Tax rates seem likely to rise for the wealthiest and
highest-earning taxpayers under the Biden administration. For those with
traditional retirement accounts, making moves ahead of tax law changes can
reduce income-tax bills in retirement.
The key strategy to pursue is the Roth conversion. These
allow account owners to transfer some or all of the money in a tax-deferred IRA
or 401(k) to a Roth account, in which you contribute after-tax dollars and get
tax-free withdrawals. For workers with the option, it can also make sense to
funnel future retirement account contributions into a Roth 401(k).
“If there ever was a year to do it, this would be the year
to maximize Roth conversions,” said Jamie Lima, a financial planner in San
Diego.
Although you will have to pay income tax on the transfer,
thanks to the tax cuts enacted in 2017, many high earners stand to pay a lower
tax rate today than they would by deferring the payments until retirement, says
Ed Slott, an IRA specialist in Rockville Centre, N.Y.
“Tax rates today may be the lowest you will see for the rest
of your life,” he said. For people with big retirement account balances, it can
make sense “to pay tax today to lock in current rates and eliminate the risk of
higher rates in the future.”
Under the Biden proposal introduced Wednesday, the
administration would raise the top income-tax rate to 39.6% from 37%.
Currently, that applies to taxable income above $523,600 for individuals and
$628,300 for married couples.
It would also raise the top rate on capital gains from
today’s 23.8% to 43.4%, including a 3.8% tax on investment income, for
households making more than $1 million.
With a traditional IRA or 401(k), individuals generally get
to subtract contributions from their income and reduce the taxes they pay.
Amounts in the account grow tax-free, but owners must pay ordinary income tax
on the money when they withdraw it in retirement.
Why bother converting? Once you hold a Roth for at least
five years and are age 59½ or older, future withdrawals of both principal and
appreciation are tax- and penalty-free.
In retirement, people with Roth accounts can take tax-free
withdrawals to supplement their taxable income and stay within a lower tax
bracket. Some may be able to use Roth withdrawals to reduce or avoid the
surcharges on Medicare premiums that kick in above $88,000 in income for
individuals and $176,000 for couples.
Another advantage to a Roth is you won’t ever have to take a
required distribution.
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Those who seem most likely to benefit from converting money
to escape future tax increases are people with incomes of more than $400,000,
said Jeffrey Levine, chief planning officer at Buckingham Wealth Partners. The
reason: During the 2020 campaign, President Biden proposed higher payroll taxes
on those taxpayers, although the administration has yet to attach that
provision to a particular plan.
For Roth conversions to make sense, “you’ve got to believe
you will be in a higher tax bracket in retirement,” Mr. Levine said.
To maximize the “dollars that can grow tax-free in the
future,” the account owner should ideally pay the tax using money outside the
IRA, he said.
Given the proposed increase in the capital-gains tax rate,
Mr. Levine said, it may make sense to sell stocks held in brokerage accounts to
lock in today’s lower capital-gains tax rate and use the proceeds to pay the
Roth conversion tax bill.
For those still contributing to retirement savings accounts,
another way to amass Roth assets is to switch contributions from a traditional
401(k) or IRA to a Roth account. Almost three-quarters of employers who use
Vanguard Group Inc. as a 401(k) administrator offer Roth 401(k)s. Anyone can contribute
to one, regardless of income.
In contrast, individuals who earn $140,000 or more and
couples with incomes above $208,000 cannot contribute to a Roth IRA. But there
is a way around this rule.
The key is to put money you already paid taxes on into a
traditional IRA and convert it to a Roth IRA. Because you already paid income
tax on the contribution, you will owe tax only on the appreciation your
investments have earned when you do the Roth conversion. If you convert
quickly, your investments won’t have much time to appreciate, Mr. Slott said.
If you have other IRAs, this is likely to become more
complicated. That is because tax rules prevent those with traditional IRAs that
contain both pretax and after-tax money from converting only the after-tax
money.
Say you have $50,000 in a pretax IRA. If you put $7,000 of
after-tax money into a separate IRA, you can’t convert only the $7,000.
Instead, you must divide your after-tax contributions of $7,000 by the total
balance in both of your IRAs of $57,000. The result—12.3%—is the percentage of
the conversion the Internal Revenue Service considers tax-free—or $860 of a
$7,000 conversion.
You can avoid this problem if you roll all of your pretax
IRA money into your current employer’s 401(k) plan, if the plan allows this.
Because you can’t roll after-tax money into a 401(k), the $7,000 in
nondeductible contributions will remain behind in your IRA, where it can be
converted tax-free to a Roth IRA.
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