The Internal Revenue Service is going to get its piece of your hard-earned, tax-deferred retirement savings accounts — it’s just a matter of when.
A harsh reality? Perhaps. A chance to think strategically about your retirement accounts? Absolutely.
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That’s because there may be ideal times — and less ideal times — for people to get the taxes on their IRAs, 401(k)s, 403(b)s and other tax-deferred accounts over and done with, if they haven’t already, according to retirement savings experts.
Spotting a good time is an art and a science, they say, that involves cold, hard numbers and regulations. But it also involves tougher-to-pin questions about a person’s future needs and future taxes.
Turning retirement money into the version that comes out tax-free may not be right for everyone, said Devin Carroll, the owner of Carroll Advisory Group in Texarkana, Texas.
But people should know what the process entails when it comes to converting a traditional IRA and other tax-deferred accounts to a Roth IRA, he noted.
“There is no best timing to do it,” said Thomas Jarecki, the national director of wealth planning at KeyBank’s KEY Key Wealth Management.
But when someone does want to make the move, “there is the possibility to get highly tactical when you want to pull the trigger,” he added.
How to convert a traditional IRA to a Roth IRA
It all centers on the act of switching, or “converting,” money from a traditional tax-deferred account like an IRA to a Roth IRA.
An IRA is funded with before-tax dollars, and the account holder doesn’t pay taxes on it until they take money out of the account. When people pull money from the account after age 59½, that counts as taxable income. (Of course, they can pull it before that age — but doing so triggers a 10% penalty, with some exceptions.)
IRAs have a required minimum distribution, an amount that account owners need to take out each year, now starting at age 73.
Meanwhile, a Roth IRA is funded with after-tax dollars. The money comes out of the account free of federal income tax, because it’s already been taxed.
There are inflation-adjusted income limits for Roth contributions. Once single filers have more than $161,000 in modified adjusted gross income, they cannot contribute to a Roth IRA. For married couples filing jointly, the cap is $240,000. Backdoor Roth conversions enable high-earning households to sidestep Roth IRA income limits and still put away money in the accounts.
“You are effectively prepaying retirement taxes in the Roth account,” said Katherine Tierney, a senior retirement strategist at Edward Jones.
Before age 59½, contribution amounts can be taken from the account without taxes and penalties. But taxes and penalties might apply on distributed earnings. That depends on the purpose for the withdrawal and how long the account has been open.
Roth IRAs do not have RMDs during the owner’s life, because the IRS already took its due.
Similar rules apply to 401(k)s and other tax-deferred workplace plans, for those who do not roll over those accounts in retirement to IRAs.
Why convert a traditional IRA to a Roth IRA?
One good reason to do a Roth conversion is if someone expects to be in a higher tax bracket in the future and wants to tamp down their future tax bill, Tierney said. That could be a person who’s on the early side of their career and poised to make more money in the future, she noted.
It could also be someone who is nearing retirement and eyeing postwork income like Social Security, Carroll said.
“It also makes sense for people who want to leave an after-tax legacy to their heirs,” Tierney said. Distributions on inherited IRAs have their own rules, but most nonspousal beneficiaries have 10 years to fully pull out the money.
But it can be difficult to look so far ahead, for retirement planning or otherwise, Jarecki said. So the benefits of a tax-free retirement account may sound great, but making it a reality is much harder.
“As humans, we are much more focused on the present,” he said. “The impact on finances today often outweighs the potential financial benefits we might get down the road.”
When is the best time to do a Roth conversion?
Carroll said he discusses “runway periods” with clients. These are times when they have a financial path to pull off the maneuver, though not an endless one. It often starts when income from work dries up at the start of retirement, he said. Less income means a lighter income-tax bill and more room to convert funds without busting tax brackets.
The IRS counts the converted amount as part of a household’s modified adjusted gross income.
The runways shorten once Social Security, Medicare, pension income and RMDs start coming, he added. Social Security benefits — which people can claim as early as 62 — may be taxable depending on how much other income a person earns. Pension payments are also taxable.
In the planning process, people should also be aware that IRA conversions will impact the cost of Medicare premiums, Carroll noted. And there’s a two-year lookback period — so this window starts at 63, not at 65 upon Medicare enrollment.
To Carroll, both of those consequences are a cost of conversion “and shouldn’t be a detractor from doing it.”
Uncertainty about the future of the tax code shouldn’t figure too prominently into a person’s thinking about IRA conversions, according to Jarecki.
If lawmakers cannot reach a deal, core features of the tax code will revert to their 2017 status when the Trump tax cuts expire at the end of 2025. Those include five of the seven tax brackets bouncing back to higher rates.
There are a lot of questions at play, including who will be in the White House and which party will control Congress. Carroll and Jarecki both said they could foresee higher taxes in the future, but details beyond that are difficult to predict.
So it’s good to follow developments on Capitol Hill, Jarecki said — just don’t fixate on them.
“You don’t want to make the conversion decision solely on what may or may not happen for legislative action in two years or 20 years,” he said. “That cannot possibly drive your decision entirely.”
Roth conversions aren’t all or nothing
Jarecki agreed the interlude soon after retirement may be a good moment for IRA conversions — with some planning. A key aspect is saving enough money ahead of time to afford regular living expenses, plus the taxes on the conversion, he noted.
“You actually need the cash to pay those taxes,” Jarecki said. It’s possible to devote a part of the converted funds to the taxes, but he and others do not recommend it.
Whenever a person decides to convert funds, the whole IRA amount does not need to be converted all at once, Jarecki added. “This is not an all-or-nothing proposition.”
Tierney agreed: “You can do partial conversions — that’s a strategy we take each year.” If someone’s converting their funds bit by bit, Tierney said, they can see what other income is coming in the year and convert just enough to stay under the next tax bracket.
That’s why the end of the year is a good time to consider any sort of Roth conversion, she said. By then, a person has a good sense of the rest of their tax picture and a view of their portfolio’s performance for the year. A poorly performing stock market has its problems, but it offers some silver lining to someone doing a Roth conversion; cheaper stock valuations will result in smaller-sized portfolios and a smaller tax bill.
For someone who’s already thinking about a Roth conversion, “down markets can be an attractive time,” Tierney said, as there’s potentially a chance to “convert the same amount of shares for a lower tax bill.”
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Source: finance.yahoo.com