The interest in the tax-now Roth IRA is expected to rise in the foreseeable future. Here’s an explanation of why that’s happening.
With the Tax Cut and Jobs Act (TCJA) of 2017, the United States embarked on an eight-year stretch of the most reduced tax rates ever, beginning January 1, 2018.
However, this phase will conclude on December 31, 2025, thanks to a sunset clause included in the law. If Congress fails to act, which often happens, taxes will go back to the levels they were at before 2018, starting on January 1, 2026. That implies a marginal tax rate increase ranging between 1% and 5%.
So, a logical strategy would be to move some of the tax-deferred retirement money in 401(k)s and conventional IRAs into a tax-now Roth IRA. By doing this, you could potentially save on taxes if the tax rates are higher during your retirement.
Now, the real question becomes: How much of your tax-deferred retirement funds should you shift? And what should be the marginal income tax bracket for contributing or converting to a Roth IRA to reduce future tax liability on your retirement?
A 2018 chart that compares old and new marginal tax rates after TCJA can give an indication of how marginal income tax rates might increase in 2026 if Congress remains inactive.
Some Personal Reflections on the Roth IRA: I’ve consistently been against the Roth IRA since I haven’t been eligible to contribute since turning 25 in 2002, thanks to certain income limits. This led me to disregard the Roth IRA altogether.
Also, a Roth IRA conversion seemed unattractive after my income plummeted by 80% when I left the banking industry in 2012. Paying more taxes was the last thing I wanted; I was more focused on preserving my funds to navigate an uncertain future.
Now, as an older parent, I view contributing to a Roth IRA as an effective way to diversify retirement income sources in a tax-efficient manner. Especially with TCJA expiring at the end of 2025, it’s time to reevaluate the Roth IRA.
Deciding How Much To Move to Tax-Now Roth IRA by 2026: When contemplating converting assets into a tax-now Roth IRA, the following assumptions need consideration:
- Congress may revert tax rates to their pre-2017 levels on January 1, 2026.
- Tax rates could climb higher than before due to an even larger budget deficit.
- You think your retirement tax rates will be higher than while you are working.
However, I don’t believe that most Americans will face higher tax rates in retirement compared to when they’re working. Many people in the country tend to spend more than they save. Therefore, the urgency to move assets from tax-deferred to tax-now accounts is minimal.
Also, don’t fall for the “tax-free” label often associated with Roth IRAs. Though growth compounds tax-free and withdrawals are tax-free after five years, you still pay taxes upfront. The Roth IRA, in essence, is a tax-now retirement vehicle.
The only situation where Roth IRA contributions are genuinely tax-free is if your earnings are below the standard deduction limit. If you’re a working student, part-timer, or at the start of your career, opening a Roth IRA makes perfect sense.
A Look at the Average American Retirement Tax Scenario: The typical retirement balance is roughly $100,000, with a median Social Security payment of about $24,000 per annum.
Even if you withdraw an additional $10,000 per year from your median retirement balance, the total income of $34,000 would place you in a low 12% marginal federal income tax bracket. Given this, it could be wise for the average American in this tax bracket to contribute as much as possible to a Roth IRA, particularly since the next bracket is a significant jump to 22%.
No Tax Hikes for the Middle Class: Politicians are unlikely to raise taxes on those making under $100,000 or even $250,000. President Biden has pledged not to increase taxes for those earning less than $400,000. This buffer provides some reassurance against future tax hikes.
Remember, nobody can accurately predict future tax bracket changes. But historically, the long-term trend has been a decrease since the 1950s.
The Mass Affluent American Tax Situation: Suppose you’ve been following financial advice from sources like Financial Samurai since 2009. In that case, you likely have an above-average income, falling in the range of $75,000 to over $200,000, and an above-average net worth.
This profile means that most of you will face the 24% and 32% marginal federal income tax rates. If you fall into the 32% bracket or higher, converting funds to a tax-now Roth IRA may not be beneficial, as you are unlikely to pay an equal or higher tax rate in retirement.
Details on various income scenarios, withdrawal rates, Social Security considerations, and tax brackets further elucidate the scenarios in which a Roth IRA might or might not make sense. It emphasizes the point that tax hikes aren’t guaranteed, especially for those earning under a certain threshold.
Conclusion: The decision to invest in a Roth IRA requires a thorough understanding of your financial situation and the potential future landscape of tax rates. A Roth IRA can be a powerful tool for retirement planning, but it isn’t a one-size-fits-all solution.
The window for capitalizing on the lower tax rates is closing, and the urgency to consider Roth IRA contributions or conversions has increased. It’s worth taking the time to consult with a tax professional or financial advisor to determine what makes the most sense for your individual situation.
Remember that with any financial decision, personal circumstances, goals, and risk tolerance play vital roles. Making the right decision now could potentially save you a significant amount in taxes down the road.
