It can be exciting to see how your retirement account grows.
However, if it’s a 401 (k) or individual retirement account that contains contributions before tax, do not forget that Uncle Sam has a portion of the balance you see.
“All too often, investors look at their traditional 401 (k) statement to forget that they have invested in a partner next to them,” says certified financial planner David Mendels, director of planning at Creative Financial Concepts in New York. “Although you can easily forget it, your partner will not forget you.”
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How much the IRS receives through taxes and when that happens depends in part on you.
For traditional 401 (k) plans and IRAs, you usually get a tax break when you make contributions and then pay tax on the withdrawals during your retirement. In contrast, Roth versions of these accounts are not pre-tax, but qualified withdrawals are excluded from federal income tax.
Although you can send money to a Roth IRA from a traditional account at any time – via a so-called Roth conversion – to benefit from tax-free benefits during your retirement, you must pay tax immediately on the dollars before tax you converted. And to determine if the compromise makes sense is nuanced.
The simplified explanation is that a Roth conversion can be smart if you retire higher taxes than the rate you are paying now. While it is impossible to know for sure where taxes will be when you start drawing bills, many experts expect rates to go up, especially given how relatively low they are at present.
“The only likely rate for tax rates is to go up,” said CFO George Gagliardi, founder of Coromandel Wealth Management in Lexington, Massachusetts. “So this may be the best time to consider Roth conversions before rates rise.”
The reduced marginal rates now in force will expire after 2025, as prescribed in the 2017 Tax Savings and Jobs Act, unless Congress extends it.
On the other hand, if you are close to retirement and expect your income to fall – 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 your retirement – and before the required minimum benefits start at age 72 – at that point, a conversion can be beneficial.
Whether or not you are doing a Roth conversion, there are a few important things to consider and possibly strategies to reduce 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% – it applies to income that falls within certain brackets, which different parts of the income are subject to different rates.
In other words, no matter how much an individual taxpayer earns in 2021, the first $ 9,950 income is subject to a marginal rate of 10% (see charts for other tax filing statuses). The next highest rate of 12% applies to income falling between $ 9,950 and $ 40,525, and so on, 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 that you would pay on that money.
To illustrate: Say that if you do not count a conversion, you have $ 40,000 in revenue for 2021. The highest rate you would pay on that income is 12%. For example, converting $ 10,000 into a Roth will push you to the next tax category, which has a marginal 22% rate for income above $ 40,525.
There may also be consequences of higher income in a particular year, including the tax rate on long-term capital gains or income from social security, or tax credits available for certain amounts of income.
“Sometimes people call too much at once,” said CFP Matthew Echaniz, division vice president of Lincoln Financial Advisors in Chesapeake, Virginia. “Eventually they jump to the next bracket and the math doesn’t work so well.”
One solution is to do partial conversions. This allows you to “fill in” a tax rate at a lower rate. In other words, say that your income, excluding the conversion, will be $ 75,000, which falls within the 22% percentage. If you were to convert $ 10,000, it would still be taxed at the rate because the bracket includes $ 86,375 in revenue.
“You can do partial conversions every year if you want,” Echaniz said.
He also said that the longer you have time to utilize your retirement savings, the less you have to analyze taxes for a conversion.
“My likelihood of encouraging a Roth conversion is higher for a 30-year-old than for a 50-year-old,” Echaniz said.
If you happen to have post-tax money in your non-Roth retirement account that is before tax, there is a formula applied to account for the amount of the conversion that has already been taxed. However, it is best to consult with a professional if this is your situation.
“It gets very complicated when you also have dollars after taxes that you convert,” Echaniz said.