Kyle Rolek, Retirement Planning Specialist
Planning Ahead for Tax Increases Once Tax Cuts Expire
This article discusses the potential expiration of the 2018 federal tax rate cuts and what you can do to plan ahead for potential future tax rate increases.
Current Federal Tax Rates vs. Rates Before 2018 Reductions
In December 2017, congress passed changes to the tax code that went into effect in 2018.
Among other things, the changes reduced the federal tax rate across most brackets.
The right-hand side of the image below shows the federal tax brackets in 2017, the year before the new tax rates went into effect.
The left-hand side of the image below shows the federal tax brackets in 2023.
The tax reform that took effect in 2018 reduced federal tax rate across most brackets, although it may not have reduced the amount of federal taxes you pay due to simultaneously establishing caps on important deductions such as state and local income taxes.
Here's an example of federal tax rates now vs. rates before the 2018 reductions:
In 2017 - A married couple with $80,000 of taxable income would have been in the 25% federal tax bracket.
In 2023 - A married couple with $80,000 of taxable income would be in the 12% federal tax bracket.
The tax rate in 2023 for a married couple with $80,000 of taxable income is less than half of what it was before 2018.
While this sounds good for now, if the tax rate cuts expire on schedule at the end of 2025 and all else remains equal, their tax rate could more than double in 2026 and beyond.
Potential Expiration of the 2018 Tax Reform
Unless Congress extends or votes to make the 2018 tax reform permanent, most provisions impacting individual income taxes expire at the end of 2025.
Among other things, this means federal tax rates would increase back to somewhere around 2017 levels.
As the example above shows, this could mean that someone in the 12% federal tax bracket in 2023 finds themselves in the 25% federal tax bracket in 2026.
As with most things under Congress control, there's many unknowns with how this will play out. Two of the most important questions to be determined:
Will reductions to federal tax rates be extended beyond 2025?
Will the ability to deduct an unlimited amount of state and local income taxes be restored?
At this point, who knows. It's very uncertain whether the 2018 tax reform will expire on schedule and if federal tax rates will increase at the end of 2025 as a result.
Even if tax rates do increase, if this is paired with a reinstatement of the ability to deduct unlimited amounts of state and local income taxes, the expiration of the 2018 tax reform could actually be a positive in some cases depending on the individual tax situation (although not a positive for retirees in Pennsylvania who don't pay state and local income tax on retirement income, and therefore wouldn't benefit from the restoration of uncapped deductions).
That said, while there are many unknowns, it may be best to plan ahead while rates are still low in case whatever Congress decides between now and the end of 2025 doesn't work out in favor of your individual tax situation.
Taking Advantage of Current Federal Tax Rates
While Congress debates the path forward between now and the end of 2025, how can you take advantage of the current federal tax rates in the meantime?
Building Roth assets is the most direct answer.
Roth accounts are one specific type of retirement account that won't be harmed if taxes increase in the future.
With Roth accounts, you pay taxes now at the current tax rates. In exchange, you can take distributions of both your contributions plus all future gains tax-free during retirement.
If taxes increase in the future, this will negatively impact the amount you get to keep when you pull money from key retirement income sources such as Traditional IRAs, pre-tax 401k accounts, and pre-tax 403b accounts.
The image below visually demonstrates what happens when each $1 is pulled out of pre-tax retirement accounts assuming a 20% effective federal tax rate.
Future tax increases will also negatively impact the take-home income you receive from pensions and social security (in most cases, social security benefits are partially federally taxable).
Roth assets are the safe-haven from future tax increases, at least under current tax law.
While most other retirement income sources would be harmed by future tax increases, Roth assets are protected.
Building Roth Assets
Here are four primary ways to build Roth assets.
Make Roth IRA contributions directly - income limits apply
Roth 401k and 403b contributions - no income limit
After-tax 401k and 403b contributions - no income limit
Roth conversion - no income limit, eligible when working and when retired
1 - Make Roth IRA contributions directly
For individuals age 50+, the maximum Roth IRA contribution for tax year 2022 is $7,000 per person. You can still contribute for tax year 2022 until the tax filing deadline.
The maximum Roth IRA contribution is $7,500 per person for tax year 2023.
However, there are income limits that prevent certain high earners from funding Roth IRA accounts directly.
The table below shows Roth IRA contribution income limits for tax year 2022.
For example, a married couple with modified adjusted gross income above $214,000 isn't eligible to contribute directly to a Roth IRA due to income limits.
2 - Roth 401k and 403b contributions
The maximum Roth 401k contribution for those age 50+ is $30,000 in 2023.
Unlike Roth IRA contributions, Roth 401k and 403b contributions are permitted regardless of income.
Anyone with a Roth 401k or Roth 403b option provided by their employer, including high income earners, can contribute to a Roth 401k or 403b.
Note that $30,000 is the total limit in 2023 for both pre-tax and Roth employee contributions for those age 50+.
For example, if someone contributes $10,000 into their 401k on a pre-tax, they can contribute a maximum of $20,000 to their 401k on a Roth basis for a total of $30,000.
Also note that not all employers offer a Roth option, although most do.
3 - After-tax 401k and 403b contributions
The maximum total 401k contribution for those age 50+ is $73,500 in 2023.
This $73,500 total includes the $30,000 maximum that can be contributed either pre-tax or Roth, any employer contributions, and any employee "after-tax contributions".
For example, if Jane contributes $30,000 into her 401k on a pre-tax basis and her employer contributes $20,000 in matching contributions, then Jane could contribute up to an additional $23,500 in "after-tax contributions" to reach the $73,500 total limit.
These "after-tax contributions" can then be rolled over by "direct rollover" into a Roth IRA to provide tax-free growth. When processed correctly, the rollover of after-tax 401k funds into Roth IRA can be performed without any additional taxes.
Note that not all employers offer an after-tax contribution option.
4 - Roth Conversions
Regardless of income and at any time (including in retirement), an individual can choose to transfer a portion of a pre-tax retirement account such as a Traditional IRA or pre-tax 401k into a Roth IRA.
This is what's referred to as a "Roth Conversion".
When funds are transferred from a pre-tax retirement account such as a Traditional IRA into a Roth IRA, the individual must count any amount transferred as income in the current year and pay tax on this amount at their current tax rate.
However, once funds are in the Roth IRA, all principal and future growth can be distributed later tax-free and unharmed by potential future tax rate increases.
This article has more details about Roth conversions: Roth Conversion Article
The tax reform that went into effect in 2018, which reduced federal tax rates for most tax brackets, is set to expire at the end of 2025.
There's still a lot of uncertainty surrounding how this will play out, but one potential scenario is that taxes will go up in 2026 and stay at these higher levels permanently.
As a result, locking in current tax rates by building Roth assets now could make sense to protect a portion of your overall retirement plan from potential future tax rate increases.
Want To Discuss This Individually?
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This is article is for informational purposes only and should not be considered as tax or legal advice. Advice is only provided after entering into an Advisory Agreement with the Advisor. See other disclosure here: Disclosures