Keep your retirement plan on track by determining if a Roth is right for you.

If you have been following tax reform, you know the Tax Cuts and Jobs Act of 2017 (TCJA) lowered the marginal tax rate of five brackets. You also know if nothing is done to make these tax brackets permanent, there is a sunset provision (the tax brackets will revert to their old marginal rates after 2025).

This temporary reduction in marginal tax rates means many people should consider switching from tax deferred retirement contributions (Traditional IRA, 401(k), 457, or 403(b)) where they receive an immediate tax deduction (but pay tax upon withdrawal) to Roth retirement contributions, where they pay tax now but receive tax-free growth and withdrawals. In this article, we will explore the criteria to consider when deciding whether you should make the switch to Roth retirement contributions. Of course, every situation is unique, so no moves should be made without first consulting your financial adviser.

Old Marginal Tax Rate* New Marginal Tax Rate Taxable Income (Single Filers) Taxable Income (Married Filing Jointly)
10% 10% $0 — $9,525 $0 — $19,050
15% 12% $9,525 — $38,700 $19,050 — $77,400
25% 22% $38,700 — $82,500 $77,400 — $165,000
28% 24% $82,500 — $157,500 $165,000 — $315,000
33% 32% $157,500 — $200,000 $315,000 — $400,000
35% 35% $200,000 — $500,000 $400,000 — $600,000
39.60% 37% $500,000 and up $600,000 and up

Who should switch to Roth contributions?

The easiest way to determine if you should be making Roth contributions is to compare your current tax bracket to your future tax bracket. This is easier said than done, since we cannot predict future tax rates, nor can we know exactly what our financial situation will look like in the future.

Therefore, the most accurate way to predict your future tax bracket is to work with your financial adviser to construct a comprehensive financial plan based on your unique situation, realistic assumptions, and build tax projections based on this plan.

But what if you don’t have an adviser or don’t care to go into that level of detail? Here are a few situations where it might make sense to switch to Roth contributions:

1.     You are currently in the 22% or 24% marginal bracket (taxable income between $77,400 and $315,000 Married Filing Jointly)

In general, people have lower taxable income when they are retired. Historically, it has made sense to contribute to a tax deferred plan, receive the immediate deduction, and withdraw at a lower tax rate in retirement. However, in the process of updating our clients’ financial plans based on this new tax reform, we have found that many who are currently in the 22% and 24% tax brackets now will be in the 25% tax bracket in retirement, should there be a tax reform sunset.

With a sunset, you will only need $77,400 (MFJ – this number will be adjusted for inflation) of taxable income to be in the 25% bracket. This means you may be receiving an immediate deduction of 22%-24% but will pay 25% tax on withdrawals in retirement later.

To illustrate this point: if you made $20,000 of tax-deferred contributions today in the 22% tax bracket, you would save $4,400 in current taxes. If we assume these investments double by retirement and you find yourself in the 25% tax bracket, you will pay $10,000 (0.25 x $40,000) in taxes upon withdrawal. Basically, you are unnecessarily paying extra tax!

2. You have a high level of retirement income

If your combined Social Security, pensions, and other sources of guaranteed, taxable income are over $100,000, there is a very good chance you will be in the 25% tax bracket or above in retirement in the case of a tax code sunset. If this is you, check line 43 of your form 1040 to determine your current taxable income and use the table above to see if you are currently in a lower marginal tax bracket.

3. You will be subject to large Required Minimum Distributions (RMDs)

Tax deferred accounts in general are subject to a withdrawal schedule once you reach age 70 1/2. If you have saved a significant amount in tax deferred accounts or will receive a lump sum from your employer that you plan to roll into an IRA, you may spike your tax bracket in the future.

A retiree with $2m in tax deferred accounts would be forced to withdrawal roughly $73,000 for their first RMD. These distributions are taxable at ordinary income rates. Roth IRAs are not subject to a mandatory withdrawal schedule, allowing you to keep your money growing tax-free.

4. You pay little to no federal income tax

According to the Tax Policy Center they estimate 45% of tax filers will have a zero federal tax liability this year under the new tax code. If you won’t be paying any tax, or your effective rate is very low it doesn’t make sense to take an immediate tax deduction that provides little to no benefit. Consider this example: A couple with four children has combined salaries of $100k and after pre-tax payroll deductions (not including retirement contributions) their “wages” on line 7 of the 1040 equals $90,000. Utilizing the new Standard Deduction of $24,000 their taxable income is $66,000 and their tax liability would be roughly $7,539, but with the enhanced child tax credit of $2,000 per qualifying child they could claim $8,000 in credits completely wiping out their federal tax liability. In this case they would want to contribute their retirement savings to Roth.

5. You own rental properties

In the early years of building a rental property portfolio the income is offset by depreciation and mortgage interest. Over time, rents increase, you pay off the mortgage, and the property is fully depreciated resulting in owing tax at ordinary income rates. This can cause you to be in a lower tax bracket now and a higher tax bracket in the future, which is the ideal scenario for saving to Roth accounts.

6. You have an inheritance goal

If you plan to leave money to your heirs a Roth account is a great vehicle for this. Since the Roth IRA isn’t subject to RMDs you can keep this money growing tax free, without required withdrawals during your lifetime. Your spouse as the primary beneficiary could assume the Roth IRA as their own and allow the account to continue to grow tax free without withdrawals. Once the account passes to non-spouse heirs they can receive the funds in a Beneficiary Roth IRA account, which will have a mandatory distribution schedule but allows them to stretch out the tax-free growth over their life expectancy. This strategy is even more powerful if your heirs are in a higher tax bracket than you and/or live in a state with higher income taxes.

7. You have maximized all your Tax Deferred Accounts

If you have a high savings rate and are looking to contribute as much as you can to tax deferred accounts, Roth accounts allow you to contribute more net of tax. Yes, a Traditional 401(k) and Roth 401(k) have the same annual contribution limits of $18,500 plus a $6,000 catch-up contribution of you are age 50+ in 2018, but when you examine your balance net of tax, the Roth is more powerful. Think about this way: if you believe you will be in the 25% marginal bracket in retirement and your accounts will grow to $1m with the Traditional 401(k), $750,000 of the $1m balance will be able to be spent by you and the other $250,000 will go to the IRS. With Roth accounts you will be able to utilize the full $1m. The reason this logic only applies to high savers is utilizing the immediate tax deduction with the Traditional 401(k) could allow you to save more. For example, if you are currently in the 32% tax bracket and have $10,000 of free cash flow to allocate to your workplace retirement plan, you could defer $14,700 ($14,700 x 0.68 = $9,996) to the Traditional 401(k) and receive roughly the same paycheck net of tax as if you contributed $10,000 to the Roth 401(k).

8. You expect a sizable inheritance

Receiving a large inheritance may increase your tax bracket later in life. Although you may not owe tax when you inherit the asset, income from the inheritance may push you to a higher tax bracket. Let’s say you inherit land worth $1m. The land should receive a step up in basis which would allow you to sell free of tax. However; if you reinvest the proceeds in a way that generates 5% annual taxable income, you have just added $50,000 of future income. If you inherit tax deferred assets like IRAs or Variable Annuities from a non-spouse you will be subject to ordinary income tax and a mandatory withdrawal schedule.

Who shouldn’t switch to Roth contributions?

If you are confident you will be in a lower tax bracket in retirement than you are now it is probably in your best interest to obtain the immediate deduction now.

1.     You will have an opportunity to convert to Roth at a lower rate later

With a well-constructed financial plan you may have an opportunity to convert your tax deferred assets to Roth at a lower rate later. For savers that have good tax diversification (a blend of taxable, tax deferred, and tax-free assets) that retire early, we often have lower tax years where we can convert assets at a lower rate. For example, if someone retires at age 62, but their optimized Social Security claiming strategy delays collecting benefits, they may be able to withdrawal from the taxable account for retirement income and convert tax-deferred assets to tax-free while staying in the first two brackets. This strategy may make sense for 8 years until they claim Social Security and start RMDs that move them to a higher tax bracket.

2. You plan to give your money to charity

Charities don’t pay tax, so you might as well take the deduction now and allow the charity to withdraw the assets tax-free after your death. If you don’t need the RMD while you are living, you can make a Qualified Charitable Distribution (QCD) of up to $100,000 each year to satisfy your RMD.

Everyone has a unique financial situation and the decision to Roth or not to Roth will be based on what’s right for them. With the temporary nature of the lower marginal tax brackets, we believe retirement savers should revisit this decision and make sure they are doing what is in their best interest.

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*Old tax brackets do not perfectly align with new

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    W. Devin Wolf, CFP®