How many times have we heard, “Put as much as you can into a tax-deductible or pre-tax retirement plan during your working years?”  You get a current tax deduction for the contribution based on your current “high” tax bracket.   You will take the money out of the account in retirement when your bracket is lower. 

For many people this may be the case.  Most Americans are not saving enough and may have low incomes in retirement, subject to a relatively low tax rate.  However, do you fit that profile?  Probably not.  Remember, the average income for a family of four is $67,019[i]  You are at the top of current wage earners and save 20% or more of your income.  You are investing the money wisely and plan on an income in retirement equal to 60% to 100% of your pre-retirement income.  And what will your tax bracket or tax rate be at that time?  Nobody knows.  But some prognosticators, political advisors, economists, and financial experts are predicting higher rates in the future.

The Federal Income Tax came into being in 1913 following ratification of the 16th amendment to the Constitution2 as a temporary (have we heard that word before relative to taxes?) way to finance WWI.  Please don’t ask if we are still involved in WWI.  From the 1940’s until 1963, the highest tax bracket was over 80%.  At one point the highest tax bracket was 94%3.  From there the highest rate decreased to 70%, then 50%, and since the early 1980’s, it has been under 40%.

We just had a tax decrease effective January 1, 2018, and from a historical perspective, the current rates are low, with a maximum bracket of 37%. 4

With the Federal debt continuing to increase, and the projected growth of the entitlement programs over the next decade, you come up with a clear picture as to why many feel that rates and brackets are likely to be increased in the future.  Projections are that, by the year 2030, spending for Medicare, Medicaid and Social Security alone will be 60% of the entire Federal budget. 5

So what do we do?  You have heard that the Roth IRA is a good idea.  A person eligible for a Roth can deposit $5,500 for 2018.  And, if you are lucky enough to be over age 50, you are allowed an additional $1,000 catch-up contribution.  The contribution is after-tax dollars (i.e., you do not get a tax deduction for the contribution).  However, the money as invested grows tax-deferred, and the qualified distributions come out tax-free when you withdraw it.  This sounds like a good idea.  But, at your income level, most of you are not eligible to contribute to a Roth IRA.  Joint filers are completely ineligible for Roth IRA if they have adjusted gross incomes over $199,000, and single filers with an adjusted gross income of $135,000 are ineligible.      

There are now three potential ways you can get on the Roth bandwagon:

Roth 401(k) and Roth 403(b) were introduced as an option that employers could add to their traditional 401(k) and 403(b) plans.  Further, more recent legislation made Roth 401(k) and 403(b) a permanent option if plans adopt it. 
Here’s how it works.  The total amount that you can defer from your salary to 401(k) or 403(b), either Roth or traditional pre-tax, is $18,500 for 2018 ($24,500 if over age 50).  If your plan has adopted the Roth option, you can make all or part of the $18,000 Roth.  No double-dipping; you can’t do $18,500 to each.  The funds will grow tax-deferred, and there are no taxes due when you withdraw at retirement, provided they are qualified distributions.  Keep in mind that anyone who participates in a 401(k) or 403(b) that offers Roth can take advantage of this option.  There are no income restrictions as with Roth IRAs.

Ask your employer to add the Roth option to your plan if it is not currently available.  Keep in mind that any matching or profit sharing contributions that your employer makes cannot go into a Roth account.  These contributions will continue to be deductible by the employer, grow tax-deferred, and will be taxed as ordinary income at withdrawal.

·         Another way to get on the Roth bandwagon is to take advantage of another tax law change that went into effect January 1, 2010.  Formerly, to convert a regular IRA to a Roth IRA, your adjusted gross income in the year of conversion had to be under $100,000.  This limitation is removed for tax years 2010 and beyond.  When you convert, usually some tax is due.  If you have only deductible IRAs, the tax, at ordinary income rates, is due on the entire balance.  If you have both deductible and non-deductible IRAs, the taxable amount is produced by a formula taking all your IRAs into account.

Some of you undoubtedly have deductible and non-deductible IRAs from many years ago, and the current tax liability to convert may be large.  Also, if you have multiple IRA, IRA Rollover, SEP and SIMPLE accounts, the process to convert is somewhat complicated. You should consult with an advisor before converting these accounts. 

·         An interesting twist or “loophole” is that an individual, regardless of income, can contribute $5,500 to a non-deductible IRA ($6,500 if over age 50) for 2018 and convert to a Roth afterwards.  Any tax would be calculated as mentioned previously, taking into account all your IRAs. 

The new 3.8% Medicare Tax on dividends, capital gains, interest, royalty and most other forms of unearned income makes this option even more attractive.  This tax applies for taxpayers filing jointly with a modified adjusted gross income of over $250,000.  Roth provides a hedge in your planning.  Also, Roth accounts do not have mandatory distribution rules like traditional IRAs and retirement plans.  With a Roth, you just let the money accumulate, and you don’t have to withdraw any of the funds.  The funds remaining at your death can be passed on to children and grandchildren and can provide a tax free income stream over their lifetimes.  

(1)      www.census.gov/hhes/income/4person.html

(2)      U.S. Treasury Department – Internal Revenue Service 2005

(3)      U.S. Treasury Department – Internal Revenue Service 2005

(4)      Married people, filing joint income over $600,000, are taxed at the 37% rate. Single, over $500,000.

(5)      Our clients at the start of their careers should be on the lookout to utilize Roth if they are planning retirement savings. Your income is low compared to where it will likely be in 5 0r 10 years. You could find yourself in a 22 – 24% federal tax bracket early on. Does it sound compelling to pay this tax now at that bracket? That way, your contributions effectively compound tax free and forever will not be taxed!

 

This Material is Intended For General Public Use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation.

Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation.

 

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2021-130970 Exp 12/23