We've all heard the saying, "There are only two guarantees in life: death and taxes."
With that in mind, let's discuss the tax law that was passed under President Trump -- the Tax Cuts and Jobs Act of 2017. This law has changed the rules for at least a few years. Essentially, it created two tax cuts -- one for businesses, the other for individuals and couples.
The big difference between the two is that one is permanent, and the other is temporary. Can you guess which is permanent?
If you answered individual, you guessed wrong.
The tax cuts for individuals will expire in 2025. One bit of good news in that, is that in the meantime you have a great opportunity to use the cuts to help protect yourself and buy out your retirement "business partner." But just who would that business partner be?
I'll get to that in a moment ...
First, let's consider the current state of things as applied to taxes and retirement. The federal deficit continues to grow, which means at some point, in order to help take care of the deficit, taxes could go up.
How much could taxes be raised? No one can say for sure. But if you look at tax rates historically, it's clear that they can be higher -- even much higher -- than they were right before this latest cut.
Here are just a few examples from across the decades:
- 1998: Top marginal tax rate 39.6%
- 1985: Top marginal tax rate 50%
- 1979: Top marginal tax rate 70%
- 1962: Top marginal tax rate 91%
For 2018, the top marginal tax rate was 37%. Clearly, right now we are in a much better situation taxwise than in any of those preceding years.
So I want you to think about your retirement account -- whether it's a 401(k), 403(b), traditional IRA, etc. -- almost like a business. Your partner in this business is the U.S. government. The government says if you contribute money to this business (your retirement account) you don't have to report that contribution on your income taxes. That means you're getting a great benefit from the U.S. government by reducing your taxable income each year.
The government says, "We want you to continue to contribute, because it benefits you, and you'll save taxes along the way." But at some point, the government is also going to say it wants to be paid off on this business agreement. Of course, if you actually had a business partner who said something like that to you, you would naturally ask: "Paid off at what percentage?"
The government basically says: "We don't know; we'll get there when the time comes."
That's not exactly reassuring. But here's where your opportunity shows itself. Right now, during this low-tax period, you can essentially buy out the government at a lower rate than you might be able to in the future.
Let's explore how that can happen.
The case for a Roth conversion
When you contribute money into a tax-deferred retirement plan, there are rules that govern when and under what circumstances you can (or must) begin withdrawing the money. If you pull it out before you reach age 59½, you'll pay income tax on the withdrawal, as well as a 10% penalty. When you reach age 70½, the government says you must withdraw a certain amount each year (the required minimum distribution, or RMD) -- whether you want to or not. If you don't, the government penalizes you 50% of the RMD, plus you'll have to pay the income tax as well.
But look at this carefully. You have a strict rule governing this retirement money before you turn 59½. You also face a strict rule after you turn 70½. But if you're between the ages of 60 and 70, you are in a prime situation for a Roth conversion.
With a Roth IRA, one disadvantage is your contributions are not tax deductible. So there's no immediate tax gratification. The greatest advantage to you is that your money will grow tax-free for the rest of your life. Now why is this so important? As we discussed earlier, the tax rates could go up in the future.
By using a Roth conversion under current tax laws, you could be buying the government out at a potential discount. Yes, you pay income taxes when you make the conversion, but you might be doing so at a lower rate than you could face in the future. And the amount it grows after that becomes 100% yours.
With the Roth IRA, there also are no required minimum distributions (RMDs). You are not required to pull money out, you pay no taxes, and you get to choose when and how to pull the money or invest the money. That allows you to be 100% owner of your business.
There is a downside to a Roth IRA: You must keep the Roth account for five years for it to be truly tax-free. But look at how you could already benefit with the new tax laws. Take the example of a married couple, with annual taxable income of $160,000 who converted $200,000 to a Roth in 2017, before the tax changes. They would have paid $56,000 in income tax on that conversion at the 28% tax rate. That same couple in 2018, after the tax cut, would have paid $44,000 at the 22% tax rate.
An important takeaway is this: The government -- your business partner, remember -- will give you the right to exercise choice. And if you don't exercise choice, they surely will. Going with a Roth IRA means you buy out your business partner, and you maintain control.
If that's not retirement, I don't know what is.
Dan Dunkin contributed to this article.
Reid Abedeen is a partner at Safeguard Investment Advisory Group, LLC. As an Investment Adviser Representative and Insurance Professional (California license #0C78700), he has helped retirees with their financial issues for nearly two decades.
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