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Income Taxes and Your Retirement Accounts

Depending on your view of where you believe taxes are headed, it might be a concern when making your retirement investment decisions. We have all been advised to put money away for retirement in tax deferred accounts like 401(k)s and IRAs. As your 401(k) and IRAs grow, so does the government’s share since they are your uninvited partner. Unlike most business partnerships, the IRS can increase their percentage of your hard-earned tax deferred savings at their discretion.

Look at where federal income tax rates have historically ranged:

History of Tax Rates: 1913 – 2014

Tax Rates Throughout History

In 1913, the United States endorsed the 16th Amendment and instituted the federal income tax. That year the top tax bracket was 7% on income over $500,000 (in today’s dollars that amount would equal approximately $11 million). Conversely, the lowest tax bracket in 1913 was 1%. Lawmakers use taxes to stimulate a sector of the economy or to raise revenue. You have heard the saying that the two things you can count on are death and taxes? Well death does not get any worse (to my knowledge) every time Congress meets.

To finance World War I, Congress passed the 1916 Revenue Act and thereafter the War Revenue Act of 1917, which increased the highest federal income tax rate from 15% in 1916 to 67% in 1917 and 77% in 1918. We all know war is very expensive. After the war in the roaring 1920s, federal income tax rates decreased to 25% from 1925 to 1931.

Then came the Great Depression, and Congress decided to raise federal income tax rates again in 1932 from 25% to 63% for those in the top tax brackets. Then came another war, WWII, and in 1944 the top rate was 94% on income over $200,000 (in today’s dollars that amount would be approximately $2.5 million). Top tax rates didn't decrease below 70% through the 1950s, 1960s or 1970s. (For related reading, see: The History of Taxes in the U.S.)

The Economic Recovery Tax Act of 1981

In 1981, the Economic Recovery Tax Act of 1981 decreased the top bracket from 70% all the way down to 50%, indexing the brackets for inflation. Then in 1986, lawmakers enacted the Tax Reform Act of 1986, expanding the tax base and dropping the top income tax rate to 28% beginning in 1988. The theory was that having a broader base had fewer deductions and would bring in the same revenue. That 28% income tax rate only lasted three years.

In the 1990s, federal income tax rates went to 39.6%. Then the Economic Growth and Tax Relief and Reconciliation Act of 2001 decreased the top income tax rate to 35% where it stayed from 2003 through 2012.

More recently, the American Taxpayer Relief Act of 2012 raised the top federal income tax rate to 39.6%. Then the Patient Protection and Affordable Care Act added another 3.8%, making the total maximum income tax rate 43.4%.

In summary, I find it imperative to look at history to predict the future since these changes can affect your investments. Higher taxes mean less money for your retirement years. Moving your tax deferred funds from accounts that are forever being taxed to accounts that are never taxed is one solution.

Converting to a Roth IRA

Converting your traditional IRA or 401(k) (or at least a portion of these funds depending on what taxes could easily be paid on those dollars that year or over a series of years) into a Roth IRA is a simple solution. By converting your traditional IRA into a Roth IRA you will:

  1. Reduce your tax rate risk: The risk that taxes in the future could be higher than they are today. Once it is converted, any withdrawals from the Roth account after five years and achieving the age of 59.5 will be tax-free. (For related reading, see: How a Roth IRA Works After Retirement.)
  2. Eliminate your Required Minimum Distribution (RMD): Once you turn 70.5 years of age the government wants your tax dollars so badly that they require you to take these funds out of your traditional IRA every year. If you forget or choose not to take these funds out of your traditional IRA, the IRS will impose an excise tax. It is a 50% penalty. The IRS is a greedy partner.
  3. When withdrawing funds from your traditional IRA, the income counts as provisional income, whereas when withdrawing funds from your Roth IRA, the distributions have no Social Security tax. Roth IRA distributions do not count against income thresholds that may cause Social Security benefits to be taxed.*
  4. Your heirs will receive your Roth funds tax-free. (For related reading, see: 4 Mistakes Clients Make With Roth IRAs and Their Estate.)
  5.  2017 Roth IRA conversions may be re-characterized if your financial situation changes that year. As of 2018 with Trump’s new tax law, Roth re-characterization are no longer are allowed.

Converting from a traditional IRA to a Roth could be a useful tool. By paying taxes today you can take advantage of historically low rates. Also, if you are young enough you may still have plenty of deductions that could potentially help offset the taxes. Additionally, our new White House administration’s tax plan could potentially make it an even more attractive time.

(For more from this author, see: Tax Savings with a Roth IRA and Real Estate.)

*In 1983, President Ronald Reagan and House Speaker Tip O’Neill passed a law that would tax Social Security benefits in order to ensure the long-term viability of the program. The IRS created income limits, or thresholds, that determine whether or not your benefits will be taxed. Now we understand what actions the IRS will take if you do not take your RMDs from your traditional IRA, if you take out too much you will pay higher taxes on your Social Security benefits.