Tax Rate Arbitrage For Taxable Income $170K-$320K
Author: Jennifer Climo
If you are married and your joint taxable income is between $170,000 and $320,000 you are in the 24% tax bracket. This means the wage income you earn between $170,000 and $320,000 is taxed at 24%. If your income will fall in between these limits for the foreseeable future, you should consider whether or not you think your marginal tax rate will continue to be as low as 24% over the next 0-10 years. Note that under current law, the marginal tax rate on that level of income is set to increase to 28%-33% starting in 2026. That’s a huge difference in taxes paid!!
If you are earning income at that high rate ($170,000 – $320,000), then you are likely contributing up to $19,000/year ($26,000 if over age 50) to your regular 401(k). If this is you, realize that you are saving 24% on these contributions, and will pay the tax rate in effect the year you withdraw the contributions. Under current law, your combined IRA distributions (and keep in mind you are REQUIRED to be taxed on a portion of your IRA/401(k) at age 70.5) plus Social Security plus investment income will need to be less than about $76,000 for this to make financial sense. (The 25% tax bracket goes back into effect in 2026 at about $76K, plus adjustments for inflation).
It is important to be aggressively saving as part of any retirement strategy, but perhaps the regular 401(k) plan is not your best option. Consider switching part or all of your 401(k) saving to your employer’s Roth 401(k) option. Contributions to Roth 401(k)s are made after-tax, but grow tax-free during your lifetime (under current law). Be careful with this strategy, as it will increase your taxable income. You need to watch so you don’t exceed $320,000 in taxable income, thereby bumping into the 28% tax bracket. (Other bad things happen at taxable income > $320K, including the beginning of the phase-out of the qualified business income deduction for service based businesses. If you are age 63 or older, you also need to be aware how your taxable income will impact your future Medicare premiums).
If you have contributed to your regular 401(k) all year (or if your employer does not offer a Roth 401(k) option), and are now realizing this has all generated only a 24% tax deduction, you can make a partial Roth IRA conversion to effectively accomplish the same thing as if you had contributed to your Roth 401(k). Simply transfer assets from your IRA to your Roth IRA (continuing to pay careful attention so you don’t exceed $320K in taxable income).
Note that “taxable income” is all taxable income, less deductions for pre-tax items such as HSA contributions, medical/dental insurance, employer retirement plans, etc.; and less the standard deduction or itemized deductions, whichever applies.
Note also that this same concept applies to other tax brackets, as well.
The calculations to determine if this is a good strategy for your specific situation are complicated. I would not suggest making any moves until you have your financial advisor run a tax projection for you under each scenario.
(Dollar amounts used in this essay are in effect in 2019 and rounded for simplicity).