Watching your retirement account grow can be exciting.
However, if it is a 401 (k) or individual retirement account that contains pre-tax contributions, remember that Uncle Sam owns part of the balance you see.
“Investors too often look at their traditional 401 (k) statement forgetting that there is an invested partner next to them,” said certified financial planner David Mendels, director of planning at Creative Financial Concepts in New York City. “While you may pleasantly forget, your partner will not forget you.”
How much the tax administration will get through the tax and when it will happen is partly up to you.
For traditional 401 (k) and IRA plans, you usually receive tax relief when you pay contributions and then pay retirement withdrawal tax. In contrast, Roth versions of these accounts do not deliver advance tax relief, but withdrawn withdrawals are excluded from federal income tax.
Although you can transfer money to the Roth IRA from a traditional account at any time – through a so-called Roth conversion – to take advantage of the non-taxable distribution in retirement, you will need to pay dollar taxes immediately before tax is converted. And determining whether that compromise makes sense is nuanced.
A simplistic explanation is that if you anticipate higher retirement taxes than the rate you are now paying, a Roth conversion may be smart. While it’s impossible to know for sure where taxes will be when you start drawing bills, many experts expect rates to go higher, especially given how relatively low they are at the moment.
“The only likely direction for tax rates to move is growth,” 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 that currently apply should expire after 2025, as prescribed by the Tax and Job Reduction Act of 2017, unless Congress extends them.
On the other hand, if you are approaching retirement and expect your income to fall – and therefore how much you pay in taxes – it might make sense to keep your money where it is. If you end up with a lower tax rate in early retirement at that point – and before the required minimum distributions begin at age 72 – the conversion could be beneficial.
Whether or not you make a Roth conversion, there are some key things to consider and, potentially, strategies you will use to reduce your tax.
First, however, it is 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 falling into certain brackets, making different parts of income at 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 minimum rate of 10% (see charts for other tax return statuses). The next highest rate of 12% refers to income that falls in the range of $ 9,950 to $ 40,525, and so on, to the highest marginal rate of 37%, which refers to income above $ 523,600.
So, if you are considering a conversion, you should estimate the tax rate you would actually pay on that money.
To illustrate: let’s say that, not counting the conversion, you would have $ 40,000 in revenue for 2021. The highest rate you would pay on that income is 12%. If you convert, say, $ 10,000 to Roth, that would push you into the next tax bracket, which comes with a marginal rate of 22% for income above $ 40,525.
There may also be spillover effects of higher income in any given year, including a tax rate on long-term capital gains or social security income or tax breaks available for certain amounts of income.
“Sometimes people turn too much at once,” said CFP Matthew Echaniz, vice president of Lincoln Financial Advisors of Chesapeake, Virginia. “They end up jumping into the next bracket, and the math doesn’t work well.”
One solution is partial conversion. This allows you to “fill in” the tax bracket at a lower rate. In other words, let’s say your revenue without conversion would be $ 75,000, which falls into the 22% group. If you were to convert $ 10,000, it would still be taxed at that rate because the bracket closes at $ 86,375 in revenue.
“You can partially convert every year if you want,” Echaniz said.
He also said that the more time you have until you take advantage of your retirement savings, the less you will have to analyze the conversion tax.
“My likelihood of encouraging Roth’s conversion is higher for a 30-year-old than for a 50-year-old,” Echaniz said.
Also, if you accidentally mix money after tax, mixed with funds before tax, on your non-Roth retirement account, there is a formula that applies to the account for the amount of conversion that has already been taxed. However, it is best to consult an expert if this is your situation.
“It gets very complicated when you also have dollars after tax that you convert,” Echaniz said.