IRAs And An Opportunity For Tax Arbitrage

The new tax law provides a few incentives for taking advantage of Roth IRAs and similar types of retirement accounts. It also preserves the contribution limits in effect prior to this year for both tax-deferred and aftertax accounts. Roth IRA conversions, however, can no longer be undone.

I bring this up now because you currently have the chance to take advantage of a little tax arbitrage. Contributions to a traditional individual retirement account attributable to the 2017 tax year can be made up to April 17, 2018. The contributions are deductible, though income limits apply to those who are covered or have a spouse who is covered by retirement plan at work. 

In 2018, many taxpayers will see their marginal tax rates decline by a range of two to four percentage points. Some will see an even bigger drop in their marginal tax rates because the income brackets have widened. The differential in tax rates allows a taxpayer to deduct an IRA contribution at the higher tax rate on their 2017 tax return and then convert the same dollar amount at the lower 2018 tax rate. (Roth IRA conversions are taxable events.) The net savings is money in their pocket. 

An example might add some clarity. A married couple, Bob and Sue, have adjusted gross income of $150,000 in 2017, putting them in the 25% tax bracket. Bob is covered by a workplace retirement plan, but Sue isn’t. They make a 2017 tax-year contribution of $5,500 to Sue’s traditional IRA. This deductible contribution results in a tax savings of $1,375 ($5,500 × 25% = $1,375). 

The Tax Cuts and Jobs Act (TCJA) lower’s the couples tax rate this year (2018) to 22%. They convert the $5,500 in Sue’s traditional IRA to a Roth IRA. The conversion results in tax liability of $1,210. Though Bob and Sue will have to pay extra tax this year, they still come out ahead by $165 ($1,375 deduction – $1,210 taxes = $165). While $165 may not be a lot relative to the size of Bob and Sue’s overall portfolio, it is still a nice sum of money for filling out a just a few forms to facilitate the conversion. Plus, the actual savings could be greater if a person is able to take advantage of the extra $1,000 catch-up contribution for those age 50 to 70 and/or has an even bigger decline in their marginal tax rate. 

Why not just make a direct Roth IRA contribution instead? The reason is the tax arbitrage. The contribution is being made at the higher 2017 tax rate, while the conversion is being made at the lower 2018 tax rate. 

The arbitrage only works if your 2018 tax rate will be lower than your 2017 tax rate. Changes regarding various deductions (e.g., the $10,000 cap on state and local taxes) and exemptions (e.g., the repeal of the personal exemption) will cause some taxpayers’ adjusted gross income to rise, so make sure you have a reasonable idea of what your 2018 taxes will be. The March AAII Journal will have an updated tax guide discussing the TCJA. 

You are, of course, not just limited to converting contributions made to an IRA last year. You can also use the now lower tax rate to convert contributions made during previous years. In addition, you can convert contributions made to a 401(k) plan to a Roth 401(k) plan, if doing so is an option. When making conversions, make sure the total dollar amount being converted does not inadvertently push you into a higher tax bracket. 

Keep in mind that once you make a Roth IRA conversion, you can no longer undo it. Prior to the start of this year, doing so was an option—and a beneficial one for taxpayers during down markets. This is no longer the case. Still, the potential long-term tax advantages of a Roth IRA may outweigh any short-term regret over timing of the conversion.

The Week Ahead

The U.S. financial markets will be closed on Monday, February 19, in observance of Presidents Day.

I will speak to our Chicago chapter about investing at the intersect of value and momentum on Saturday, February 24.

The earnings calendar lists 54 S&P 500 companies as being scheduled to report, including Dow Jones industrial average components Home Depot Inc. (HD) and Walmart Inc. (WMT). Both retailers will report on Tuesday.

The week’s economic reports will be the February Purchasing Managers’ Index (PMI) composite flash, January existing home sales and the January Federal Open Market Committee (FOMC) meeting minutes, all of which will be released on Wednesday.

Four Federal Reserve officials will make public appearances: Minneapolis president Neel Kashkari on Wednesday; Atlanta president Raphael Bostic on Thursday; New York president William Dudley on Thursday and Friday; and Cleveland president Loretta Mester on Friday.

The Treasury Department will auction $28 billion of two-year notes on Tuesday, $15 billion of two-year floating rate notes (FRNs) and $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.