With the Tax Cuts and Jobs Act, passed late in 2017, federal income tax rates are currently at historic lows. These lower rates in effect for tax years 2018 through 2025. In 2026, however, rates will revert to higher rates under prior law.
The next several years present a significant opportunity for many to convert money from traditional IRAs and 401(k)s to tax free Roth IRAs. Doing so may substantially increase your spendable wealth after taxes.
TAX RATES
Generally, rates are now lower and brackets wider. Notice from the table below that under prior law the 25% tax bracket occurred at $77,401 of taxable income. Now a 24% tax rate holds all the way up to $315,000 of taxable income.
But these rates will rise in 2026. Persistent budget deficits and an aging demographic will put more strain on our government’s finances through spending on programs like Medicare, Medicaid, and Social Security. It is quite possible tax rates will not only revert but rise even more. The time to act is now.
| Taxable Income ($) | Expected 2018 Rates | Actual 2018 Rates |
| 1 – 19,050 | 10% | 10% |
| 19,051 – 77,400 | 15% | 12% |
| 77,401 – 156,150 | 25% | 22% |
| 156,150 – 165,000 | 28% | 22% |
| 165,001 – 237,950 | 28% | 24% |
| 237,951 – 315,000 | 33% | 24% |
| 315,001 – 400,000 | 33% | 32% |
| 400,001 – 424,950 | 33% | 35% |
| 424,951 – 480,050 | 35% | 35% |
| 480,051 – 600,000 | 39.6% | 35% |
| Over 600,000 | 39.6% | 37% |
| Actual rates resulting from Tax Cuts and Job Act. Expected rates were under prior law. | ||
CONVERTING TO ROTH IRAS
A Traditional IRA or 401(k) is an account funded with pre-tax dollars and taxes are paid at ordinary income rates when money is distributed. Required minimum distributions (RMDs) start at age 70½. It is not uncommon to find that RMDs have historically pushed successful families into higher tax brackets in retirement … the opposite of what they thought would happen.
A Roth IRA is funded with money that has already been taxed. Growth is not taxable and with Roth IRAs there are no RMDs. There are two ways to get money into the Roth account. You may be eligible for limited contributions to a Roth if your income is not over certain thresholds. Regardless of income, you may convert an unlimited amount from a traditional IRA to a Roth.
A conversion is taking money from your IRA or 401(k) and transferring it into a Roth IRA where the money will grow tax-free. This causes you pay tax on the amount converted to the Roth at today’s known tax rate.
While the tax-free growth of a Roth is well known and desirable, deciding whether to fund a Roth or converting funds to a Roth are less commonly understood. Simply stated:
“A Roth conversion makes sense whenever a you would pay a lower tax rate today than you would eventually pay if you did not make the conversion and later withdrew these funds from the traditional IRA or 401(k).” [1]
Historically, lower tax rates were achieved when you first entered retirement. You retired from what was likely your highest earning years. Plus, you have more discretion over how you are taxed as you withdraw money from various account types.
Now with lower tax rates from tax reform, many more Americans – and not just those in the earlier years of retirement – will find themselves in lower tax rates through 2025. By making conversions to a Roth IRA, you can pay tax at today’s known and likely lower rates. Doing so will also reduce your RMDs from traditional IRAs in future years and increase your spendable wealth over time.
Roth conversions aren’t for everyone. The devil is in the details. While tax reform was beneficial in many ways, it did eliminate the ability to recharacterize or undo your conversion. You must be precise. Ongoing tax projections and spreading conversions over several years are often advisable to avoid crossing into higher brackets.
For example, going over the 12% bracket causes a hefty increase in your tax rate to 22%. If 22% is lower than what you expect your rate to be in the future upon withdrawal, crossing into the 22% bracket can be okay. Otherwise, you want to avoid the higher bracket.
You still have time to act for 2018 and take advantage of lower rates. Doing so may allow you to retire sooner or spend more over time.
[1] William Reichenstein, Ph.D., CFA, Valuing Roth Conversion and Recharacterization Options, Journal of Financial Planning, November 2017.
