The money you have saved for retirement likely has not yet been taxed. If you own an IRA, SEP IRA, 401(k), TSP through the federal government, 403(b), SIMPLE IRA, and that plan does not allow contributions to be treated as Roth after tax deposits, which likely they do not or you didn’t elect them as such, those balances you have accumulated are waiting to be taxed.
Congress and The IRS Don’t Care
Every single penny that comes out of those accounts and arrives to your pocket will be taxable income no matter how much or little you take, how much you have saved, how much total income you have for the year, or what you use the money for. Congress and the IRS don’t care. They created this system on purpose long ago so that the $5.3 trillion held in 401(k) accounts and the $9.3 trillion held in IRA accounts as of June 30th 2018, according to the Investment Company Institute, would eventually be taxed.
They knew exactly what they were doing. Congress decided that if they didn’t tax your money before you saved it, they would tax it when you pulled it out in retirement. If you don’t use your retirement savings while you are alive – instead passing it on to your beneficiaries, Congress will tax it when your beneficiaries take the money. Then just to be safe Congress will force you or your beneficiaries to start taking withdrawals from all these accounts, whether you need the money or not, so they can tax it when you turn 70.5 or when the beneficiaries inherit it, respectively.
Well all right, but how much tax do you have to pay? Maybe the rate won’t be so bad. The answer? Nobody knows. What year will you take the withdrawal? How much will you take? What other income will you have that year, including Social Security? Will you have any tax deductions, like a mortgage, then? And most importantly what will Congress make the tax rate in that future year when they get around to realizing they need money and look to this $15 trillion dollar and growing piggy bank they built for themselves?
Convert Your IRA to a Roth IRA
There is really only one action you can take if you think this is going to be a problem for your retirement, and that is to convert these pre-tax assets to a Roth IRA. The Roth IRA, or Roth 401(k) requires you to pay tax on the money before you deposit your contribution, or in the case of a conversion at the time it switches over to the Roth from the traditional IRA. In exchange for paying taxes now, withdrawals you take in the future, including any interest growth, will not be taxed. If you are considering this conversion step, or the tax aspects of contributing to and withdrawing from these accounts, it would be wise to involve a tax advisor.
If you have decided to convert these assets for the sake of the future tax environment, then the next question is when? Here are 4 reasons why now may be a good time.
Taxes Are Lower But Might Not Stay That Way – The tax legislation passed for 2018 noticeably lowered tax rates by extending the income ranges per bracket and introducing a new 12% tax bracket. The amount of political energy these tax changes take, and in the downward direction, probably means there won’t be another one soon, but you never know. And the same income is now taxed less than it was just last year.
Values Should Be Higher In The Future – The money in these Roth retirement accounts is likely invested in some form. Whether that is stocks, bonds, or mutual funds the goal presumably is they will be worth more in the future. In some cases, a lot more. The time period between now and when you use the majority of these assets could be decades. It might be decades before you start taking even partial withdrawals. So, converting now causes that future growth to be tax free. This is provided Congress doesn’t again change the rules and change Roth IRAs to be less tax favorable. However, it would take a great deal of political will to take away such a popular provision in the tax code.
Medicare Costs are Based on Taxable Income – When you are retired and reach age 65 it’s likely you will use Medicare and its’ supplements for your health care. Congress has repeatedly stated they wish to change how Medicare works, for its’ own viability. Red ink aside, how much you pay for Medicare part B is determined by your total household income.
The more income you have the more you pay, and conversely the less taxable income you have, the less you pay for your health care. This is a reason in itself to have more of your assets on the Roth side. But getting back to Congress, it is possible one of the ways they could make the program more viable is to lower the thresholds on income or raise the premiums per income range, thereby further encouraging you to get your taxable income as low as possible in retirement. Here is a link to how much you will pay per income range in 2019. https://www.medicare.gov/your-medicare-costs/medicare-costs-at-a-glance
Social Security Might Become Fully Taxable – Social Security is hot button for Congress. With the current majority in Congress, as of this writing, in favor of making changes to its benefits for its own viability. Read – changes as cuts in one form or another. What the end legislation will look like, or if it ever gets passed are unknowable, but one of the features of Social Security is there exists a formula to determine how much of your benefit payments go on your tax return.
This formula is mostly driven by the size of all the other income coming in to your home, like pensions, part time work, and you guessed it IRA withdrawals. What does not count toward this formula and therefore determine how much of your Social Security you have to pay tax on? Distributions from Roth IRAs. With the goal of increasing tax revenue to fund future Social Security payments, Congress could make this formula more restrictive. Meaning, those with lower income would still find their Social Security benefits taxable or mostly taxable. It is possible they could make Roth distributions count toward the formula as well. But if they did that you still would not be in any worse shape than if those distributions were coming out of a taxable retirement account.
Have you thought about converting your IRA to a Roth IRA? If so, tell us more in the comments below.
Brian Kuhn CFP® is a financial planner and writer based in Fulton MD. He is the author of “Total Compensation: A Practical Guide to Federal Employee Benefits” and “The Personal Finance Handbook,” a Guide to the Most Common Personal Finance Questions.” He is available at www.PSGClarity.com and @IRAGuidance on Twitter. No content in this article should be construed as a specific investment recommendation. Securities offered through Triad Advisors, Member FINRA / SIPC. Advisory Services offered through Planning Solutions Group, LLC. Planning Solutions Group, LLC is not affiliated with Triad Advisors. PSG Clarity is a division of Planning Solutions Group, LLC.