Tax planning for 2018
By David J. Haas CFP®, April 4, 2018
Tax returns for 2017 are due April 17th this year. Hopefully you have worked with your tax professional to prepare your return by now and you have plans to complete your 2017 IRA contributions by the 17th. Now its time to turn to 2018. With Tax Reform in the guise of the Tax Cuts and Jobs Act (TCJA) passed in the waning hours of 2017, a lot has changed for taxes in 2018. In this blog post, I will go over some of tax planning opportunities for saving money in the long run by paying more taxes in 2018.
Lowest Federal Taxes Ever
Federal tax rates are lower than ever. I really think that government revenues are so low versus expenditures that you can be sure the current tax regime is the lowest ever. The GOP has given us a historic tax cut as part of the tax reform, but they seem to be unable to cut the budget to match. This means ballooning deficits moving forward. In fact even the large deficits forecasted are probably understated, since the long-term growth rate of the economy will be constrained by a low birth-rate, lower immigration, and an aging population. This means that taxes are going up from here, no matter which political party is in power.
Pay your Taxes
So what should you do when tax rates are at a generational low? The answer is to pay more taxes! What I really mean is you need to rethink how you save your money and where that money resides when it comes to tax qualified accounts. A tax-qualified account is an account such as an IRA or 401(k) which defers taxes to a future date or a ROTH IRA or ROTH 401(k) where contributions are paid with after-tax funds, but earnings are tax-free.
Let’s review commonly available tax qualified accounts and their features:
|Account||Contributions Taxed||Earnings Taxed||Tax Treatment on Withdrawal||Comment|
|Traditional IRA||No||No||Taxed at ordinary rates|
|SEP and SIMPLE IRAs||No||No||Taxed at ordinary rates||Retirement plans for self-employed and small business|
|ROTH IRA||Yes||No||Tax free|
|401(k)||No||No||Taxed at ordinary rates|
|ROTH 401(k)||Yes||No||Tax free||Not available from every employer|
|403(b)||No||No||Taxed at ordinary rates||For some non-profit and government employees|
|ROTH 403(b)||Yes||No||Tax free||Less common|
|HSA||No||No||Tax free when used for medical expenses||Best plan in table! Must have high deductible health plan.|
|529||Yes*||No||Tax free when used for education expenses||Best option to save for college!|
*529 plan contributions are not deductible from Federal Taxes, but many states, including NY, but not NJ, have a state tax deduction.
Some of these accounts are available only through employers and others have income restrictions. So you will typically only be able to participate in a few of these accounts.
Are Tax Deferred Accounts a Good Deal?
Accounts offering tax deferral include IRAs and 401(k)s which many workers have access to. The idea is that your contribution is deducted from taxes now and you pay taxes when you withdraw the money. This sounds great, but it really only works when your tax rate is higher during your earning years than when you withdraw the money. Typically when you retire, you will be making less money, right? Well, that’s not true for everyone and remember, tax rates when you retire are likely to be higher than the really low rates right now. You might find yourself in the 24% marginal tax bracket right now ($165k to $315k married filing jointly), but in a higher tax bracket such as 28% (previous law for $151k to $153k) when you retire. Deferring taxes at 24% and paying it later at 28% is NOT a good deal.
ROTH Accounts to the Rescue!
With a ROTH IRA or a ROTH 401(k), you are paying your taxes now, but earnings are tax-free as long as you follow the rules for the account and wait until age 59 1/2 to withdraw any money. If you are in the 24% marginal tax bracket, it probably makes sense to pay your taxes now, save your money in a ROTH account and enjoy tax-free withdrawals when you retire. This is more powerful the longer time you have to let your money compound tax-free, but it is probably a good move even if you have as little as 5 years before retirement. If you are in higher tax brackets it can still be a good idea to use a ROTH because even a high-rate tax bracket will probably be still higher in the future. But it then becomes more likely that you will have lower income in retirement and end up in a lower bracket. Your Certified Financial Planner™ professional should be able to advise you.
HSA accounts are so good, I should write a separate blog article about them. HSA stands for Healthcare Spending Account. HSAs are available to you if you have a High Deductible Health Insurance Plan (HDHP). That is a health insurance plan with a deductible greater or equal to $1350 (individual) and $2700 (family). The nice thing about HSAs is that there are no income limits on them, unlike IRAs and ROTH IRAs. So even high earners are eligible for HSAs. Your contributions are yours to keep and you can withdraw the contributions and earnings tax-free anytime for qualified medical expenses. Since the withdrawals are tax free, your best use of these plans is to contribute the maximum each year ($3450 for an individual and $6900 for a family with a $1000 catch-up for those over 50). While you are working, pay for your medical expenses with your other savings instead of using the HSA. When your account balance is large enough, most providers allow you to invest your HSA in mutual funds or the stock and bond market. Once you retire, you can use your HSA funds to pay for Medicare premiums and uncovered dental and vision expenses. Those withdrawals will be tax free and you will benefit from tax-free compounding over your working years.
If you have access to an HSA, its an excellent retirement savings vehicle.
Maybe This Is a Year for a ROTH Conversion
If you have significant savings in a tax-deferred account, such as an IRA or 401(k), maybe now is the time take advantage of lower tax rates to convert some or all of those accounts to a ROTH. When you convert your tax-deferred account to a ROTH, you pay taxes on the amount converted in the year of conversion and then the funds compound tax-free in your ROTH account. It make sense to convert and pay the taxes at a low rate now instead of a higher rate in the future.
How Much to Convert?
How much to convert takes some tax planning. Look at where your earned income falls in your tax bracket. For instance if you file “Married Filing Jointly” and your taxable income is $120,000, you are in the 22% marginal tax bracket in 2018. In that bracket you can make up to $165,000 before moving to the 24% bracket. So fill up your bracket with your ROTH conversion. In this example you can convert $45,000 at a tax rate of 22% before it pushes you into the next bracket. But beware of certain other things. The Net Investment Income tax starts at an income of $200,000 (individual) or $250,000 (Joint) and you don’t want to pay this extra tax if you don’t have to. Also, if you are eligible for any of the higher-education tax credits, make sure your income stays below the thresholds for the credits. Higher income can cause problems with college financial aid, eligibility for health insurance subsidies, and increased Medicare premium surcharges. Its best to work with a Certified Financial Planner™ or CPA to make sure you’ve planned properly for your individual tax situation.
When to Convert?
It used to be you could change your mind and re characterize your ROTH conversion any time before the filing deadline for your tax return. The TCJA law has removed the ability to re characterize ROTH conversions starting in 2018. So its probably best to wait until November or December when you might be sure of your tax situation before converting your IRA to a ROTH. Remember, you can’t take it back anymore.
Future Tax Reform
It’s instructive to look at taxation in the Reagan years. President Reagan instituted a historic cut in taxes in 1981. But he followed this tax cut by reducing loopholes and instituting other measures which restricted people from using deductions to reduce their taxes. The result was that actual tax rates were lowest right after the initial tax reduction in 1981, but people were paying more taxes by 1986. The projected deficits as a result of the current tax bill will become hard to ignore and personally, I don’t believe in Congress’ ability to cut spending further. Congress will be forced to raise revenue. and they may not call it a tax increase, but you and I will end up paying more taxes in the future.
The bottom line is that you should think about taking advantage of today’s historically lower rates. It might mean paying more taxes now, but over the long term, you will end up paying less. Remember, taxes are a complicated subject and the TCJA did nothing to make it simpler. You need professional expertise and careful planning. Find a CPA or CFP® to help you with your tax planning and avoid tax mistakes.