With this simple year-end change to your retirement accounts, you can reap significant tax rewards

Before we get into the nuts and bolts, let’s define “middle-income earner.” We are focusing on the 22% and 24% brackets. Under the current tax law — changes made from the Tax Cuts and Jobs Act of 2017, which sunsets after 2025 — these rates fall in the middle of the brackets as seen below:

Think of tax brackets as a bucket

Let’s take a second to explain how marginal tax rates work. Think of each increasing tax bracket as a bucket that gets filled to the top with income taxed at that rate. Once the lowest rate bucket gets filled, you fill the next bucket at the incrementally higher rate.

This goes on until you reach your gross income. As an example, with annual taxable income of $178,150, the first three buckets would get filled (the 10%, 12% and 22% buckets) and you would owe $30,427 in income tax. Even though $178,150 is the top of the 22% bracket, this works out to a 17% average tax rate. The math would look like this: $30,427 ÷ $178,150 = 17%.

Average tax rates are significantly lower than most people realize: If you are one of those people, congratulations on this good news! When compared historically, 22% is low for incomes in this range.

For example, under the last tax law — the American Taxpayer Relief Act of 2012 — a married couple with $178,150 of annual taxable income would be in the 28% marginal bracket. 

Roth IRA conversion

Now, back to that simple change that was mentioned earlier. It has a name: Roth IRA conversion.

A Roth IRA is an Individual Retirement Account where contributions are made after tax, growth is tax free, withdrawals are not taxable, and there are no required minimum distributions (RMDs).

Roth IRAs are different from traditional IRAs, where contributions are made before tax, growth is tax deferred, withdrawals are treated as taxable income, and withdrawals must be made via RMDs.

In other words, with a Roth IRA you pay taxes now — and never again. With a traditional IRA you get a tax break now, but pay taxes later.

A Roth IRA conversion takes a traditional IRA and converts it to a Roth. You pay taxes on the amount of the conversion now, then let the account grow tax-free forever.

Roth conversions may be timely given three current conditions:

1. Historically favorable tax rates in the middle brackets (22%-24% marginal rates).

2. A down stock market.

3. A lot of cash on the sidelines.

Roth IRA conversions

There are two simple scenarios we like for using Roth IRA conversions. A Roth IRA conversion makes sense if certain conditions exist, the most important being that taxes are paid with non-IRA assets and should only be executed with the approval of your tax adviser.

Example 1: Married couple age 38; $500,000 in Traditional IRA’s. $200,000 a year in household income.

Strategy: Make annual Roth IRA conversions of $125,000 for the next four years (until the current tax law sunsets in 2025). After five years, all IRA assets will be tax free. This strategy takes household income close to the upper barrier of the 24% bracket, thus “filling” it.

To be clear, taxes will be owed on the entirety of those annual conversions at the marginal rate of 24%.

Example 2: Married couple age 60; $1 million in Traditional IRA, and $75,000 a year in household income.

Strategy: Make annual Roth conversions of $100,000 until the current law sunsets, (for the next four years). This allows taxes to be paid now at historically low rates and will reduce taxes owed on RMDs in the future.

This strategy takes household income close to the upper barrier of the 22% bracket, thus “filling” it. 

Again, taxes on conversions will be owed at the 22% marginal rate.

In conclusion, if you are sitting on excess cash and fall in the middle range of the tax brackets, take a close look at a Roth IRA conversion before Dec. 31.

Kevin Caldwell is principal at Golden Road Advisors in Tampa, Fla.