I just discovered a New Tax Law Loophole, of sorts! It’s an element in the New Tax Law that I’m excited about, especially as an Early Retiree. I’ve found an area where the new tax law favors retirees and solves a problem that many Baby Boomers face in their retirement finances. I’ve not seen much written on this topic yet, so I decided to weigh in by presenting today’s post.
I’m planning on taking advantage of this discovery to reduce “my problem”, and I suspect you may be able to do the same. Today, I’ll share the idea with you, and why I think it offers an opportunity for many of you, my (much appreciated) readers.You Know That Loophole in the new Tax Bill which benefits Retirees? I'm taking advantage of it, are you? Click To Tweet
As a person who plans to retire this year, I’m laser-focused on the new tax law and what it means for my retirement planning. I’m paying attention. Fortunately, it seems to be good news. I’ll lay out what I’m thinking, and I welcome your thoughts.
Shoot holes in my logic, I could well be wrong. But I think there’s something here worth looking into.
Please appreciate that this is a high-level overview of the new tax law. We can talk about specific situations, and how they impact the overall “net” benefit of the loophole, all day long. They do matter, but that’s not the point of today’s post. A few examples: To my SALT Friends: I feel for you. Not everyone is going to benefit from the new tax law. In many of your situations, I’d think “geo-arbitrage” like Stacy is, and consider moving to Nevada. Thx for your spreadsheet, Stacy – fascinating stuff. The same goes to my SINGLE Friends. Unfortunately, you don’t get the same benefits as married folks do. However, SALT and SINGLE are out of the scope of this post, tho I appreciate you all.
But we’re going down a rabbit hole.
The Point Is This…
….I think there’s a unique opportunity for retirees in their 50’s and 60’s, especially those with IRA’s or 401(k)’s.
Give me a minute of your attention, and see if you agree.
The Tax Loophole For Retirees
The Chart above shows the new tax law, effective Jan 1 2018. It’s an important chart, and I’m going to get into it shortly. First, there’s a quick backstory that I trust you’ll appreciate, a bit of color commentary if you will…..
I came up with the chart last week. In about 30 seconds. Unplanned. On a whiteboard in my office, with an inquiring co-worker. Unscripted. Long story made short, that brainstorming session on the whiteboard led to this post. I thought you’d find that interesting. Here’s what started it all (please don’t critique the numbers, I drew the darn thing from memory!)…
So….What’s The Chart Mean?
Ok, you want to know the Bottom Line. I understand that, and I promise that we’ll get to the “So What” in a minute.Baby Boomer retirees may benefit in a big way from the New Tax Law. Click To Tweet
However, and as you know, things aren’t always that easy. Before we get to the solution, and what the chart means, you need to understand the problem. A problem that many baby boomers face, whether they realize it or not. I’d like to explain this problem first, as a prelude to discussing how this tax law provides a bit of a solution.
So bear with me a minute, as I explain the problem.
The Problem? Required Minimum Distributions
Do you have money in an IRA? A Before Tax 401(k)?
If so, are you familiar with Required Minimum Distributions (or “RMD”, for short?). To keep it simple, IRA’s have long been touted as a great way to build your retirement investment portfolio in a tax-efficient manner. In essence, you are able to invest “Before Tax” money in an IRA, meaning it’s tax deductible in the year you make the contribution. The investments continue to grow tax-deferred until you withdraw the funds in retirement.
Um, yeah, until you hit the Requirement Minimum Distribution in retirement.
The problem is that you are required to begin taking taxable withdrawals from your IRA’s at the age of 70 1/2. The government was ok with letting you avoid taxes during your working years, but it’s time to pay the piper. The government wants their tax revenue, after all. Darn Government.What's The Problem Many Baby Boomers Face? Required Minimum Distributions. The New Tax Law may help. Click To Tweet
The RMD is mandatory, and the amount that you’re forced to withdrawal counts as taxable income. If you have $500k in your IRA and you’re 71 years old, you must withdraw $19,531 in 2018. (using this calculator).
The Big Issue: That withdrawal is unavoidable, and is taxed at your marginal tax rate. For folks with significant IRA investments (hello, Baby Boomers, who had no “Roth” option for the first 2 decades of their working career!), these RMD’s can easily bump you into a higher tax bracket, and there’s nothing you can do about it.
An Example: Joe has a decent pension from his long corporate career, and pulls in a decent social security check each month. Joe’s taxable income in retirement is $65k, and he and his wife are comfortable living on that. Unfortunately, Joe just turned 70 1/2, and he got hit with his $19,531 RMD. His taxable income jumped to $84,531.
Looking at the “Old” tax brackets, you can see that Joe just got bumped from the 15% to the 25% tax bracket:
How The New Tax Law Offers A Loophole
Fortunately, Joe doesn’t have to deal with the 2017 tax law anymore. It’s 2018, and there’s a new law in the land! Now, he’s subject to the new tax law, which has lower tax rates, and higher thresholds between each bracket.
THAT’S what the chart up above is all about, and what we’re going to talk about below.
Early Conversions Of Before-Tax IRA’s
While the REQUIRED Minimum Distribution kicks in at age 70 1/2, there’s no law against taking distributions from your IRA BEFORE AGE 70 1/2.
In fact, doing so can prove to be quite beneficial.
Even more so under the new tax law.
- I’m planning to take early distributions from my 401(k) / IRA starting at Age 55. I talked about it in my Retirement Drawdown Strategy last summer. My goal was to take whatever amount of withdrawal I could take each year to push me right up against, but not over, the next marginal tax rate income hurdle.
Looking at the numbers from the “Joe Example” above, I was planning on taking just enough to get my income to, but not above, the $153,100 threshold. This would ensure I paid no higher than the marginal 25% tax (details in the Drawdown Strategy post).
I was discussing this strategy with Physician on Fire in a comment on his excellent post on RMD’s, and his response (pasted below) led to today’s post:
I was quick to realize the Doc was on to something, began researching this post, and promptly tweeted out this well-deserved attaboy:
The Loophole That Doc Discovered
Thinking through what Physician On Fire said in that comment, I realized there was, indeed, a potentially large loophole in the new tax law for certain individuals. Those individuals are most likely married, long-term corporate or government employed Baby Boomers with high before-tax 401(k) and IRA’s. I realize it’s not everybody, but I think it’s worth highlighting for those folks who may stand to benefit.Are you a Baby Boomer with significant $ in an IRA or 401(k)? The new tax law may offer you a loophole to avoid your RMD problem... Click To Tweet
Here’s the loophole – we’d discuss it below:
How To Take Advantage Of The Loophole
If you’re ~55-69 Years Old and have a sizeable investment in a pre-tax 401(k) or IRA, you may want to study the chart above in some detail. Below, I’ll lay out how playing the “Early Conversion Tax Bracket” game compares in 2017 vs. 2018:
- In 2017, Joe can only convert IRA’s up to $153k of income before triggering the 28% rate (red line).
- In 2018, Joe can convert IRA’s up to $315k before triggering a tax greater than 24% (blue line).
The Window Of Opportunity:The New Tax Law Allows You A Window Of Opportunity To Convert Up to $315k / yr From An IRA! Click To Tweet
This window may not work for you, and the new tax law could actually worsen your situation vs. 2017. The results depend very much on your specific situation.
However, if you’re in your 50’s or 60’s and have a lot of money in an IRA, you’d be wise to check into it.
(As a prudent disclaimer, please recognize my analysis is intentionally a “simplified and generic situation” to communicate the overall issue, and the findings are not necessarily applicable to your personal situation, especially if you’re single or live in an area with high State & Local Taxes (SALT). Sorry, you don’t get much of a break from this new law.)
How To Execute The Plan
Starting later this year, I’m planning on meeting with my CPA to discuss how much of my Before-Tax IRA I should consider converting in 2018. The decision will be based on how much income we’re projecting I’ll earn, and how much room is left between that number and the $315k income threshold for the start of the 32% marginal tax bracket. Say, for an example, that I have income of $100k. The conclusion would be that I could consider converting up to $215k ($315k Threshold – $100k Income = $215k window for IRA Conversion).
I haven’t gotten into the specific details of how to execute the conversion, but I’ll figure that out with Vanguard when the time comes to make the conversion later this year.
A Limited Time Opportunity!!
This Window Will Likely Close, and higher tax rates will most likely become the norm again in the USA. You can argue against that conclusion if you’d like, and that’s fine. Decide for yourself if you think this is a short-term opportunity to convert some before-tax money at the potentially lowest tax rate you’ll have available to you.
Physician On Fire and I are in agreement that this is likely a limited opportunity, perhaps until 2025. While his email below is small, his key sentence is “You might have 7 or 8 years in which to take advantage of the new low rates”.
The new tax law may offer an opportunity for Baby Boomers with significant investments in before-tax 401(k)’s or IRA’s to consider converting those funds into Roth or After-Tax status before the Required Minimum Distributions kick in at Age 70 1/2. Converting these funds now may avoid the unpleasant experience of having your RMD’s force you into a higher tax bracket in your 70’s and beyond.
The extension of the historically low 24% tax hurdle to a surprisingly high level of $315k allows a window of opportunity for Baby Boomers to convert more money, at a lower tax rate, than was possible under the prior tax plan. If you don’t have as much money to convert, a similar strategy could be used targeting the $77,400 cutoff @ a 12% tax rate, or the $165k cutoff @ a 22% rate.
This opportunity will be lost if/when future tax law re-introduces higher tax rates, which this writer thinks is a likely scenario in the next 8 years.
If you think this concept has merit in your situation, seek the advice of a licensed professional. Heck, I wrote this article, but I’m still relying on my CPA to help me work through the numbers and make sure this is a prudent tax planning move for my retirement years.
If you’re interested in the new tax law and the impact it has on various retirement income planning schemes, I’d encourage you to read this article from the Mad Fientist, a real expert on these types of strategies. His article is worth your time if you’d like to study further on the concept.
Finally, I put the chart from this post up on various social media channels a week ago, and it’s generated a ton of discussion. Nick Nelson, a reader on the Radical Personal Finance Facebook Group, recreated my chart to show the “Effective Tax Rate” (total tax / taxable income) comparison between the 2017 and 2018 Tax Laws. It’s an interesting chart, but it didn’t really fit in the commentary above. I’ll include it here as an interesting additional item (thanks for the permission to share, Nick!). A shout out of thanks to all of my friends on Social Media for jumping in on the discussion, I appreciate the exchanges!
PS: Finally, in really small print here at the end…where no one is still reading. Disclaimer!! This analysis is based on very broad assumptions, and no reader should draw conclusions for their specific personal situation. Many personal situations will affect how this law applies (SALT, and Single vs. Married are two huge ones that come to mind). The purpose of this article is merely to communicate the broad stroke changes in the tax law, illustrate the potential loophole for married-filing-jointly filers, and raise awareness for those who may benefit from the theory raised.
I look forward to some likely chatter in the Comments. What do you think, is there a loophole?
Let’s start a discussion!