Did you know the government owns a piece of your traditional 401 (k) or IRA? Here’s how to get it back
It can be exciting to see your retirement account grow.
However, if it’s a 401 (k) or individual retirement account that has pre-tax contributions, don’t forget that Uncle Sam owns some of the balance you see.
“All too often, investors look at their traditional 401 (k) statement and forget they have a partner by their side,” said certified financial planner David Mendels, director of planning at Creative Financial Concepts in New York. “While you can easily forget, your partner will not forget you.”
More from Personal Finance:
401 (k) Investors Vulnerable to Cyber Hacks, Says Watchdog
This is how Americans issue their stimulus checks
Use these three strategies to make your interview perfect
How much the IRS receives on taxes, and when it does, is partly up to you.
With traditional 401 (k) plans and IRAs, you typically get a tax break if you make contributions and then pay tax on the withdrawals in retirement. In contrast, Roth versions of these accounts do not have an upfront tax break, but qualified withdrawals are exempt from federal income tax.
While you can transfer money from a traditional account to a Roth IRA at any time – via a so-called Roth conversion – to take advantage of tax-free retirement distributions, you would have to immediately convert taxes on the dollars you paid before taxes. And determining whether this compromise makes sense is nuanced.
The simplified explanation is: If you expect higher taxes in retirement than the rate now paid, a Roth switch can make sense. While it is impossible to know for sure where the taxes will be when you start accessing accounts, many experts expect tax rates to rise, especially given the current relatively low levels.
“The only likely direction for tax rates is to increase,” said CFP George Gagliardi, founder of Coromandel Wealth Management in Lexington, Massachusetts. “Now is perhaps the best time to think about Roth conversions before interest rates go up.”
The reduced marginal tax rates now in effect will expire after 2025, as required by the Tax Cuts and Employment Act 2017, unless Congress extends them.
However, as you are nearing retirement and expect your income to drop – and therefore how much tax you pay – it might make sense to keep your money where it is. If you have a lower tax rate at the start of retirement – and before the required minimum payouts commence at the age of 72 – switching over may be beneficial.
Regardless of whether you are performing a Roth conversion, there are a few important considerations to consider and strategies to potentially use to minimize your taxes.
First, however, it is important to understand how income is taxed. There are currently seven different tax rates – 10%, 12%, 22%, 24%, 32%, 35% and 37% – but they apply to income that falls within certain brackets, which means that different parts of income are subject to different rates.
In other words, regardless of how much an individual tax advisor earns in 2021, the first $ 9,950 of income is subject to a 10% marginal rate (see Statuses for Other Tax Return Statuses). The next higher rate of 12% applies to income between $ 9,950 and $ 40,525, and so on up to the highest limit of 37%, which applies to income above $ 523,600.
So if you are considering making the move, evaluate the tax rate you would actually pay for that money.
To illustrate, suppose, without the conversion, you would have an income of $ 40,000 in 2021. The highest rate you would pay on that income is 12%. For example, if you convert $ 10,000 to a Roth, you move into the next tax bracket, which has a marginal rate of 22% for income over $ 40,525.
There may also be spillover effects if higher income is earned in a given year, including the tax rate on long-term capital gains or social security income, or tax credits available on certain income amounts.
“Sometimes people convert too much at once,” said CFP Matthew Echaniz, division vice president of Lincoln Financial Advisors in Chesapeake, Virginia. “In the end, you jump to the next bracket and the math doesn’t work that well.”
One solution is to do partial conversions. This allows you to “fill in” a tax bracket at a lower rate. In other words, let’s say your income without the conversion would be $ 75,000, which falls into the 22% class. If you were to convert $ 10,000 it would still be taxed at that tax rate, as the range ends at an income of $ 86,375.
“You could do partial conversions every year if you wanted,” said Echaniz.
He also said the more time you have before you use your retirement savings, the less you will need to analyze taxes for a switch.
“My likelihood of promoting a Roth conversion is higher with a 30-year-old than a 50-year-old,” said Echaniz.
If there is some after-tax money in your non-Roth retirement account mixed in with pre-tax funds, a formula is applied to account for the amount of the conversion that has already been taxed. However, it is best to consult a professional if this is your situation.
“It gets very complicated when you also have post-tax dollars to convert,” said Echaniz.