When you contribute to an IRA, a 401k, 403b, 457, TSA, TSP, or any other type of tax-deferred vehicle, the IRS allows you to invest their dollars alongside of your dollars for as long as you leave the money invested. So you do not pay Federal income tax in the contributions, and you do not pay Federal income tax on the growth.
However, in exchange, you must pay ordinary income tax on the proceeds when you take it out. How much income tax will you pay? That depends on many factors. If you have been investing for several decades, then you may remember someone telling you many years ago that you should not pay income tax when you are working and are in a higher bracket. You should invest in a tax-deferred vehicle and instead pay the taxes when you are in a lower tax rate.
So where will tax rates be in the future? There are as many opinions on this as there are investors and experts providing those opinions. The Tax Cuts and Jobs Act of 2017 provided some of the lowest tax rates we have seen in decades. Yet that Act has a Sunset Provision, meaning that, in the absence of some other action on the part of Congress, after December 31st, 2025, those tax rates will go back to where they were in 2017. Many people, both working and retired, are experiencing some of the lowest tax rates they have seen or may see in the future.
More and more retirees are finding that they are in lower tax brackets, not just because they are no longer working but also because the actual tax rates are lower than they were before. Once those tax rates expire or are changed by Congress, many will find their tax bill increasing.
Let me give you an example based on the brackets that I most often see. Let’s use Bob and Mary Smith. Bob and Mary Smith have a pre-tax household income of $150,000. The first $24,400, they pay Federal Income Tax of Zero because of their standard deductions. The next $19,***, they pay 10%, which is the same before and after the tax change. The next $59,***, they pay 12%, which was 15% before the TCJA, and the last $4*,***, they pay 22%, which was 25%. This couple, under the TCJA, could increase their household income all the way up to $326,000 and still only pay 24% on income dollar $326,001. Yet, once the TCJA expires or is changed, their income could come down by $222,000, and still their next dollar would be taxed by more—25% instead of 24%.
What if we could lock in today’s tax rates on some portion of your pre-tax savings? What if you feel that your current 12%, 22%, or 24% tax rate is actually a good deal? How do we lock in today’s rate? You can do that through a Roth Conversion. By converting some portion of your pre-tax dollars to a Roth, you pay the income tax now at today’s rates. Then, assuming you satisfy a waiting period of 5 years and do not take withdrawals before age 59 ½, then all of the growth and all of the withdrawals will be income tax-free.
Some might say, “I don’t want to pay tax now when I can put it off for the future.” For too many people, the goal of the pre-tax account seems to be to put off paying the taxes as long as possible. What if we approach it less from trying to forecast when the lowest possible tax is going to be. What if, instead, we gauge the success as being able to pay a lower percentage of tax when we take it out (or Roth-Convert it), than we would have paid when we put it in? What if you were working and had a marginal income tax of 28% and now have a marginal income tax of 22%. Is paying 22% better than paying 28%? Of course, you would rather pay the lower amount.
Here is what I am suggesting: let’s spend less effort trying to figure out what taxes will be in the future. As we watch the U.S. Debt increase year after year, it is not hard to guess which direction taxes are likely to go. From another angle, if you tried to name five politicians who are pushing for lower taxes, could you do it?
But let’s not even assume all of that for now. Let’s spend more effort determining whether your marginal tax rate is lower today than it would have been when you contributed.
If the stock market is higher today than it was last year, does that mean that you should not invest in it? To the contrary, we see that the long-term trend of the market is up. So why worry so much about whether taxes are or are not the lowest they can possibly be? If your tax rate is lower than it has been before or it is lower than you think it might be in the future, this may be the time to do some proactive tax planning.