Seeing your retirement account grow can be stimulating.
However, if it’s an individual or 401 (k) retirement account that has pre-tax contributions, don’t forget that Uncle Sam owns a portion of the balance you see.
“Too often, investors look at their traditional 401 (k) statement forgetting that they have an invested partner next to them,” said certified financial planner David Mendels, planning director of Creative Financial Concepts in New York. “While you can conveniently forget about it, your partner won’t forget about you.”
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Still, it depends in part on the IRS through taxes and when that happens.
For traditional 401 (k) plans and IRAs, you usually get a tax cut when you contribute and then pay taxes on retirement withdrawals. In contrast, Roth versions of these accounts do not show any reduction in initial taxes, but qualified withdrawals are excluded from federal income taxes.
Although you can move money at any time to a Roth IRA from a traditional account (via the so-called Roth conversion) to take advantage of tax-free distributions on retirement, you must pay taxes immediately on the dollars before converted taxes. And it is determined whether this commitment makes sense.
The simplified explanation is that if you anticipate higher retirement taxes than the rate you pay now, a Roth conversion may be smart. While it’s impossible to know for sure where taxes will be when you start taking out bills, many experts expect rates to rise, especially given the relatively low level they have right now.
“The only likely direction for rising tax rates is to go up,” said policy president George Gagliardi, founder of Coromandel Wealth Management in Lexington, Massachusetts. “So now may be the best time to consider Roth conversions before they raise rates.”
The reduced marginal rates that exist now must expire after 2025, as dictated in the Tax Cuts and Employment Act of 2017, unless Congress extends them.
On the other hand, if you’re about to retire and expect your income to go down (and therefore how much you pay in taxes), it might make sense to keep your money where it is. If a lower tax rate is achieved at the end of retirement and the mandatory minimum distributions begin at age 72, the conversion may be advantageous.
Regardless of whether you make a Roth conversion, there are some key things to keep in mind and potentially strategies to use to minimize your taxes.
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 that is in certain tranches. , which means that the different parts of the income are different.
In other words, no matter how much a taxpayer earns in 2021, the first $ 9,950 in income is subject to a marginal rate of 10% (see charts for other tax returns). The next highest rate of 12% applies to income between $ 9,950 and $ 40,525, among others, up to the highest marginal rate of 37%, which applies to income over $ 523,600 .
So, if you are thinking of a conversion, you should evaluate the tax rate that you will actually pay for this money.
For example, say that without counting a conversion, you would have $ 40,000 in revenue by 2021. The highest rate you will pay for that revenue is 12%. If you were to convert, for example, $ 10,000 into a Roth, you would move on to the next tax bracket, which includes a marginal rate of 22% for income over $ 40,525.
There may also be side effects of having a higher income in a given year, including the rate of long-term capital gains tax or Social Security income or tax credits available for certain income amounts.
“Sometimes people convert too much at once,” said policy president Matthew Echaniz, vice president of Lincoln Financial Advisors division in Chesapeake, Virginia. “They end up jumping to the next parenthesis and the math doesn’t work that well.”
One solution is to do partial conversions. This allows you to “fill” a tax bracket at a lower rate. In other words, we assume that your income without conversion would be $ 75,000, which is between 22%. If it converted $ 10,000, it would still be taxed at this rate, as support closes at $ 86,375 in revenue.
“Partial conversions could be done every year if you want,” Echaniz said.
He also said that the more time you have to take advantage of retirement savings, the less you will have to analyze taxes to make a conversion.
“My chances of incentivizing a Roth conversion are higher for a 30-year-old than for a 50-year-old man,” Echaniz said.
Also, if you have a non-taxable amount of money in your non-Roth retirement account combined with pre-tax funds, there is a formula that applies to account for the amount of conversion you already have. was recorded. 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’re converting,” Echaniz said.