16 | RKL 2018 Year-End Tax Planning Guide RKL 2018 Year-End Tax Planning Guide | 17 Tax rate arbitrage is a maneuver that allows individuals to realize income now at lower tax rates instead of doing so in the future when rates may be higher. Also referred to as “filling out the bracket,” tax rate arbitrage opportunities often occur due to a decrease in adjusted gross income (AGI) thanks to retirement, the onset of Social Security payments and/or Required Minimum Distributions from IRAs. Tax reform presents a unique opportunity for tax rate arbitrage because the legislation was passed through the budget reconciliation process. To comply with reconciliation’s various requirements related to timing and budgetary impact, Congress scheduled tax reform’s individual provisions to sunset after 2025. This means the lower marginal tax rates and doubled standard deduction will revert to 2017 levels without further legislative action to extend or make permanent. This window of opportunity sets the stage for individuals to realize more income now at the new lower tax rates before they expire, as outlined below. Tax-advantaged retirement savings plans Traditional IRAs are funded with pre-tax dollars and withdrawals are taxable as ordinary income after age 59½. Roth IRAs are funded with post-tax dollars, which means withdrawals are tax-free after age 59½. Both types are subject to income phase-outs and contribution limits. Given that the choice between a traditional IRA or Roth IRA is essentially a choice to pay taxes now or pay taxes later, it makes sense that this historically low rate environment plays a large role in the decision around which type of IRA to fund. Previously, individuals in higher marginal tax brackets were encouraged to defer as much income as possible through contributions to a traditional IRA, take a tax deduction for the contributions and then strategically draw down assets in retirement when they are in a lower tax bracket. Planning opportunities under tax reform • Contribute to a Roth IRA: Barring any legislative action to extend or make these tax rate reductions and doubled standard deduction permanent, contributions to a Roth IRA should be prioritized during this brief window to capitalize on the lower rate environment, particularly for taxpayers who expect to be taxed at a higher rate in retirement. • Convert a traditional IRA to a Roth IRA: Changing from a traditional IRA (pre-tax dollars) to a Roth IRA (post-tax dollars) means that the taxes must be paid all at once during the conversion. The rate reduction and expanded tax brackets, combined with the increased standard deduction, may lower tax payments and allow taxpayers to contribute to the converted Roth IRA at the current lower rates. Keep in mind that tax reform disallows the practice of recharacterizing Roth IRAs after conversion. Social Security taxability Social Security recipients must beware the “provisional income” thresholds that could tip their benefits into taxable territory. Defined as modified adjusted gross income (AGI) plus half of Social Security benefits, provisional income that surpasses the base amount for an individual’s filing status below may be taxed at a rate of 50 or 85 percent. • $25,000 – single, head of household, qualifying widow or widower with a dependent child or married filing separately and lived apart from spouse for the entire year • $32,000 – married filing jointly • $0 – married filing separately and lived with their spouse at any time during the year Income and transactions throughout the year can bump an individual over a provisional income threshold, so monitor finances carefully, particularly as the end of the year approaches. In some cases, it may make sense to defer income until the start of a new year. TAX ARBITRAGE & SCHEDULED RATE SUNSET RETIREMENT PLANNING 2017 2018 - 2025 2026 AND BEYOND 10% 10% 10% 15% 12% 15% 25% 22% 25% 28% 24% 28% 33% 32% 33% 35% 35% 35% 39.6% 37% 39.6% INFLATION OF BRACKETS (CPI-U vs. C-CPI-U) Previously, the Consumer Price Index for all Urban Consumers (CPI-U) was used to inflate tax brackets. Tax reform shifted this to C-CPI-U, also known as Chained CPI. C-CPI-U supplements existing indexes by incorporating “substitution bias” (for example, when steak gets expensive people eat more chicken). C-CPI-U is actually considered a more accurate estimate of inflation because it is a truer reflection of consumer behavior. C-CPI-U is historically approximately 0.2 percent lower than CPI-U on an annualized basis. The impact of this shift will be more pronounced at higher income levels with higher marginal rates and will compound over time.