Here’s a way to boost your last-gasp deduction for state taxes.
Do you have a big IRA? And live in a soak-the-rich state? Run, don’t walk, to your accountant. You’ve got two weeks left to do a Roth conversion that just might save you a bundle.
The pending tax legislation, soon to become law if Trump gets his way, is going to pretty much kill off the federal deduction for state and local income taxes. Obvious ploy: Accelerate some income into 2017, and pay state income tax on it in 2017, too. This may be your last opportunity to deduct those state income taxes.
The easiest way to accelerate income is with a Roth conversion. This moves money from a pretax IRA into an aftertax Roth account. With this move you prepay both federal and state income tax on savings you will be drawing down during retirement.
Joseph J. Perry, a partner at the national accounting firm Marcum, has several clients in New York City about to Rothify sizable chunks of their IRAs.
He explains it this way. Suppose you’re in a 33% federal bracket and an 11% state/local bracket. The federal benefit from deducting the state tax equals .33 x .11, or 3.6%. That benefit is going to vanish next year. The tax bill going through Congress has a $10,000 cap on deductions for state and local taxes. In a high-tax state you’ll be well over that limit no matter what you do with your IRA, which means that incremental deductions for state and local taxes will become completely worthless.
Does it make sense to pay income tax on your IRA before you have to? It often does. This is counterintuitive, but the numbers are likely to work in favor of a Roth conversion if you meet these two conditions:
(a) Your tax bracket is not going down much between now and when you would eventually be forced to take money out of the IRA. The forced disbursements begin at age 70-1/2.
(b) You pay the up-front tax bill with cash from outside the IRA. Using outside cash for the tax magnifies the power of tax-free compounding going on inside the Roth account.
But don’t jump into a conversion without doing some what-if planning on your taxes. That means either visiting your accountant (who will be very busy for the next two weeks) or else plugging numbers into tax software like TurboTax from Intuit (INTU) or the competing product from H&R Block (HRB).
If a conversion in 2017 does make sense, you have to get your state tax payment into the hands of the tax collector by Dec. 31 so that it’s an itemized deduction for 2017. That means sending off your Jan. 15, 2018 estimated state taxes right now.
There are rules against prepaying taxes too far in advance—trying, for example, to deduct in 2017 the state tax you’ll owe for 2018. But, says Philip S. Gross, a New York City lawyer who helps financial-sector clients with complex tax problems, you clearly can deduct in 2017 any money sent in now against your 2017 state tax obligation.
Here are some cautions to consider before pulling the trigger on a conversion:
—Watch your brackets. You probably won’t come out ahead with a conversion large enough to push you into a higher bracket. Fill the bracket you’re in, but don’t go beyond.
For 2017 a married couple’s 33% bracket reaches up to $416,700 of taxable income, which corresponds to roughly $500,000 of adjusted gross income.
—Think about your retirement locale. It would be foolish, Perry says, to do a conversion while living in high-tax California if you are going to retire to low-tax Florida.
—Look at the alternative minimum tax. The AMT may go away in 2018 but is very much in place for 2017. Once you cross into AMT territory, any further state tax deductions go to waste.
This gets complicated. Boosting your income with a conversion pushes you away from the AMT because it increases your regular income tax. But a boost in your deduction for state taxes pushes you back toward the AMT red line.
So, where’s the right balance? The only way to find out is to run what-if exercises on tax software.
—Consider postponing to 2018. The Roth deal can make plenty of sense at any time because it increases the deferral power built into an IRA. Maybe you can afford to wait. You could do a conversion in January.
Brackets come into play here. High-paid taxpayers are probably going to see their marginal rate go down next year (from 39.6% to 37%). That will make a rush job in December 2017 less compelling. But some middle-class taxpayers are going to see their bracket go up. That makes an immediate Roth plan more likely to be a winner.
Amid all this complexity there is one more thing to ponder, and that is politics. If your Roth scheme offers only a modest gain, tax lawyer Gross offers this reason to hesitate before executing it: “The law could change with the next president. Maybe Congress is controlled by Democrats and they put back the state and local tax deduction.”
Originally published at Forbes