The government owns a portion of your 401 (k) or traditional IRA –

The government owns a portion of your 401 (k) or traditional IRA

Watching your retirement account grow can be exhilarating.

However, if it’s a 401 (k) or individual retirement account with 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) return forgetting that they have an invested partner there alongside them,” said David Mendels, certified financial planner, director of planning at Creative Financial Concepts in New York. “While you can conveniently forget it, your partner will not forget about 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) and IRA plans, you generally get a tax break when you make contributions and then pay taxes on withdrawals during retirement. In contrast, the Roth versions of those accounts do not include an upfront tax exemption, but qualified withdrawals are excluded from federal income taxes.

While you can transfer money to a Roth IRA from a traditional account at any time, through a so-called Roth conversion, to take advantage of tax-free distributions in retirement, you will need to pay taxes immediately on the pre-tax dollars you converted. And determining whether that tradeoff makes sense has nuances.

The simplified explanation is that if you anticipate higher taxes in retirement than the rate you pay now, a Roth conversion may be smart. While it’s impossible to know for sure where the taxes will be when you start using the accounts, many experts expect rates to go up, especially given how relatively low they are right now.

“The only likely direction for tax rates to go up is up,” said CFP George Gagliardi, founder of Coromandel Wealth Management in Lexington, Massachusetts. “So now might be the best time to consider Roth conversions before rates go up.”

The reduced marginal rates now in effect will expire after 2025, as provided in the Tax Cuts and Jobs Act of 2017, unless they are extended by Congress.

On the other hand, if you are approaching retirement and expect your income to decline 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 before retirement, and before the required minimum distributions begin at age 72, at that time, a conversion could be advantageous.

Regardless of whether you are doing a Roth conversion, there are a few key things to consider and potentially strategies to employ 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 found in certain brackets, which makes different portions of income are subject to different rates.

In other words, no matter how much an individual taxpayer earns in 2021, the first $ 9,950 of income is subject to a marginal rate of 10% (see tables for other tax filing statuses). The next highest rate of 12% applies to income that is 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.

So if you are considering a conversion, you need to assess the tax rate you would actually pay for that money.

For example: Let’s say that without counting a conversion, you would have $ 40,000 in revenue by 2021. The highest rate you would pay for that revenue is 12%. If you’re going to convert, say, $ 10,000, into a Roth, it would push you into the next tax bracket, which comes with a 22% marginal rate for income over $ 40,525.

There can also be side effects of having higher income in a given year, including the tax rate on long-term capital gains or Social Security income, or the tax credits that are available for certain amounts of income.

“Sometimes people convert too much at once,” said CFP Matthew Echaniz, divisional vice president at Lincoln Financial Advisors in Chesapeake, Virginia. “They end up jumping to the next group and the math doesn’t work that well.”

One solution is to do partial conversions. That allows you to “fill in” a tax bracket at a lower rate. In other words, let’s say your income excluding conversion would be $ 75,000, which falls in the 22% range. If you were to convert $ 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,” Echaniz said.

He also said that the more time you have until you tap into your retirement savings, the less you will have to analyze taxes for a conversion.

“My likelihood of encouraging a Roth conversion is higher for a 30-year-old than a 50-year-old,” Echaniz said.

Also, if you have some after-tax money in your non-Roth retirement account mixed with pre-tax funds, there is a formula that applies 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 after-tax dollars that you’re converting,” Echaniz said.


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