Traditional retirement plans – like 401(k)s and IRAs – are wonderful vehicles for saving. You can contribute, receive a match and reduce your taxable income to save on taxes. Better still, the assets in these accounts are allowed to grow without having to worry about Uncle Sam’s reach. However, nothing lasts forever.
Eventually, Uncle Sam comes calling and wants his share of the pie. For those investors with 30 or 40 years’ worth of compounding under their belt, this tax bill could be significant.
But there may be a way to skirt some of the long-term taxes. By paying taxes today and converting to a Roth account, investors could avoid paying taxes later on and ignore the dreaded required minimum distributions (RMDs).
And right now, could be a great time to consider such a tactic.
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One of the reasons why workplace 401(k)s and traditional IRA accounts are so great is that they offer long-term tax deferral. By deferring taxes on dividends, capital gains and interest income, investors can keep more of their money compounding over time, leading to higher overall returns.
The problem is that Uncle Sam won’t let you defer those taxes forever. When you finally tap those accounts for retirement, the IRS wants its share and they do so at ordinary income rates. Perhaps even worse is that the IRS will force you to eventually withdraw money from the accounts even if you don’t need it.
When a saver turns 70 ½ years old, or 72 after the pandemic, the IRS forces you to take what’s called required minimum distributions from their traditional IRAs and 401(k)s. The amount you need to withdraw is based on your account balance at the end of the previous year and your life expectancy based on your age. That withdrawn amount is then taxed as ordinary income rates.
The issue is that after decades of compounding and contributions, our 401(k)s and IRAs could be quite large indeed. Some investors could be faced with significant tax bills as withdrawals are taxed as ordinary income – 22%, 24% or even 32% for most people. Avoiding or forgetting to take your RMDs comes with a 50% tax penalty on top of the number they calculate.
The potential for significant taxes on our workplace retirement balances isn’t something to take lightly. The impact of taxes on a portfolio can have a major effect on outcomes. But there is something investors can do about it. And that’s making a conversion.
Traditional IRAs and 401(k)s aren’t the only flavor around. Roth accounts are made with after-tax money and as such are allowed to compound tax-free. Because of this, there are no taxes paid when withdrawing money, and there’s no dreaded RMDs. But there are income limits to contribute to open in the first place and many employers still don’t offer Roth 401(k)s.
But there is hope for investors. The IRS will allow you to convert all or some of the money in a traditional account and turn it into a Roth account.
Now, when you do this, you will pay taxes on any money in the traditional IRA that would have been taxed when you withdrew it, including contributions and tax-deferred earnings. That money will be taxed as income for the year you make the conversion and you’ll need to file an 8606 form with your taxes. Basically, the IRS allows paying taxes now to avoid paying taxes later on in retirement.
There are some added benefits as well. While the SECURE Act killed “stretch IRAs,” a Roth account will still allow beneficiaries ten years’ worth of tax-free distributions after the original owner dies. This can be beneficial as most beneficiaries are typically in peak earning years when this happens.
Don’t forget to check out this article to know how new bills in the Congress could affect your portfolio.
There are a lot of moving parts to consider when thinking about making a conversion. Potential future tax liabilities, current and future states of residencies, what your RMDs could be and years left of compounding are just some examples. Making a conversation doesn’t always make sense.
But now may be a good time to consider taking the plunge. For one thing, the pandemic has left many people in lower tax brackets or even furloughed. This could be a major win for those willing to convert as the taxes paid during the conversion could be less.
Secondly, future tax liabilities are up in the air. President Biden hasn’t unveiled an official tax plan just yet, but there have been some early indications of what his administration is thinking. Already, the President has talked about raising taxes on higher earners and repealing parts of the 2017 Tax Cuts and Jobs Act, as well as making some changes to various tax rates for investments. So, going forward, tax rates could be much higher. Given potentially high plan balances in 401(k) and RMDs rates, some savers could be facing an even heftier tax bill down the road. Converting now could save them a bunch of taxes later on.
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Traditional IRAs and 401(k)s are wonderful vehicles that allow for tax-deferred savings. However, that tax deferral isn’t indefinite. Eventually, Uncle Sam wants his share.
As such, converting your traditional accounts to Roth accounts can make sense for many investors with large account balances and long timelines/compounding time left. Paying taxes now for avoidance later on could be a good deal for many.
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