Federal Employees News Digest
TSP and roth IRA planning strategies following the 2017 Tax Act - Part II
- By Edward A. Zurndorfer
- May 21, 2018
The passage of the Tax Cuts and Jobs Act of 2017 (TCJA) has resulted in lower individual tax rates for the years 2018 through 2025. But under TCJA, individual tax rates in 2026 will revert back to higher individual tax rates that were in effect during 2017, adjusted for inflation. TCJA is therefore affecting several tax-based strategies related to retirement planning. In the second of two columns discussing how TCJA affects retirement planning for Federal employees, this week’s column discusses Roth IRA conversion strategies for employees applicable starting this year and through 2025.
The question is: Should an employee who owns before-taxed individual retirement arrangements (IRA) - traditional IRAs - convert the traditional IRAs to Roth IRAs, paying the resulting tax due now while individual tax rates are temporarily lower? Or should the employee not convert and have these traditional IRAs taxed when IRA distributions are made in retirement, and taxed most probably at a higher tax rate? Traditional IRA owners must begin withdrawing their traditional IRAs starting the year they become age 70.5. The key fact in deciding to perform a Roth IRA conversion this year is the comparison of this year’s marginal tax rates to future marginal tax rates should the traditional IRA not be converted and withdrawn in retirement.
The following three examples illustrate some of the issues involved in answering the question of whether one should convert a traditional IRA to a Roth IRA during a period of temporarily lower tax rates.
Example 1. Marilyn, age 60 and single, is a Federal employee. Her projected taxable income during 2018 is $108,000. According to the tax tables resulting from TCJA, Marilyn is in a 24 percent marginal tax bracket during 2018. But Marilyn expects her marginal tax rate in retirement to be higher than 24 percent. Towards the end of 2018, Marilyn should estimate her 2018 income, including her interest, dividend and capital gain income held in taxable accounts, in addition to her salary income. She should then convert a sufficient amount of pretax funds from a traditional IRA to a Roth IRA account so as to not have her taxable income exceed the top of the 24 percent tax bracket. It is better that Marilyn pay 24 percent tax to the IRS in 2018 on her converted IRAs rather than what is expected to be a higher tax rate should Marilyn not perform the conversion and withdraw her traditional IRA funds after 2025 when she will be over age 70.
Example 2. Phyllis, age 56, is a Federal employee with a TSP account currently valued at $1 million. Phyllis will retire from Federal service on Sept. 29, 2018. After retiring from Federal service, Phyllis should directly transfer half of her TSP account to a traditional IRA. Between age 55 and 62, Phyllis should divide her transferred TSP account in the traditional IRA into several traditional IRAs. Each year, Phyllis will convert a traditional IRA to a Roth IRA. By the time Phyllis is age 63, she will have converted all of her transferred TSP account to Roth IRAs. The converted amount of all of those traditional IRAs between ages 55 and 62 will not affect Phyllis’s Medicare Part B premiums at age 65 since Phyllis will enroll in Medicare Part B at age 65. The reason is that Medicare Part B premiums at age 65 will be based on Phyllis’s income level two years earlier at age 63. Also, by converting funds to Roth IRAs from age 55 to 62, Phyllis may reduce the size of her required minimum distributions (RMD) and thus the size of her future Medicare Part B premiums.
Example 3. Ted and Anita are a married couple, both over age 70 and Ted is a Federal retiree. Anita retired from private industry. Their adjusted gross income during 2018 will be $90,000. After deducting their $26,600 standard deduction, their taxable income will be $63,400. A good portion of Ted’s and Anita’s income comes from RMDs from the TSP and traditional IRAs. According to the TCJA tax brackets, Ted and Anita are in a 12 percent tax bracket. But if Ted or Anita were to die between 2018 and 2025, then starting one year after the death of the first spouse and assuming the same amount of income, the survivor’s taxable income will be $90,000 less the standard deductions of $13,600 or $76,400. This means that after the death of the first spouse, the surviving spouse may be either in a 22 percent tax bracket or in a 25 percent tax bracket beginning in 2026 when TCJA’s marginal tax brackets expire. To avoid this possibility that the surviving spouse ends up in a higher tax bracket, Ted and Anita are encouraged to convert their retirement accounts to Roth IRAs. Ted should transfer some of his traditional TSP to Roth IRAs. Both spouses should convert their traditional IRAs during the period 2018 – 2025 while they are in a lower tax bracket.