Don't Mess With Taxes

Five turkeys might not technically be enough to be classified a rafter or gang or death row of turkeys — and yes, all are among the many collective nouns for a gathering of this particular fowl — but these birds represent today's fifth and final Tax Turkey to Avoid. (Photo by Chris Henry on Unsplash)

Are you enjoying your Thanksgiving break? Maybe time off from work this week has you thinking about when you can leave the 9-to-5 completely.

Whenever that happens, you’ll want to have enough of a nest egg to enjoy your retirement. That will be possible if you’ve been saving, preferably in a tax-advantaged individual retirement arrangement, or account as most of us refer to it. Either way, the IRA acronym works.

If your IRA is a traditional one, you’ve put money in before it was taxed, and possibly got an immediate tax deduction. But when you eventually start taking out money, either your own choice or because you’re facing required minimum distributions (RMDs), you’ll owe tax on the amounts.

A Roth IRA, however, is funded by already taxed contributions. That means you won’t own Uncle Sam when you start withdrawing from your Roth. And those withdrawals are always at your discretion. There’s no RMD rule for Roth IRAs.

If all or most of your retirement money in a traditional IRA, and you haven’t ever considered converting it to a Roth version, then you're falling victim to this week’s fifth and final Tax Turkey to Avoid: Not exploring a Roth IRA conversion.

Conversion advantages and disadvantages: As with all things tax, there are pros and cons. Let’s start with the advantages of converting a traditional IRA to a Roth IRA.

The main one was mentioned earlier, but bear repeating. You won’t owe tax on the Roth amounts you eventually withdraw. You also won’t be tied to RMDs.

On the con side of the conversion ledger, the main issue is the immediate tax bill. Since your traditional IRA money, both contributions and earnings, has not been taxed, you’ll owe tax on the converted amounts in the tax year in which you make the shift.

The added income from the conversion also could push you into a higher tax bracket.

If you’re already getting Social Security benefits, that could mean a bigger tax bill on those federal retirement payments. Depending on just how much more income it adds, you also could face bigger Medicare premiums.

Financial and tax factors to consider: Also as with all things tax, you need to consider a traditional-to-Roth IRA move only after assessing all your financial and tax factors.

A Roth conversion might be right for you if your tax rate is likely to be higher when you take distributions. Of course, there’s an element of guess work here, since we can’t, darn it, see into the tax future.

But things that might make a Roth conversion worthwhile include —

• Your current income is unusually low, meaning your tax rate is, too.
• You have money from other sources to pay conversion taxes.
• Your assets are primarily in tax-deferred accounts, and you want more asset and tax diversification.
• You want a hedge against potentially higher federal tax rates, although that seems less likely now following Donald J. Trump’s election earlier this month.
• You won’t need traditional IRA RMDs to cover your expected retirement expenses. Again, this requires some prognostication, but generally a Roth conversion could be beneficial if you pay the due taxes from an account that isn’t very tax-efficient.

Retirement law changes: Note, too, that there are no Roth do-overs. You used to be able to recharacterize a conversion if things changed, but the Tax Cuts and Jobs Act of 2017 ended that option. Now once you convert your traditional IRA money to a Roth retirement account, it's forever a Roth.

More recently, provisions in the two Setting Every Community Up for Retirement Enhancement (SECURE) retirement laws also could come into play when considering a Roth conversion.

First, under SECURE 2.0 the starting age for RMDs was moved to age 73 in 2023. It is scheduled to go to age 75 in 2033. This gives traditional IRA owners more time to implement a conversion strategy.

Second, SECURE Act’s 10-year RMD rule might make conversion more appealing for those who want to leave IRA money to heirs. The law requires funds in most inherited IRAs (there are exceptions of spouses and others) to be fully distributed within 10 years of the original owner’s death. Inherited traditional IRA income subject to RMDs could push some beneficiaries into higher tax brackets.

Partial conversion OK: If want to convert, but your traditional IRA is so big that the tax bite would be untenable, all is not lost.

Conversion is not an all-or-nothing proposition. You can convert all or a portion of your eligible IRA. Generally, you'll want to convert just enough to remain within a specific tax bracket to avoid a hefty tax bill.

So, you could set up a multi-year conversion strategy, moving a portion over time from the traditional IRA to the Roth. Or skip a year if your other income was so high that the converted funds would create a large tax burden.

Get professional conversion help: I’m not arguing for or against a traditional to Roth IRA conversion. I am, however, arguing for knowing how the move fits into your current (and future, as far as you can comfortably prognosticate) financial and tax circumstances.

If you don’t even look into the possibility of turning your traditional IRA funds into Roth retirement money, you could be missing out on a potentially beneficial move.

I’ve addressed some conversion issues in this post, but I want to emphasize that they are general highlights. Every person's situation is different, and there are some exceptions that could apply to you.

One of the many online IRA conversion calculators can give you an idea of how the change might affect you. But you really need to run your personal, and various, retirement and tax scenario numbers with a tax (and retirement) professional to make sure the potential benefits of converting your traditional IRA to a Roth are worthwhile.

The end of 2024’s Tax Turkeys: And so it ends, this year’s list of Tax Turkeys to Avoid.

In case you missed any, the previous four are, from 1 to 4, Not reviewing and adjusting if necessary your paycheck withholding on Monday, Nov. 25; Not establishing a bunching strategy on Tuesday, Nov. 26; Not using, therefore losing, your medical FSA money on Wednesday, Nov. 27; and Overlooking alternative ways to give to charity on Thursday, Thanksgiving Day, Nov. 28.

You also might find these items of interest:

• Ways to pay Roth IRA conversion taxes
• The great traditional IRA to Roth conversion debate
• Don’t need your RMD? Give up to $105,000 of it as a QCD

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