A few years ago, the Tax Cuts and Jobs Act of 2017 cut income taxes for most Americans. Few remember that these lower rates were temporary and are scheduled to spring back to their old, higher rates on January 1, 2026. That’s a little over two years from now.
For those in the highest tax bracket, that means their marginal rate will rise from 37% to 39.6% with taxpayers in other brackets also seeing a bump up. While Congress could still act to extend or make these lower rates permanent, current law says they are scheduled to go up.
What should you do?
Planning for changes in the tax law is not easy. Congress could act but only if they have enough votes to make the change. With the current Congress closely divided and the Senate almost evenly divided, it is hard to say. Plus, any new legislation would require the President’s signature.
In thinking about these higher rates, we like to lay plans based on what we know. We know that rates are set to rise. So, what would be some good strategies?
What do you really have in your retirement accounts after taxes?
Many investors who are saving for retirement have 401(k) or IRAs with significant balances of pre-tax money. With these traditional retirement accounts, investors receive a tax deduction at the time of contribution but must pay income taxes when its time to withdraw funds, usually at retirement. For many, this approach is “kicking the tax can down the road” because they get the tax deduction now but have to pay later. This approach tends to make the most sense for those in higher tax brackets and for older taxpayers. However, I think that many people underestimate how much of their retirement account withdrawals will have to be put towards income taxes. A million-dollar retirement account may sound like a lot but if 37% to 50% of each withdrawal must go to federal and state income taxes,1 that may mean your million-dollar 401(k) is really only $500,000 or so. That’s a lot less than a million.
Start making Roth conversions now
If you have a pre-tax retirement account, most allow you to convert it to an after-tax or Roth account. You can even do this conversion inside of a 401(k), if the plan allows it (It’s called an in-plan conversion). By converting your traditional, pre-tax 401(k), 403(b) or IRA now, you’ll need to pay income tax on the amount converted. This strategy usually only makes sense if you have separate cash outside of the retirement account to pay the tax. In other words, it typically does not make sense to withdraw some of the account to pay the additional tax due.
High income savers who are close to retirement tend to have large balances. From a practical standpoint, it may not make sense to convert the entire retirement plan account because the amount of the conversion is added to your taxable income for that year. That could push you into a higher tax bracket or have other unintended consequences. So, making smaller conversions each year up until the end of 2025 might be a good alternative.
If you are trying to figure out how to make the most of the low tax rates now before they go up, give me a call or call your tax professional. We’re here to help. You can schedule a quick call with me by clicking HERE.
Lyman H. Jackson
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· High expectations for retirement https://planwithfps.com/blog/high-expectations-for-retirement
1The current top federal income tax rate is 37% plus the Net Investment Income tax of 3.8% plus the add-on tax for Medicare of 0.9% plus state income taxes (if any).
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