Maximize Your Tax Strategy: Exploring Possible Tax Rate Changes
The Tax Cuts and Jobs Act (TCJA) of 2017 made several changes to the tax code, including reducing individual tax rates. These tax rates are scheduled to sunset in 2026, meaning that they will revert to pre-TCJA levels unless Congress takes action to extend them. You can see the potential moves by looking at the chart below, with the 2026 tax rates on the very right.
How do Roth conversions relate to this change?
Roth conversions allow you to move money from a traditional IRA to a Roth IRA.
Traditional IRAs are tax-deferred, meaning that you don't pay taxes on the money you contribute until you withdraw it in retirement.
Roth IRAs are tax-free, meaning that you pay taxes on the money you contribute upfront but don’t pay taxes when you withdraw in retirement.
Roth conversions can be especially beneficial for people who expect to be in a higher tax bracket in retirement than they are now. This is because you will pay taxes on the Roth conversion amount at your current tax rate. If your tax rate is higher in retirement, you will end up paying more taxes overall. This is important because as the rules sit today, you will be in a higher tax bracket after 2026, even if your spending stays the same unless Congress takes action to keep tax rates low. However, with the debt ceiling climbing and interest rates on our national debt soaring, it looks very unlikely that they will not take this opportunity to raise taxes.
The good news is if we are incorrect in our assumption that they will raise taxes and they do keep tax brackets the same, it will not harm your situation. This is because of the principle of tax equivalence. If tax brackets do not change after 2026, it is ultimately a wash if you were to stay in the same tax bracket. This principle states that the tax burden on two investments with the same after-tax returns is the same, regardless of the tax treatment of the investments upfront.
In other words, if you convert your traditional IRA to a Roth IRA and stay in the same tax bracket, you will end up paying the same amount of taxes in retirement on the converted money as you would have if you had left it in your traditional IRA. So, if you are currently retired and plan on spending relatively the same amounts throughout your retirement, Roth conversions before 2026 could benefit your situation.
Overall, whether or not to do a Roth conversion in light of the sunsetting of the TCJA is a complex decision that depends on your financial situation. There are a lot of moving parts that can be affected using this strategy, such as Social Security taxation, IRMA surcharges for Medicare, changing your AGI, which could affect some tax-favored benefits, and much more.
You must speak with a professional before executing this strategy. For our current clients, we review these scenarios for you at the end of every year as our end-of-year planning kicks off. We will be sure to contact you if we believe this strategy could potentially be beneficial. If you aren’t currently working with us and believe that this may be right for you, please schedule a meeting, and we can discuss more!
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