Some of the tax cuts that were passed as part of the 2017 Tax and Jobs Act (informally known as the Trump tax cuts) have an expiration date at the end of 2025, which brings a potentially significant increase in some taxes for Americans. This may be of special interest to retirees, who are already typically living on a reduced income and have less money to spare to taxes.
For instance, the top tax tier will revert from 37% back up to 39.6%. The standard deduction that had doubled will also return to its prior level, and several tax credits will revert to lower amounts or disappear (though it’s notable that both presidential candidates have said they aim to reduce taxes for most Americans should they be elected).
This sudden tax increase will be a shock to those who aren’t prepared, according to Stephen Kates, CFP, principal financial analyst for RetireGuide.com and a former wealth management advisor.
“It is expected that the restoration of the prior tax rules will increase average tax bills, with the largest increases impacting those with the highest incomes who do not own property,” he said.
There’s a Possible Solution for Retirees
While the next president may be able to reinstate or save those cuts, since that could take months or even years to be decided, there is one possible strategy that can help lower retirees’ taxable income: A Roth IRA conversion.
Roth conversions are wise moves in many cases, according to Joe F. Schmitz Jr., CEO of Peak Retirement Planning. “The concept is to move money from a tax-deferred retirement account into a Roth (after-tax) account that will grow tax-free,” he said.
Learn more about how and when you should consider a Roth conversion.
It’s All About Your Tax Rate
It’s important to understand your tax rate in the future to ensure you are not paying taxes on a Roth conversion at a higher rate today than you would in retirement once you factor in required minimum distributions (RMD), Social Security and possibly a pension, Schmitz said.
“If you do not have a pension, and your RMD is going to be relatively low, you may have a lower tax rate in retirement than you do now, and Roth conversions may not be advantageous for you,” Schmitz explained.
When To Make a Roth Conversion
Future tax policy is hard to predict, but acting on the knowledge you have today, controlled and annual conversions into a Roth IRA can be beneficial — especially for those who do not anticipate needing all of their retirement assets as income.
Roth conversions could also benefit you if you have a higher amount in tax-deferred investments, Schmitz said. “Typically, it starts to make more sense for those with $500,000 (or more) in tax-deferred investments.”
When Not To Make a Roth Conversion
However, there are some instances when making a Roth conversion is not a good idea. “I would not recommend Roth conversions for the sake of side-stepping any single-year tax bill,” Kates said.
Instead, consider how Roth conversions may reduce your total future taxes over the rest of your life, regardless of this particular tax law change. “If your required minimum distributions exceed your necessary withdrawals, then conversions to a Roth will greatly reduce your future tax bill, even if it may increase your near-term taxes,” Kates stated.
Split Your Conversions Over the Years
If possible, another approach, Kates said, is to split your conversions over multiple tax years and coordinate with an accountant to balance the phantom income with your current income so that you don’t breach higher tax brackets during this process.
“Market downturns are the best time to make conversions because the smaller dollar values will require less tax.”
You can also consider Roth 401(k) or backdoor Roth contributions for new money contributions so you are not adding to the balance of pre-tax money that needs to be converted later, Kates said.
Either way, consult with your financial planner to determine if Roth conversions make sense for your situation and how much you should look to convert each year to achieve the most optimal outcome.
