Updated: Aug 12, 2021
Try these simple strategies to reduce the taxes you pay on your retirement accounts, leaving more money in your own pocket. Paying tax on your retirement account is inevitable, however there are ways to reduce taxes and have more control of your retirement fund, leaving you with more profit. A Roth conversion is one way to minimize taxes on withdrawals during retirement, but it is important to weigh any future pros against any possible cons by assessing how your immediate tax situation could possibly be affected. If you are looking at the Roth conversion as an option, there are other ways to minimize the tax you pay on your converted savings, so it’s important to make yourself aware of the strategies that are available. Most people will enjoy watching their nest egg grow, but many will not realize that the government is also watching, thinking about the cut they are owed. For any individual retirement account or 401(k) account, there will be pre-tax contributions that will need to pay tax eventually at some point.
David Mendels, Certified Financial Planner and Director of Planning at Creative Financial Concepts in New York reiterates this: “All too often, investors look at their traditional 401(k) statement forgetting that they have a partner invested there alongside them. While you may conveniently forget, your partner will not forget about you.” But, it is not all doom and gloom and we do not have to hand over thousands of dollars of our hard earned cash to the government in taxes when it least suits us. How much we pay, and when we pay is something that we do have some control over. In your traditional IRA and 401(k) plans you contribute now, generally tax free, and then get taxed later when you withdraw the money in retirement. If you can you afford to pay more taxes upfront now to take advantage of tax-free distributions in retirement, then you can do a Roth conversion. By moving money into a Roth IRA from a traditional account via a Roth conversion, you pay tax upfront at the time of conversion, but then no federal income tax on qualified withdrawals in retirement. Determining if this tradeoff is the right move for you requires evaluating what you can afford now, your age, lifestyle, current and predicted earnings and other factors. Think about whether paying taxes now or later is going to work best for you. Or, is it a combination of both? While it’s impossible to know with certainty where taxes will be when you start drawing on accounts, many experts expect rates to head higher, especially given how relatively low they are right now. In order to evaluate this, there are some key things to consider and potential strategies to employ to minimize your taxes. First, though, it’s important to understand how income is taxed. The current tax percentages are – 10%, 12%, 22%, 24%, 32%, 35% and 37%. They apply to income that falls into certain brackets, making different portions of income subject to different rates. Everyone is taxed 10% on earnings up to $9,950 for the year. Earnings between $9,951 and $40,525 are taxed at a rate of 12%. Then each income bracket is taxed at the next rate up, until the highest rate of 37% is reached which is for all earnings over $523,600. (More information can be found on the IRS website www.irs.gov) . So if you are considering a conversion, you should evaluate the tax rate you would actually pay on that money. For example: Say that not counting a conversion, you’d have $40,000 in income for 2021.The highest rate you would pay on that income is 12%. If you go to convert $10,000 to a Roth, it would push you into the next tax bracket, which comes with a marginal rate of 22% for income above $40,525. There also may be spillover effects of having higher income in any given year, including the tax rate on long-term capital gains or Social Security income, or tax credits that are available to certain amounts of income. “Sometimes people convert too much at one time,” said CFP Matthew Echaniz, divisional vice president for Lincoln Financial Advisors in Chesapeake, Virginia. “They end up jumping to the next bracket and the math doesn’t work as well.” One solution is to do partial conversions. That allows you to “fill up” a tax bracket at a lower rate. In other words, say your income excluding the conversion would be $75,000, which falls into the 22% bracket. If you were to convert $10,000, it would still be taxed at that rate because the bracket closes at $86,375 in income. “You could do partial conversions every year if you wanted to,” Echaniz said. He also said that the more time you have until you would tap your retirement savings, the less you have to analyze taxes for a conversion. “My likelihood of encouraging a Roth conversion is higher for a 30-year-old than for a 50-year-old,” Echaniz said. Also, if you happen to have some after-tax money in your non-Roth retirement account commingled with pretax funds, there is a formula that gets applied to account for the amount of the conversion that already was taxed. However, it’s best to consult with a professional if this is your situation. “It gets very complicated when you also have after-tax dollars that you are converting,” Echaniz said. In terms of ensuring that you are getting the most out of your retirement accounts, it pays to be aware of the different options available to you and how they work and can benefit you. If you have any questions regarding your retirement account(s) please let me know. I’ll be more than happy to assist you.
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