It isn't often that rushing makes sense in retirement planning. But when it comes to converting your tax-deferred IRA to a tax-free Roth one, Ed Slott thinks now may be the exception. "Tax rates may never get lower in your lifetime than in 2017," says the accountant and creator of the personal finance website
irahelp.com. "Now would be the time to strike."
Donald Trump has said he wants to lower the top income tax rate from 39.6% to 33%. However, if history is any guide, the change won't be permanent, creating a potentially narrow window of opportunity. Savers can take a number of actions this year to cash in.
"If you have a healthy retirement account, taxes become the single biggest factor that will separate you from your retirement dreams," Mr. Slott says. If you're in the top income bracket, taxes on converting a $1 million traditional IRA to a Roth would drop from $390,600 to $330,000 if the top rate falls to 33% — a $60,600 immediate savings. But the savings would be even greater thereafter because assets in a Roth IRA compound tax-free, while in a traditional IRA you'd have to pay even more upon withdrawal if that $1 million grew to $2 million.
Of course, with health-care and trade overhauls on the new administration's front burner, there's no guarantee the White House and Congress will also serve up the promised tax revamp this year. "I think Republicans will do corporate tax reform this year and individual tax reform next year," says Brian Jacobsen, Wells Fargo Asset Management Corp.'s chief portfolio strategist. "They'll take care of what's possible in 2017 — corporate tax reform, regulatory relief, repealing Obamacare — then leave the other stuff that's more politically popular, individual tax cuts and infrastructure spending, to right before 2018's midterm election, so it's more salient in voters' minds."
The timing of the individual tax cut won't matter as much if you've already converted to a Roth IRA this year. That's because IRA rules allow you to reverse or "recharacterize" your Roth back into a regular IRA. "If you convert today or anytime in 2017, you have until Oct. 15, 2018, to change your mind and undo it for any reason at all," Mr. Slott says. "It's like getting to bet on a horse after the race is over. It's a no-risk scenario."
If you're in the top income tax bracket, you should also consider accelerating your itemized tax deductions to claim them this year, while delaying other forms of income until the promised tax cuts come through. This won't only lessen the tax bite of the IRA conversion, it could prevent you from losing those deductions down the road. Mr. Trump's tax plan would cap itemized deductions, including those on mortgage interest and charitable donations, at $100,000 for single filers and $200,000 for married couples.
Even if those caps don't make it into the final legislation, deductions will be less valuable when tax rates are lower, points out Wendy Diamond, a tax adviser for high-net-worth clients at Deloitte Tax LLP. "If we do think rates are going down," she says, "the client should defer recognition of income and accelerate deductions, because those deductions may be worth less in a future year."
It's also worth thinking about how Republican policies might affect retirement portfolios, so you can overweight sectors and asset classes that will benefit and underweight those that will suffer from them. "A straight corporate tax cut would tend to favor small- to mid-cap companies rather than large-cap," says Mr. Jacobsen. That's because those businesses have a higher effective tax rate than large multinationals that shelter much of their taxable profits overseas. Mr. Jacobsen favors mid-caps over small. "Only about two-thirds of small-cap companies are profitable," he says. "To benefit from a tax cut, you need to be profitable. Mid-cap stocks are about 80% profitable."
Stocks of domestic-oriented businesses that are heavily regulated also stand to benefit more than global, lightly regulated ones under Mr. Trump's agenda. "From a sector perspective, the most heavily taxed and regulated sectors tend to be financial services, utilities and telecom companies," Mr. Jacobsen says. These sectors, plus industrials, tend to fall on the value side of the investment spectrum, their stocks cheaper than lightly regulated peers. Deregulation may make their businesses more profitable by shielding them from consumer lawsuits and federal prosecution for fraud, safety violations and pollution.
The outlook for bonds is mixed. Lower personal income taxes combined with greater military and infrastructure spending could spark inflation, causing interest rates to rise. That would be bad for Treasuries, whose prices, like all debt instruments, move inversely with rates.
If income tax rates decline, muni bonds could also suffer, as their tax-adjusted yields will look less attractive for investors in the top brackets. But it's unlikely that such low tax rates will last indefinitely. By comparison, top federal tax rates were 50% in the 1980s, 70% in the 1970s and 91% in the 1960s.
The U.S. federal deficit continues to expand, so it seems unlikely that the 33% rate Mr. Trump is aiming for would hold for long. According to analysis by the nonpartisan Tax Policy Center, his plan would cause a $6.15 trillion decrease in federal tax receipts by the end of 2026. "All of this stuff Trump's planning takes money," Mr. Slott says. "At some point the bills have to get paid and taxes will snap back, maybe to 40%, 50%." When they do, you'll be glad the assets in your Roth IRA are already tax-free.
