If you are a middle-income person, your tax situation may be far better than you believe. Being in this position may allow you to boost your retirement income strategy in the future. With a simple adjustment to the structure of your retirement funds, you might reap considerable long-term benefits.
Before getting into specifics, let’s define “middle-income earner.” Concentrating on the 22 and 24 percent groups. According to the current tax legislation – the Tax Cuts and Jobs Act of 2017, slated to expire in 2025 – these rates are in the middle of the brackets.
Consider tax brackets to be a bucket.
Here is an explanation of how marginal tax rates operate. Consider each ascending tax bracket as a bucket filled to the brim with income subject to that rate of taxation. Once the lowest rate bucket is full, the following bucket is filled at a progressively increasing rate.
This continues until your gross revenue is reached. With a yearly taxable income of $178,150, for instance, the first three buckets (the 10%, 12%, and 22% buckets) would be full, resulting in a tax liability of $30,427. In spite of the fact that $178,150 is the top of the 22% tax band, the average tax rate is 17%. The calculation follows $30,427 divided by $178,150 = 17%.
The average tax rate is far lower than most individuals realize: If you are one of these individuals, congrats on your good fortune. When compared historically, 22% is low for salaries in this group.
Under the previous tax legislation, the American Taxpayer Relief Act of 2012, a married couple with an annual taxable income of $178,150 would be subject to a marginal tax rate of 28%.
Conversion of Roth IRAs
Contributions to a Roth IRA are paid after taxes, growth is tax-free, withdrawals are not taxed, and withdrawals are not subject to required minimum distributions (RMDs).
With standard IRAs, contributions are made with pre-tax dollars, growth is tax-deferred, withdrawals are considered taxable income, and withdrawals must be made through RMDs.
In other words, a Roth IRA requires a one-time tax payment. With a typical IRA, you receive a tax deduction today but pay taxes in the future.
A Roth IRA conversion converts a regular IRA to a Roth IRA. You pay taxes on the conversion amount now and then let the account grow tax-free forever.
Roth conversions may be timely in the following circumstances:
- Historically advantageous tax rates in the intermediate tax bands (22%-24%).
2. A depressed stock market.
A substantial amount of capital is sitting on the sidelines.
Roth 401(k) conversions
A Roth IRA conversion makes sense under particular conditions, the essential being that taxes are paid using non-IRA assets and should only be completed with your tax advisor’s agreement.
Example 1: A 38-year-old married couple with a $500,000 Traditional IRA. $200,000 in annual household income
Strategy: For the following four years, convert $125,000 annually to a Roth IRA (until the current tax law sunsets in 2025). After five years, IRA assets are exempt from taxation. This technique brings household income near the 24% tax bracket’s maximum limit, therefore “filling” it.
To be clear, taxes will be owing at the 24% marginal rate on the total of these yearly conversions.
A married couple aged 60 earns $75,000 per year and owns a $1 million Traditional IRA. Make yearly Roth conversions of $100,000 until the expiration of the present statute (for the next four years). This permits taxes to be paid at historically low rates and will lower taxes due on RMDs in the future.
This method puts household income near the upper limit of the 22% bracket, thereby “filling” it.
Once more, conversions will incur taxes at the 22% marginal rate.
In conclusion, if you have surplus wealth and fall inside the intermediate tax levels, you should examine a Roth IRA conversion before the current tax law expires.