Between now and April 15, 2018 there exists a unique opportunity to save hundreds of dollars on a Roth IRA contribution that we may never see again in our lifetimes. It is caused by Trump’s tax cut, and whether you are for the tax cuts or not, it has created an odd tax loophole that you don’t have to be rich to exploit.
How it works
The basic idea is similar to the one I wrote about in an article last year called What the Roth IRA tax calculators won’t you. To understand how this loophole works we need to start with the basics.
First you need to know about the basic IRA. This is a retirement savings account that let’s you save money with pre-tax dollars. In other words when you contribute to a regular IRA account, you get a tax deduction. Then that money grows and grows until you withdraw it after you have retired. Because you didn’t have to pay tax on the money you put in, you have to pay tax on the money when you take it out.
Next you need to know about the Roth IRA, which kind of works in reverse. In this retirement account you don’t get a deduction for contributing money today, but when you pull the money out in retirement you get to take the money out tax free.
Finally, you need to know that the IRS allows you to convert a regular IRA to a Roth IRA. The catch is since you got a tax deduction when you put the money into a regular IRA, you have to pay that deduction back when you transfer your account to a Roth IRA. But, in some circumstances, you may not have to pay as much for that deduction as the benefit you originally got.
For example let’s say in year 1 your tax rate is 25% and you contributed $100. You just saved yourself $25 in taxes.
Then let’s say your tax rate goes down in year 2 to 10%. During year 2 you convert your $100 regular IRA to a Roth IRA. On your year 2 tax return you basically have to declare that $100 as income. So you declare that $100 as income and your tax bill goes up $10. Did you catch that? In year 1 you saved $25 in taxes, but in year 2 you only had to pay $10 back! You saved yourself $15 more than if you had simply contributed to a Roth IRA to begin with.
How to take advantage
In addition to the various circumstances you might be able to use this trick I wrote about last year, the Trump tax cuts for 2018 has created a unique opportunity to use this between now and April 15th, 2018.
For most people, the tax rate is decreasing from 2017 to 2018. The last piece of information you need to know is that even though 2017 is long gone, you can still make an IRA contribution before April 15, 2018 and report it on your 2017 income tax return to get the deduction on your 2017 taxes.
Here are the steps you need to do:
- Contribute to an IRA account. The broker you open your account with will have all the information you need on how to do this and the limits.
- Report that IRA contribution on your 2017 tax return that you file by April 15, 2018. You will save money on this tax return by taking a deduction. Already filed your 2017 return? That is OK, you can file an amended return.
- Convert your regular IRA to a Roth IRA in 2018. You can do this immediately if you want.
- Report your conversion on your 2018 tax return. You will have to pay extra money on your 2018 tax return, but it will hopefully be less money than you saved from your 2017 deduction.
Things to keep in mind
There is no benefit to doing this if your 2018 tax rate won’t be lower than your 2017 tax rate. For example, if you make a bunch more money in 2018 than you did in 2018.
This is not personal tax advice for you. Your financial situation and your taxes are unique and this won’t work for everybody. I recommend you discuss this with your CPA or personal tax professional.
This is not personal investment advice for you. While contributing to a retirement fund is generally a good idea, your financial situation is unique. I recommend you discuss this with your broker.
How much could you save calculator?
Just how much could you save? To find out, you can use this calculator. First you will need to know your 2017 tax rate, which can be found here. Next, you will need to know your 2018 tax rate, which can be found here. Finally, fill out the calculator below to see just how much you can save.