Be careful with a Roth conversion

Are you considering converting some or all of your traditional IRA or 401k accounts to a Roth account because you are concerned that future tax rates will increase? If so, you will need to perform careful analysis to determine whether it is realistic to expect to pay taxes at a higher rate in the future.

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This analysis will depend on several factors, including the level of your current taxable income, the level of your current income taxes, and the amount and composition of income you expect to receive when you retire.

The question of “tax hikes”

One of the reasons for converting funds from a traditional account to a Roth account is that you expect to pay higher federal tax rates in the future, compared to the tax rates you pay or plan to pay now. To estimate if you might have to pay higher income taxes in the future, it helps to understand the federal tax rate brackets that will apply in 2021 and beyond. The table below shows the 2021 federal tax brackets for married couples filing jointly.

Please keep in mind that the taxable the income used in the table above is not your total Income. Your taxable income reflects any deductions you might take, whether you use the standard deduction or itemize your deductions. In addition, the tax amounts indicated do not reflect the tax credits that you could benefit from.

Large tax rate increases for higher income levels create planning opportunities and traps for the unwary if you don’t understand how tax rates might apply to your pre and post retirement situation. Let’s take a closer look.

Most retirees will have lower taxable income in retirement compared to their working years, since they will have lower total income in retirement and will be able to use a higher standard deduction once they turn 65. For example, in 2021, a married couple with one or both spouses still working and earning a combined annual taxable income between $ 80,251 and $ 171,050 would pay federal income taxes at the marginal tax rate of 22%. However, in retirement, this couple’s taxable income would most likely fall below $ 80,250, and they would pay a marginal income tax rate of just 12%, a rate 10% lower than when they did. was working. This typical situation is the usual justification for investing in a Traditional or 401k IRA, not a Roth version.

If such a couple were concerned that their income tax rate would increase in the future, their marginal tax rate in retirement would have to increase significantly – from 12% to over 22% – in order for them to pay more taxes. raised after retirement. It may be highly unlikely that future tax rates will go up that much, and in this case, a Roth conversion could now cause this couple to pay more income taxes compared to leaving their money in one. Traditional or 401k IRA.

The situation could be quite different if your taxable income in 2021 while you were working were between $ 171,051 and $ 326,600; at this level, you pay income taxes at a marginal rate of 24%. If you expect your retirement income to be more than $ 80,251, you will continue to pay taxes in retirement at a marginal income tax rate of 22% or 24%. In that case, it wouldn’t take much of a tax increase to pay at a higher rate in retirement, and a Roth conversion might make sense.

Tax planning considerations are similar if you pay taxes at even higher marginal rates. The considerations are also similar for single filers, but they have different tax brackets as shown below.

It is important to note that the IRS increases the income tax brackets each year for the cost of living.

A conversion means paying income taxes on any amount you convert

If you decide to convert some or all of the funds from a Traditional IRA or 401k to a Roth, you will have to pay income taxes on any amount you convert. You’ll want to make sure that no conversions push you into a much higher income tax bracket, as the previous charts show. For example, suppose a married couple has taxable income just under $ 326,600 before a Roth conversion. In this case, they would pay taxes at a marginal rate of 24%. However, a significant Roth conversion, when added to their existing taxable income, would be taxed at a rate of 32% or more.

Because of these potentially higher tax rates, you’ll want to estimate your current taxable income and make sure any conversions keep you in your current tax brackets. It’s easier to check if your taxable income is near the bottom of a tax bracket. For example, if a married couple has taxable income of $ 80,251, they could convert up to $ 90,000 of taxable income in a Roth account and remain in the 22% marginal tax bracket.

You have some control over your taxable income in retirement

Keep in mind that you will have some control over the amount of your taxable retirement income at retirement. This is because the exact amount of your retirement income will depend on your strategy for deploying your IRA and 401k accounts in retirement. Important considerations include the rate you withdraw each year from your traditional IRA and 401k accounts, whether you are using savings to purchase an annuity, and whether you are using a Social Security gateway strategy to optimize your Social Security benefits. Therefore, you will want to develop your retirement income strategy before preparing an analysis on a Roth conversion.

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You will also need to make a big estimate of the level of future income tax rates and keep in mind that you could be wrong!

As you can see, there are several key mobile elements that you will need to consider when deciding to convert some of your traditional accounts to a Roth account. It is worth taking the time to prepare the appropriate analyzes or to ask your tax accountant to help you.

About Alma Ackerman

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