The tax law passed late last year reduced tax rates for many investors, changing the calculations for evaluating options like ordinary taxable accounts, traditional IRAs and 401(k)s, and tax-free Roth accounts.
But are the changes big enough to spur a wholesale redesign of long-term retirement strategies?
Probably not for most investors, experts say, though many urge investors to make sure. Up-front tax deductions for traditional IRAs and 401(k)s will be slightly less valuable under the new lower income tax rates, for example, while tax-free Roths could be more appealing if you believe growing deficits will someday force Washington to raise tax rates.
Investors with workplace plans like 401(k)s should continue to contribute at least enough to get the maximum employer match, says, Ryan Moore, an IRA expert in Corpus Christi, Texas.
[See: 7 of the Best Stocks to Buy for 2018.]
“If an employer matches your money, it’s like getting free money,” Moore says.
Though the Republican tax bill signed by President Donald Trump was proclaimed a major reform, the changes for most taxpayers are relatively modest. The standard deduction taken by those who do not itemize nearly doubles to $12,000 for individuals and $24,000 for married couples filing a joint return, but many investors will still opt to itemize, anyway.
The law left in place a 3.8 percent investment surtax levied against the wealthiest taxpayers to pay for Obamacare. But the top income tax rate was reduced from 39.6 percent to 37 percent, and rates were trimmed on lower incomes as well.
Tax on short-term capital gains will be slightly smaller than before, since the income tax rates apply to investments sold after a year or less. But the rates on long-term capital gains and dividends stayed the same, at 15 percent for most taxpayers, 20 percent for the wealthiest.
Much depends on the investor’s individual situation, of course. Those who expect to build up large retirement accounts, for instance, will benefit from lower income tax rates on withdrawals after they turn 59.5. But that assumes rates don’t go up in the future.
Among the questions investors should explore:
Taxable versus tax favored. Taxable accounts continue to be simpler, with no restrictions on what you can own. If your returns come mainly from long-term capital gains, a given asset may be taxed less in a taxable account than a traditional IRA or 401(k), where withdrawals would be taxed at the potentially higher income tax rate. This remains the case.
“In taxable accounts the investment management will not change much,” says Mark Avallone, president of Potomac Wealth Advisors in Rockville, Maryland. “Rates on capital gains and dividends were unchanged, as were the investment taxes (for wealthy investors) from the Affordable Care Act.”
Traditional and Roth. Many investors have a choice between traditional IRAs and 401(k)s, where withdrawals are taxed as income, and Roth IRAs and 401(k)s that allow contributions and gains to be withdrawn tax free. But Roth contributions, unlike ones to the traditional accounts, are not tax deductible. A lower tax on money put into a Roth may tip the balance on this choice, Avallone said.
[See: 10 Reasons to Save for Retirement in a Roth IRA.]
“Many lower earners have been moved to a lower tax bracket, or even a zero percent tax bracket, and this makes the traditional 401(k) contribution slightly less attractive,” Avallone said, meaning that a deduction on contributions is moot for an investor not paying tax anyway. “However, if this is the case, and if you can manage to save a few bucks, a Roth may be a great place to save, especially if you are young and your income will increase in future years.”
For an investor in a zero tax bracket, there would be no tax on money before it is put into a Roth — and no tax when taken out, either. With a traditional account withdrawals would be taxed.
As the Roth example suggests, the big unknown is what will happen to tax rules in the future. If the recent tax cuts produce larger deficits in the federal budget, Washington could someday raise rates to close the gap, upsetting plans made today.
“Given the fiscal Long-term state of the U.S., taxes must go up in the future,” says Richard D Quinn, a long-time compensation and benefits expert who is retired himself. “Therefore, tax-free income will be more valuable” after tax rates go up in the future.
Recharacterizations are out. Under the old law, investors could convert a traditional IRA or 401(k) into the Roth version, a move that could be even better now for those expecting to be in a higher tax bracket in retirement, because of higher rates or bigger income. Those investors could pay tax on the converted amount at current rates to avoid higher taxes later, since the Roth withdrawals would be tax-free.
Investors can still convert, but the new law eliminated the option to undo a conversion through a recharacterization, which some investors did when they realized a conversion had been a mistake. Now the conversion is irreversible.
Future tax rates have always been a wild card, and most experts caution against letting the tax tail wag the investment dog. For most investors, the best response to the new tax law is to continue saving as much as possible, choosing an asset mix that suits their age and views on taking risks.
Avallone also recommends investing any tax savings.
[See: 10 Investing Themes to Remember for 2018.]
“A married couple with two children earning $125,000 are expected to save about 3.2 percent of their income — about $4,000,” he says. “Immediately increasing your salary deferral by this 3.2 percent can make a huge difference to your future retirement income. The key is to start now before the money hits your checking account and you start spending it.”
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3 Ways the Tax Law Affects an IRA originally appeared on usnews.com
