Taking Advantage of the AMT Sweet Spot

El Turk

Level 14 Insurance Salesman
The point I'm covering below has been glossed over in a couple of places online, but I didn't see it covered here, so I thought I'd throw it out to the community.

As many in the forum discussed in the past, for those contributing to the max, a Roth 401(k) allows them to effectively shelter more money. This factor alone can result in Roth contributions offering a sizable advantage over contributing to a traditional 401(k). And, of course, Roth 401(k) contributions are more appropriate for those in lower income brackets, who don't think they will stay there.

However, as many have noted, traditional 401(k) plans offer their own benefits, which must be considered alongside Roth benefits in order to determine whether one or the other (or a mix of both) will offer the greatest benefit. One of the benefits of a traditional 401(k) is that it gives you an option of converting to a Roth later on, when tax rates might be more advantageous (because you are making less money, living in an area with lower state or city taxes, etc.). But, as I have argued, converting during low tax periods is often not realistic: it's often not feasible to increase one's taxable income, and pay higher taxes, when he or she is making less money to begin with. The argument is especially true if conversion the window (the period of reduced earnings) is small.

But what about the opposite? What about converting Traditional to Roth when one is making MORE money?

If you are making enough money, and have enough deductions (often the very state and city taxes that made a traditional 401(k) more attractive in the first instance), sooner or later you'll get hit with AMT. If, and only if, you know that your AGI is going to go up in the coming years, but you are on the edge of AMT this year (i.e., each additional dollar you make is phasing you out of the AMT exemption) you can use traditional 401(k) contributions (and a few other tactics, such as deferring property taxes) to keep you within the exemption. If, however, you are reaching the end of the exemption, and you are done being phased out, you are in what is known as the "AMT sweet spot," since your marginal tax rate is 28%. In situations where a person is already in the AMT sweet spot, it might make sense to do Traditional to Roth conversions, then, and take advantage of all of that "28%" space that AMT affords you.

Obviously, this has a somewhat narrow application, for a select group of people, and the AMT sweet spot doesn't last forever: if you accelerate too much income, you'll move out of AMT, back to regular taxes, which would, at that point, be higher than 28%. But I thought it was cool to point out that (with a bit of planning) their is a way to take advantage of traditional 401(k) to Roth conversions, even if you don't think low income windows will ever open up, so long as you have sufficiently high income windows.
 
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kodiak jack

Level 2 Member
interesting point, but you'd have to expect a pretty high level of income in retirement to want to convert from Traditional to Roth in the 28% bracket. Some folks will be there, sure, but the GREAT majority of people are going to be at 25% or less marginal in retirement. For a married couple to pay greater than 28% marginal in retirement (which would make it seem advantageous to convert at 28%), they'd have to earn $210,000+ a year. Not gonna happen for most people.
 

El Turk

Level 14 Insurance Salesman
interesting point, but you'd have to expect a pretty high level of income in retirement to want to convert from Traditional to Roth in the 28% bracket. Some folks will be there, sure, but the GREAT majority of people are going to be at 25% or less marginal in retirement. For a married couple to pay greater than 28% marginal in retirement (which would make it seem advantageous to convert at 28%), they'd have to earn $210,000+ a year. Not gonna happen for most people.
(1) I imagine that among people that can take advantage of this, the percentage earning above 210K in retirement is higher than the average population. (2) More importantly, if you do this when you are young enough, you have the advantage of being able to shelter more money (giving you a 5% or so advantage over traditional assuming you are already contributing to the max).
 

Sesq

Level 2 Member
Kitces has a nice article on this concept for those looking for more.

Code:
https://www.kitces.com/blog/evaluating-exposure-to-the-alternative-minimum-tax-and-strategies-to-reduce-the-amt-bite/
I record a liability of 30% in my net worth for deferred taxes. If I hit the 28% sweet spot I may do some conversions (state tax would not apply to me). I only have about $25K that I can convert since my 401(k) doesn't currently allow in plan conversions. Its only a 2% delta, but I like the increased certainty. I don't think my 30% estimate is unreasonable since I can easily see myself in a 25% federal bracket plus 5%+ state tax (I expect to move).
 
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