This Method Can Lower Taxes for Upper Income Taxpayers

Taxpayers in the highest tax bracket should take a long-term view of tax planning. This method can help lower long-term tax liabilities.

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Taxpayers in the highest tax bracket should take a long-term perspective to save taxes. The top income tax rate is 39.6%, but it might be closer to 50% when you add the Medicare surtax and the Pease limitations. It’s no wonder tax planning is often focused on reducing taxes in the current.

One long-term tax planning tool is the Roth conversion. This strategy is sometimes dismissed because it increases current taxable income. However, a Roth conversion won’t affect current taxable income if the conversion is done in an IRA that contains only after-tax contributions. Taxpayers with high incomes cannot make Roth contributions directly, but they can make non-deductible IRA contributions and then immediately convert them to a Roth IRA. Taxpayers using the strategy need to be aware of the pro-rata rule if they have other IRA accounts.

Converting pretax IRA funds to a Roth can also work for upper-income taxpayers if the funds will be in the Roth IRA long enough to offset paying taxes today. There has been a lot of debate over how long it takes to get to “break even.” Determining the break-even point depends on the future of tax rates, the future tax bracket of the IRA owner, assumed rates of return, and so on.

In general, it is advisable not to convert IRA dollars that would push you into a higher tax bracket. Have a tax adviser prepare a projection to determine how much additional income you can earn while remaining in your current tax bracket. The projection will also show the impact a conversion may have on the Pease limitations of itemized deductions.

Ideally, Roth conversions work best in years when your income is unusually low. Conversions also make more sense when the stock market is down. Converting an IRA when the asset values have dropped creates a lower tax bill on the amount converted and more tax- free growth when the market recovers.

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