It can be exciting to watch your retirement account grow.
However, if it’s a 401 (k) or individual retirement account with pre-tax premiums, don’t forget that Uncle Sam owns some of the balance you see.
“Too often, investors look at their traditional 401 (k) statement and forget that they have a partner invested there,” said certified financial planner David Mendels, director of planning at Creative Financial Concepts in New York. “Although you can easily forget, your partner will not forget you.”
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However, how much the IRS gets through taxes and when that happens is partly up to you.
For traditional 401 (k) plans and IRAs, you generally get a tax break when you make contributions and then pay tax on the withdrawals at retirement. Roth versions of those accounts, on the other hand, don’t have an upfront tax break, but qualified withdrawals are excluded from federal income taxes.
While you can move money from a traditional account to a Roth IRA at any time – via what’s called a Roth conversion – to take advantage of tax-free retirement benefits, you should immediately pay tax on the pre-tax dollars you paid. converted. And determining whether that consideration is correct is nuanced.
The simplified explanation is that if you expect taxes higher than the rate you pay now when you retire, a Roth conversion could be smart. While it’s impossible to know with certainty where the taxes will be when you start drawing bills, many experts expect rates to be higher, especially given how relatively low they are now.
“The only likely direction for tax rates to rise is upward,” said CFP George Gagliardi, founder of Coromandel Wealth Management in Lexington, Massachusetts. “So now may be the best time to consider Roth conversions before interest rates rise.”
The reduced marginal rates now in effect will expire after 2025, as mandated in the 2017 Tax Cuts and Jobs Act, unless Congress extends them.
On the other hand, if you’re about to retire and expect your income to fall – and thus how much you pay in taxes – it might make sense to keep your money where it is. If you retire early at a lower tax rate at that point – and before the required minimum benefits begin at age 72 – a conversion can be beneficial.
Regardless of whether you are running a Roth conversion, there are some important things to consider and possibly strategies you can use to minimize your taxes.
First, however, it is important to understand how income is taxed. While there are currently seven different tax rates – 10%, 12%, 22%, 24%, 32%, 35%, and 37% – they apply to income that falls in certain brackets, making different cuts of income at different rates. be subjected.
In other words, no matter how much an individual tax return earns in 2021, the first $ 9,950 in income is subject to a marginal rate of 10% (see charts for other tax return statuses). The next-highest rate of 12% applies to income falling in the bracket of $ 9,950 to $ 40,525, and so on, up to the highest marginal rate of 37%, which applies to income above $ 523,600.
So if you are considering a conversion, you need to evaluate the tax rate you would actually pay on that money.
To illustrate, suppose if you don’t count a conversion, you would have $ 40,000 in income by 2021. The highest rate you would pay on that income is 12%. For example, if you were going to convert $ 10,000 into a Roth, it would push you into the next tax bracket, which comes at a marginal rate of 22% for income over $ 40,525.
There may also be spillovers from higher income in a particular year, including the tax rate on long-term capital gains or social security income, or tax credits available for certain amounts of income.
“Sometimes people convert too much at once,” said CFP Matthew Echaniz, division vice president for Lincoln Financial Advisors in Chesapeake, Virginia. “They eventually jump to the next bracket and the math doesn’t work very well.”
One solution is to do partial conversions. This allows you to “fill” a tax bracket at a lower rate. In other words, suppose your income excluding the conversion would be $ 75,000, which is in the 22% bracket. If you converted $ 10,000, it would still be taxed at that rate because the bracket closes in 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 before tapping into your retirement savings, the less you need to analyze taxes for a conversion.
“My chance of encouraging a Roth conversion is greater for a 30-year-old than a 50-year-old,” said Echaniz.
If you happen to have some after-tax money in your non-Roth retirement account mixed in with pre-tax funds, there is a formula that is applied to account for the amount of the conversion that was already taxed. However, it is best to consult a professional if this is your situation.
“It gets really complicated when you also have after-tax dollars that you are converting,” said Echaniz.