The Tax Cuts and Jobs Act of 2017 Will Your Taxes Go Up or Down?
Taxes Are on Sale: Here's How to Take Advantage
Saving for retirement is important, and if you don’t have access to a workplace savings account an individual retirement account (IRA) might be your best option. You may be considering, though, how to choose between traditional IRA vs. Roth IRA. This is not an easy decision, and it will have a big influence on your future. Make sure you know everything you need to know about the differences between traditional IRAs and Roth IRAs before making the decision.
Roth vs. Traditional IRAs: The Basics
The investing portion of these two options works exactly the same. You put money into your account and invest it as you please. Mutual funds and exchange-traded funds (ETFs) are the most popular options, but you can also invest in stocks, bonds and other securities. You keep investing while you work and see your account grow, thanks to compound interest. When you retire, you start taking the money out, often as monthly distributions.
The difference between the two comes when you consider taxes. Contributions to a traditional IRA are tax-deductible, meaning that every dollar you contribute reduces your taxable income, up to the IRS limit, which stands at $6,000 for 2019.The money grows without being taxed until you start taking distributions. When you reach retirement and start taking distributions, the money is taxed as normal income. In some states, however, IRA benefits are exempt from state income taxes. If you have a traditional IRAs, you’ll need to take Required Minimum Distributions (RMDs), which kick in when you hit age 70 1/2. You can’t leave the money in the account to grow indefinitely. You also can’t contribute to your traditional IRA after age 70 1/2.
Roth IRAs, on the other hand, is funded with after-tax dollars. You can’t deduct your contributions. Because you pay taxes when you put money in the account you don’t have to pay taxes when you take the money out, either in retirement or at any time before retirement. Roth IRAs don’t have RMDs so you can take money out only as and when you need it. Here’s another Roth IRA perk: You can continue contributing to a Roth IRA no matter how old you are. This means you can contribute for as long as you work, even if that is into your 70s.
Roth vs. Traditional IRA: How to Choose
When deciding between a traditional and a Roth IRA it’s helpful to think about your tax bracket. If you are in a relatively high tax bracket now and think that your tax bracket will be lower in retirement, a traditional IRA makes more sense. If you are in a very low tax bracket now, though, and expect your income tax rate will be much higher when you retire, a Roth IRA may be a better choice.
If you already have a 401(k) through your job, you’re getting a lot of the benefits of a traditional IRA already. Your contributions lower your taxable income and your account grows tax-deferred. Plus, 401(k) plans have higher contribution limits than IRAs. So, if you already use a 401(k) you may want to diversify your retirement holdings by opening a Roth IRA on the side. That way, when you hit retirement, you’ll have at least one source of tax-free income.
You’re Accounts, in Retirement and Beyond
As we mentioned, one of the main advantages of a Roth is that they don’t have RMDs. That means that you never have to tap your savings if you have other sources of retirement income to support you. For folks with plenty of money who are concerned with estate planning, Roth IRAs have serious appeal. Once you have a Roth IRA you can leave it to your heirs in your will. You can continue contributing to it every year of your life, making it a great way to accrue tax advantages. If you have income or gains from taxable accounts, you can use them to fund a Roth IRA.
There is an income limit for a Roth IRA — $137,000 for singles and $203,000 for married couples filing taxes jointly. You can, though, do a “backdoor” Roth conversion. Simply contribute to a non-deductible traditional IRA and then make a rollover from that IRA to a Roth IRA. You’ll have to pay taxes on the money you roll over, but then you’ll be good to go with your Roth IRA. Keep in mind, though, that the Roth IRA backdoor conversion option might not be around forever. Some reformers say it’s a loophole that needs to be closed to keep the wealthiest Americans from accessing it.
The Bottom Line
If you have money sitting in pre-tax investments like a traditional IRA or 401 (k), you may want to pay the tax bill that comes with them sooner rather than later.
Who can resist a good sale? When prices are slashed, there’s usually a great financial opportunity. This carries over to financial planning, too. Essentially, right now taxes are on sale. Smart investors should take note of tax cuts implemented by the Trump administration and use them to their advantage.
Under the 2017 Tax Cuts and Jobs Act, our tax brackets have been reduced. For example, the 15% tax bracket went to 12%. The 25% tax bracket went to 22%. Under the taxes-on-sale concept, we have only a few years before they are scheduled to sunset in 2025. So what do I do?
Every financial plan has five key elements – income, investment, health care, legacy/estate planning and tax planning.
Why is tax planning on this list? Look, I could be the best financial adviser in the world. My insight could make you an extra 2% in the market, and that’s great. But if I’m not talking to you about taxes, then I’m losing you money and certainly not providing a comprehensive plan.
It’s not just about having a budget, sticking to a budget or diversifying a portfolio. It’s about tax diversification and making sure you and your adviser are applying the current tax brackets to your ultimate advantage.
Here’s another reason taxes should command your attention – they literally require an act of Congress to change. When it comes to things like tariffs and trade wars, who’s to say what will happen? I can give you an educated hypothesis. Really, though, I have no clue … and no one else knows, either. But on taxes, I do know. So do you. If there is a future change in the political landscape who knows how high taxes will go.
It’s the old Donald Rumsfeld line: Taxes are “known knowns.” Everything else is an unknown. But taxes are a known known that doesn’t require speculation. Taxes are on sale. It’s time to take advantage.
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