“This is going to be Tax Armageddon. It’s time to suit up,” Virginia
Democratic Senator Mark Werner recently told Bloomberg News. “The main goal
here is this can’t just be a debate about the 2017 tax cuts.” Other Senate
Democrats have echoed similar sentiments. Senator Elizabeth Warren of
Massachusetts said she is willing to hold the middle-class hostage with tax
cuts that expire at the end of 2025 if Republicans don’t agree to raise taxes
on corporations and the wealthy. “Better to let all the Trump tax cuts expire
than be accomplices to another slash-and-burn tax bonanza for America’s
billionaires.”
While it is sometimes difficult to distinguish between
posturing and principled stands when it comes to politics, there is little
question that the looming expiration of the Tax Cuts and Jobs Act is upending
the tax planning efforts of millions of Americans.
In the months leading up to the November Presidential
election we are very likely to hear much more about the 2025 tax cliff. We are
also going to be bombarded with messages from both sides of the political aisle
about the merits of their tax plans going forward.
What's Going To Happen in 2025?
At the conclusion of 2025 one of two things is going to happen with Federal income taxes. Under one scenario, no consensus between Democrats and Republicans will be reached on new tax rates and brackets. If this happens, tax rates and brackets will revert to where they were in 2017, adjusted for inflation of course. This means that most taxpayers will see a two to four percent increase in their income tax obligations based on 2017 rates.
In the other scenario a new tax package will be negotiated. What the new tax environment will look like will depend largely on the outcome of the November election as well as the state of the US economy and amount of government debt. Although it is not likely, some taxpayers could see lower taxes. What is more likely is that higher earners, and maybe even middle-class taxpayers could see significantly higher tax bills in the not-too-distant future.
What Can You Do Now?
It is almost a certainty that the tax rates we are enjoying
now will not go lower for the majority of Americans in 2026. Depending on your stage
of life and situation, here are some smart moves to make before January 1,
2026.
If You Are Still Working
The focus for the next year-and-a-half should be on funding Roth IRA and Roth 401(k) accounts and non-qualified investment accounts. We do not yet know how painful and punitive the anticipated tax increases could get, but we do know that income tax rates are lower today than they were in 2017, meaning we get less tax deferral in 2024 than we did in 2017 with pre-tax IRA and 401(k) contributions. Workers should focus on switching 401(k) contributions from pre-tax to Roth, if that option is available. (Don’t worry – you will still get your employer’s match whether your employee contribution is pre-tax or Roth.)
If you are eligible to contribute to a Roth IRA based on
your income, you should also plan to do so. Contribution limits are $7,000 for
those under age 50, and $8,000 for those 50 and older in 2024. Converting
pre-tax IRA, 401(k), and/or 403(b) assets to Roth is also an attractive
strategy while tax rates remain low through December 31, 2025.
The next best option once Roth options are exhausted is to
fund non-qualified investment accounts. Like funding your Roth IRA and/or Roth 401(k),
you will not get an immediate tax deduction for doing so, but non-qualified
investment accounts offer much greater flexibility in accessing money from the
account. Additionally, the tax treatment
will be more favorable when taking future withdrawals from non-qualified
accounts.
If You Are Already in Retirement
While you have fewer options if you are already retired, there
are still some smart moves you can make between now and January 1, 2026.
If you are already taking required minimum distributions
(RMDs) from your IRA, 403(b) and/or 401(k) you will have to continue doing so
during your lifetime. But you can take out more than the required amount
anytime, you just have to pay the income tax on the withdrawal amount. Since
tax rates today are lower than they are likely to be in 2026, and taxes will
need to be paid anyway, why not pay the income tax on the withdrawal today at
lower rates? The biggest caution with
this strategy is to make sure that the withdrawal amount you take does not push
you into the next higher tax bracket. The additional withdrawal amount can
either be converted to a Roth IRA to grow without any future tax liability or
deposited into a non-qualified account with more favorable tax treatment.
If you have not yet begun taking required minimum
distributions, i.e. you are under 73 years of age, but you are over age 59-1/2 you
can begin taking withdrawals from your traditional IRA, 403(b) and/or 401(k) at
today’s lower income tax rates. This strategy will make future RMDs, which are
unavoidable, less painful. As mentioned above, the withdrawals can be converted
to a Roth IRA for continued tax-free growth or a non-qualified account for more
favorable tax treatment.
Additionally, accelerated distributions from
traditional IRAs and related accounts may help your estate planning efforts for
beneficiaries. Distributions for retirees are typically taxed at lower income
tax rates than their children and younger beneficiaries will pay when receiving
inherited traditional IRA assets, since beneficiaries are typically closer to
their peak wage-earning years in their careers. Also remember that recent law
changes require inherited IRAs to be completely distributed by beneficiary
owners within 10 years
The Unknown
At this point we don’t know how high future income tax rates
could go, which calls to mind the expression “better the devil you know than
the devil you don’t.” What we do know is that income tax rates are the lowest
we have seen in many years. We also know that one political party appears to be
very eager to raise taxes on the wealthy and corporations and has indicated
that it is willing to include the middle-class as collateral damage to get
those higher tax rates.
Do not overlook the fact that we are also likely to face
higher payroll taxes soon in efforts to prop up our failing Social Security
retirement system. Combined with higher income tax rates, higher payroll taxes
could pack a potent one-two punch to workers’ take-home wages.
We are happy to help you optimize your tax obligations over
your lifetime. If you would like to discuss your situation in detail, please
contact our office at 419-878-3934 or visit our website bollinwealth.com to
schedule time.
Source: The Wall Street Journal