-over option is done, “taxpayers need to be sure that the conversion is for them and stick to their long-term goal of settling their bill with the IRS for once and for all,” Walser says.
Time your Roth conversion right
Under the new rules, more investors will time their Roth conversions for year-end, experts predict. The sweet spot will be between Thanksgiving and mid-December, says Ed Slott, a certified public accountant and founder of IRAhelp.com.
Why? By that time, you’ll probably have a clearer picture of what your income will be for the full year — and whether you have enough outside funds to pay taxes on your conversion.
Also, if you wait until late December, financial institutions might be so busy that they limit the number of new transactions they allow, Slott cautions.
Staggering the conversion will help you minimize the tax bite. Some advisors suggest you convert 20% of your IRA each year over five years.
Others recommend converting just enough each year to keep you within your current tax bracket — in other words, watch that any additional amount that’s added to your income from the conversion doesn’t bump you up into a higher bracket.
Converting a traditional IRA to a Roth is ultimately a low-risk move for many investors, Slott says. “What have you got to lose?” he asks. “You’ll have a 0% tax rate in retirement.”