With the tax filing deadline tomorrow, most of us will be trying to put income taxes out of our mind for the next year. This would be a mistake, because with the passage of the Tax Cuts and Jobs Act (TCJA) in late December come new strategies in 2018 to reduce your tax bill. More than ever, tax-free accounts are a smart move for most of us.
What are these tax-free accounts? They’re nothing new as they have been around for almost a generation since 1997. Roth IRAs and retirement plans allow you contribute money that has already been taxed and invest it in mutual funds, stocks, and other assets. If you use Roth accounts correctly, the growth of the investments inside Roth IRAs will not be taxed in your lifetime, and possibly those of your children depending on your personal financial goals.
Most of us can contribute $5,500 a year ($6,500 for those 50 and older) as long as we have earned income and don’t have a Modified Adjusted Gross Income over $186,000 (married filing jointly) or $118,000 (single) for 2017. The deadline for contributions for 2017 is tomorrow so make them today, if you haven’t already. Even if your earnings exceed these levels, you may have access to a 401(k) or 403(b) retirement plan at work that permits you to make Roth contributions. Unlike Roth IRAs, there are no income limits to contributing to Roth retirement accounts. Just like Roth IRAs, Roth retirement accounts allow you to deposit funds that will never be taxed under current law.
Roth accounts could give you a century of growth because unlike IRAs and other pre-tax accounts, Roth IRAs do not have required minimum distributions (RMDs) when you turn 70 ½. In fact, you can still contribute to Roth IRAs into your 70s and 80s as long as you have the earned income. It’s true that Roth retirement plan accounts have required distributions, but those accounts can be rolled over into a Roth IRA.
Plus you can leave your Roth IRA to your children and other younger heirs. Inherited Roth IRAs do have RMDs, but the inheritors usually must withdraw (tax-free) a small percentage of the account each year. In the meantime they get the wonderful tax-free growth of a Roth.
Financially astute readers may agree with all of this Roth love, but may wonder what has changed with the new tax law. The primary reason is that this year most of us will see a decline in our marginal tax rate. That’s the tax rate that applies to our final dollar of income, which is important when considering a Roth.
Let’s consider the case of two upper middle income families with taxable incomes after deductions of $160,000 and $240,000. In 2017 those families had marginal federal income tax rates of 28 percent and 33 percent respectively. For 2018 both families will be paying a marginal rate of 24 percent, which is shockingly low given historical tax rates.
With annual federal budget deficits now projected to exceed $1 trillion
annually, we can reasonably speculate that individual income tax rates will increase over the decades to come. When you decide to put funds into a Roth retirement account, you are making a decision to pay taxes today to avoid them for the future. I would contend that the case is stronger for Roth retirement account contributions than it ever has been before.
The same calculus applies to Roth conversions, which is the process of moving from pre-tax traditional IRAs or retirement accounts into tax-free Roth accounts. With a Roth conversion you pay income tax on the amount you convert over to tax-free Roth accounts. Just like the case with Roth retirement plans, with a Roth conversion you are choosing to pay taxes now to avoid them later. Be careful with Roth conversions as new rules in 2018 make them impossible to reverse. You may find the income from a Roth conversion can eliminate health insurance subsidies if you’re on an Obamacare health plan or can eliminate education or other tax credits.
Finally, the new tax law formalized the approval of so-called backdoor Roth contributions. This is a method for higher income earners to effectively contribute to a Roth IRA even if they exceed the income limits. In order for it to work well, you need to have little or no traditional IRA balance in any account and a good tax preparer.