It is the middle of November, and we still do not have a passed tax bill to know if there are any changes for 2021 and the potential changes for 2022. I have some recommendations that can be advantageous regardless of what the final tax bills might say – and even if nothing changes, they should not harm your future tax liabilities.
There is a lot of talk about further limiting Roth conversions, and it is vital to do them while you can do so. Consider doing conversions up to the top of your current tax bracket and, if applicable, pay attention to your Medicare bracket. I ask clients constantly – what is the likelihood that tax rates will go down during your lifetime? The sooner you get funds transferred into a Roth means, the sooner that growth is tax-free rather than you having to pay taxes on it.
If you are in the 12% tax bracket, convert enough to get to the top of that tax bracket. If you are in the 22% tax bracket, you can go to the top of it. Or – since the next bracket is only 24%, if you have a considerable amount to convert, it might make sense to work your way through some or all of that tax bracket too. As you have enough income to make your way to the top of the 24% tax bracket, you may also need to consider the net investment income tax (NITT), a 3.8% surcharge.
I know that the tax bill to convert can seem daunting to take out of a savings account. Consider that most savings accounts right now are paying less than 1%, many paying around .1%. If you take $10,000 out of a savings account to pay a tax bill, you lose less than $20 of earnings. What if, in paying that tax, you can convert $50,000? That $50,000 growing by even more than ½ of a percentage will quickly make up that interest you lost on the funds in your savings account.
The other response I often hear is, what if I have an emergency and do not have that $10,000? If you are of the right age, you can take that money from the remaining funds in your Traditional IRA or other retirement accounts without penalties. In some cases, borrowing the money might be a good option, with historically low loan rates right now. I certainly would also not advocate for putting all your reserves into paying taxes on a Roth conversion. Maybe you convert less to only partially use those funds.
Many individuals have done complete conversions of their Traditional IRAs. What they have left is hundreds and, in some cases, millions of dollars in pre-tax 401(k), 403(b), or 457 employer plans. There is a little-known option called an “in-service” withdrawal that may give you the ability to convert some of those funds. The first step is to determine if your company allows an in-service withdrawal. This option allows you to pull funds from your existing work-related retirement plan even while you still work there. Some companies allow anyone to do it. Some companies only allow those over the age of 59 ½ to make an in-service withdrawal. Some do not allow anyone to do it.
If you are eligible, you can take funds from your 401(k), for example, and roll them over to a Traditional IRA. Once they are in the Traditional IRA, you can then convert by paying the taxes. Those dollars are moved into a Roth IRA and become tax-free in the future. This must be a direct rollover or transfer to avoid the withdrawal’s mandatory 20% tax withholding.
Do you have a SEP-IRA or a Simple-IRA? If so, you have the option of moving those funds to do conversion without your employer’s permission. I want to caution that funds placed in a Simple-IRA within the last 2 years should not be moved since they would be subject to a 20% early distribution penalty. All the other retirement accounts have an exception to that early distribution penalty except the Simple-IRA.
The last words on Roth conversions – be thoughtful out how much you convert and do not let fear be the controlling factor in making your decision.
We are waiting for the results of some Roth conversions proposals. Those over an income of $400,000 single or $450,000 MFJ may not be able to do Roth conversions after the year 2032. Backdoor Roth IRAs may stop for all taxpayers sooner than that.
What is a backdoor Roth? Some individuals, because their income is too high, put funds into a non-deductible Traditional IRA. We immediately do a conversion of those dollars to get them into a Roth IRA. There is a proposal that would prevent the conversion of those funds.
And for a laugh, I am sure it will get from most who read this – the final proposal I want to mention is if you have more than $10 million in your Roth IRA, you may be required to take required minimum distributions (RMD) from your Roth IRA. Certainly, not something our existing clientele at Planning with Purpose must worry about today. However, will this be the start of a precedent to start RMDs for all Roth IRAs in the future? I see that as a possibility.
With possible further limits to whom can put money into a Roth, funding your contributions to the maximum while you can make sense. For those under age 50, you can contribute $6000 per year. For age 50 or over, you can contribute $7000 per year. To contribute to an IRA, you must have earned income at least in the amount of IRA contributions. Under the spousal IRA rules, you can contribute to your IRA if your spouse has earned income and you do not.
The final note related to retirement accounts concerns 401(k) contributions. If you have put funds into your 401(k) plan at work as after-tax dollars, you should consider moving them. After-tax dollars are typically used when someone has fully funded their 401(k). They grow in the 401(k) tax-deferred. When you take the funds out later, you only pay taxes on the earnings.
By the end of 2021, if you roll those after-tax dollars, you can roll them into a Roth IRA. Starting in January 2022, you would have to roll them into a Traditional IRA. The difference – how the earnings grow. If you have after-tax dollars in your 401(k), consider rolling them to a Roth IRA before the end of the year to allow for future tax-free growth.
We are all having to deal with costs increasing as we watch inflation heading towards new recent highs. I do not want to be all “doom and gloom” and add more to that. My concern for tax increases matches my concern for the impact of inflation. Everyone needs to consider both and do what you can do to improve your financial situation today and far into the future. Planning with Purpose is here to help you with strategies to minimize taxes in the future and discuss current cash flow issues.
Many of our current clients have converted all they have to convert. Be a good friend and pass this article on to those individuals who are not getting this advice from their financial planner or their tax preparer. Give them the gift of improving their future tax bill too.
