The Tax Cuts and Jobs Act presents an opportunity to maximize savings that may not last
By Robert Fishbein, Prudential Financial, Inc.
Individuals who rushed to prepay property taxes after the passage of the Tax Cuts and Jobs Act may have saved some money in 2018—but that’s pennies compared to the long-term tax savings taxpayers should take advantage of before the TCJA’s individual tax provisions are expected to expire in 2026.
Also expected to expire in 2026? According to trustees for Social Security, that’s when Medicare’s main trust fund will run out of money. With the increasing likelihood that Social Security and Medicare benefits may be reduced in the future, it’s more important than ever to ensure you use every technique available to maximize your retirement savings.
“Since the individual tax law changes are temporary and tax rates will revert to the former higher amounts starting in 2026, you have an eight-year window under current law to benefit from the lower rates.”
No matter how close you are to retirement, three outside-the-box strategies could make an enormous difference in your retirement readiness. You don’t have to wait until tax time—the sooner you start, the more you may save.
Fund an HSA for retirement health care
Estimates suggest even a healthy 65-year-old couple will need at least $275,000 to cover retirement health care costs. Fortunately, for millions of Americans with high-deductible health care plans, a Health Savings Account, or HSA, provides a way to save that money without paying a dime in taxes.
First, these individuals can fund their HSA through a tax-deductible contribution or pre-tax payroll deduction. Second, any interest and investment gains are tax-free. Finally, the funds can be withdrawn tax-free to pay for qualified medical expenses—providing a triple tax advantage over a traditional savings account.
The best part? While there are yearly contribution limits, there is no requirement to use HSA funds in the year of contribution, which means funds can grow on a tax-favored basis for future health care expense needs.
For 2018, the family contribution limits are $6,900, or $7,900 if you are 55 or older, and those amounts are indexed for inflation in future years. If you start contributing the maximum even as late as age 55, and earn 3 percent per year, you will have more than $90,000 to pay for your retirement health care by age 65. If you start contributing the maximum as early as age 40, assuming the same conservative rate of return, you will have saved almost $270,000. Moreover, these funds will continue to grow tax-free in retirement until you need them.
If you don’t use your HSA funds in full before you die, excess funds are subject to income tax but will be otherwise available for your spouse and children or other heirs.
Consider a Roth IRA conversion
The typical dogma says that converting an IRA or traditional 401(k) to a Roth IRA does not make sense if you expect your tax rate in retirement to be lower than at the time of conversion. However, lesser-known benefits of a Roth IRA may make it worthwhile to have at least part of your retirement assets in Roth IRA form no matter what.
Start with no required minimum distributions. Unlike a traditional IRA, with a Roth you aren’t forced to draw down your funds once you attain age 70½ and can continue to benefit from the tax-free growth, thereby maximizing the after-tax funds eventually available for you or your heirs.
Another significant benefit of a Roth IRA or Roth 401(k) is tax diversification, or having taxable, tax-deferred and tax-free assets that can be managed year over year to minimize your income tax liability. For example, you may choose to take taxable distributions up to a certain amount and then tax-free distributions to avoid a higher income tax bracket.
If you are a high-income taxpayer, Roth IRA distributions are not considered income when determining income thresholds for increased Medicare premium charges or the 3.8 percent income tax surcharge on investment gain. If your income is more modest, Roth IRA distributions are not considered income when determining whether you are subject to higher income tax on your Social Security benefits.
If anything, a conversion is more attractive now since you have an opportunity to convert and pay income tax with marginal rates that are generally lower than under prior law. Since the individual tax law changes are temporary and tax rates will revert to the former higher amounts starting in 2026, you have an eight-year window under current law to benefit from the lower rates.
Make “backdoor” Roth IRA contributions
The tax law prescribes income limits so that high-income individuals may not make a direct contribution to a Roth IRA. However, there are no income limits on converting traditional IRA funds to a Roth IRA.
Any person who has earned income and has not attained age 70½ by year-end can make an IRA contribution. While income limits may prevent you from making a pre-tax contribution, you can still make an after-tax contribution—and you can make this contribution even if you have fully funded a 401(k) or another employer plan.
Once you have made your contribution to a traditional IRA, you simply convert that amount to your Roth IRA. As long as this is your only traditional IRA and you have made an after-tax contribution, then an immediate conversion will have converted a tax-deferred asset into a potentially tax-free asset. If you have multiple IRAs, the IRAs are aggregated to determine how much is taxable upon conversion.
Note that the backdoor Roth IRA technique is dependent on the traditional IRA being after-tax funds. If you make a pre-tax contribution, then all the pre-tax funds converted will be subject to ordinary income tax upon conversion.
HSAs, Roth IRA conversions and backdoor Roth IRAs are often overlooked, but are potentially valuable strategies, especially given the new tax law. While we spend much time on our investment strategies to help gain an extra percentage or two of investment yield, these tax planning strategies are a more reliable way of maximizing your after-tax retirement income and wealth for your family—no matter how Social Security and Medicare turn out.
Please consult your tax and legal advisors regarding your particular circumstances.