Watching your retirement account grow can be exciting.
However, if it is an individual retirement account or 401 (k) with pre-tax contributions, don’t forget that Uncle Sam has a portion of the balance you see.
“Too often, investors look at their traditional 401 (k) statement, forgetting that they have a partner invested there beside them,” said financial planner David Mendels, director of planning at Creative Financial Concepts in New York. “Although you may conveniently forget, your partner will not forget you.”
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How much the IRS receives through taxes and when it does, partly depends on you.
For traditional 401 (k) plans and IRAs, you generally get a tax break when you make contributions and then pay taxes on retirement withdrawals. In contrast, the Roth versions of these accounts do not come with tax incentives, but qualified withdrawals are excluded from federal income tax.
Although you can transfer money at any time to a Roth IRA from a traditional account – through a so-called Roth conversion – to take advantage of tax-free distributions on retirement, you would need to pay taxes immediately on the pre-tax dollars you converted . And determining whether that exchange makes sense is nuanced.
The simplified explanation is that if you predict higher taxes on retirement than the rate you pay now, a Roth conversion can be smart. While it is impossible to know with certainty where the taxes will be when you start to draw the bills, many experts expect rates to rise, especially considering how relatively low they are at the moment.
“The only likely direction for tax rates to go up,” said CFP George Gagliardi, founder of Coromandel Wealth Management in Lexington, Massachusetts. “So now may be the best time to consider Roth’s conversions before rates go up.”
The reduced marginal rates now in effect are due to expire after 2025, as dictated in the 2017 Tax and Employment Reductions Act, unless Congress extends them.
On the other hand, if you are approaching retirement and expect your income to decrease – and therefore how much you pay in taxes – it may make sense to keep your money where it is. If you end up with a lower tax rate early in retirement – and before the mandatory minimum distributions start at age 72 – at that point, a conversion can be advantageous.
Regardless of whether you do a Roth conversion, there are some important things to consider and, potentially, strategies to be employed to minimize your taxes.
However, it is first important to understand how income is taxed. Although there are currently seven different tax rates – 10%, 12%, 22%, 24%, 32%, 35% and 37% – they apply to income that falls within certain ranges, subjecting different portions of income to different rates .
In other words, no matter how much an individual taxpayer earns in 2021, the first $ 9,950 of revenue is subject to a 10% marginal rate (see charts for other tax return status). The next highest rate of 12% applies to income that falls in the range of $ 9,950 to $ 40,525 and so on, up to the highest marginal rate of 37%, which applies to income above $ 523,600.
Therefore, if you are considering a conversion, you should evaluate the tax rate that you would actually pay on that money.
For illustration: let’s say that, not counting a conversion, you would have $ 40,000 in revenue in 2021. The highest rate you would pay on that revenue is 12%. If you convert, say, $ 10,000 into a Roth, it will push you into the next tax bracket, which comes with a marginal rate of 22% for income above $ 40,525.
There can also be side effects of having a higher income in a given year, including the tax rate on long-term capital gains or Social Security income, or tax credits that are available for certain income amounts.
“Sometimes people convert a lot at once,” said CFP Matthew Echaniz, vice president of division at Lincoln Financial Advisors in Chesapeake, Virginia. “They end up jumping to the next key and the math doesn’t work well.”
One solution is to do partial conversions. This allows you to “fill out” a tax bracket at a lower rate. In other words, let’s say your revenue excluding conversion would be $ 75,000, which falls in the 22% range. If you converted $ 10,000, you would still be taxed at that rate because the range closes at $ 86,375 in income.
“You could do partial conversions every year if you wanted to,” said Echaniz.
He also said that the more time you have to take advantage of your savings for retirement, the less you will have to analyze taxes for a conversion.
“My likelihood of encouraging a Roth conversion is greater for a 30-year-old than for a 50-year-old,” said Echaniz.
In addition, if you happen to have any tax-less money in your non-Roth retirement account mixed with pre-tax funds, there is a formula that is applied to account for the conversion amount that has already been taxed. However, it is best to consult a professional if this is your situation.
“It gets very complicated when you also have dollars after taxes that you are converting,” said Echaniz.