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Paradigm Shift: Pay Taxes…Now!

May 18, 2021

For as long as I can remember, sound financial advice was to save in Traditional IRAs and 401k plans for the purpose of deferring taxes.  The widely accepted idea was that at retirement, you could then withdraw monies at a lower tax rate since your income would be lower.  This strategy has historically worked very well. 

I believe it is time to consider a paradigm shift:  Pay taxes.  Now.  Don’t defer. 

Consider two current scenarios that will be intersecting in the very near future:

  1. We are currently experiencing some of the lowest tax rates in history. Nobody likes paying taxes, but it’s important to realize how low taxes have been in recent years for many.
  2. Our government has spent trillions keeping people afloat during the pandemic and they have signaled a desire to spend trillions and trillions more on other programs.

These low tax rates are set to expire at the end of 2025.  Given the massive amount of government spending and mounting deficits, it seems illogical to assume the government will extend them.  In fact, it’s more likely that they’ll also increase them across the board.  Given this (highly likely) scenario, wouldn’t you rather pay taxes now and not wait in the future? 

Think of your pre-tax investments (Traditional IRA/401k/403b/457/TSP) this way:  With these assets, you are co-owner with the IRS.  The IRS hasn’t yet told you how much of your asset they own… they’ll decide that amount in the future.  This adds on yet another uncertainty on top of many others that retirees must plan for.  I don’t know about you, but I like the sure thing- paying taxes now at reasonable rates.  Would you rather buy something when it’s on sale, or wait until the price goes up?


The Solution: The Roth Strategy

A Roth account allows for tax free growth and tax free withdrawals in retirement (over age 59 ½ and after 5 years of account opening).  You do not get a tax deduction for contributions, as they are made with after-tax money.  There are several ways to have assets in a Roth.

  1. Roth IRA: If you have earned income (from a job) and meet the income eligibility requirement, you can contribute to a Roth IRA, subject to IRS limits.
  2. Roth Conversions:Money in Traditional IRAs and 401k plans can be converted to a Roth IRA.  In the year you convert, you must pay ordinary income taxes on the conversion amount.  It is prudent to have your advisor work directly with your accountant/tax person to plan this out correctly to ensure your total income stays in a reasonably low tax bracket.
  3. Roth 401k: In recent years, many 401k plans added a Roth component.  This allows you to pay taxes now and save within a Roth vehicle.  Any employer match still gets deposited into the traditional pre-tax 401k.


Who it’s For

Again, every situation is different, so it’s important to include your tax advisor in the decision, but in general, if you fall under any of these four scenarios, you should look into whether it makes sense to start a Roth or do a Roth Conversion.

Low Wage Earners

If you are in the 10% or 12% tax brackets (single filers with taxable income up to $40,525 in 2021, or married filing jointly with taxable income up to $81,050), then it may make sense to pay taxes at these low rates now and invest in a Roth IRA, Roth 401k if available through your employer, or convert Traditional IRA money to a Roth.

Job Loss/Transition

If you recently lost a job or are changing jobs and have a gap in earnings for the year, lowering your taxable income, it may make sense to take advantage of this situation and convert a portion of your retirement savings to a Roth at your currently lower tax rate.

Recent Retirees

For those who have recently retired, but have yet to start receiving Social Security benefits, you are in an ideal window to make Roth Conversions.  Your income is likely much lower than when you were working, so you’re likely to be in a substantially lower tax bracket, making the amount converted to Roths taxed at that lower rate. 

Retirees with Significant Pre-Tax Assets

If you have a large amount of assets in pre-tax investment vehicles (mentioned near the beginning) and you intend to preserve as much as possible as an inheritance to your children, the government recently threw a wrench into this plan.  Previously, any non-spouse beneficiary of retirement assets were able to “stretch” the inherited IRA withdrawals over their own lifetime, taking smaller annual required distributions based on their age.  With recent changes to the rules, most non-spouse beneficiaries inheriting an IRA must fully close out the IRA within 10 years.  This means that your adult children will be forced to add on a large amount of additional taxable income in a much more compressed timeframe.  For example, say you have $500,000 in a Traditional IRA and your 35 year old daughter inherits it at your death.  Your daughter will be forced to close out the inherited IRA within 10 years.  If your daughter is married and her household income is $225,000, there is no ideal scenario to efficiently draw down the inherited IRA other than taking $50,000 per year for 10 years.  Your daughter would then be paying taxes at a much higher tax rate, which could be more than what you’re paying currently.  So if you prefer to not give the IRS any more of the money that you saved your whole life for, then (along with your financial advisor and tax advisor) you could formulate a strategy to gradually convert your Traditional IRA to a Roth IRA and at least lessen the tax burden to your daughter so that she can enjoy as much of your retirement savings as possible, which was your intention all along.


Added Benefits

First, with Roth money, your tax situation is certain!  There are no more taxes due in Roth IRAs once you’ve met the over age 59 ½ and 5 year rule.  This adds withdrawal flexibility to your retirement and may help to ensure overall retirement withdrawals and taxable income stay within a reasonable tax bracket.

Secondly, did you know that under proper planning, you can avoid paying income tax on your Social Security?  If your income (IRS calls this provisional income) is low enough, you don’t have to pay taxes on your Social Security, which could be a substantial annual savings.  The more taxable income you have, the more of your Social Security could be taxed.  Currently you could pay tax on up to 85% of your Social Security.


Three important points to Roth Conversions

  1. The optimal amount to convert should be up to the top of your current tax bracket. If you get bumped into the next tax bracket, be sure that it is not to a substantially higher one.  In other words, going from the 10% to the 12% bracket is not as significant as going from the 12% to the 22% bracket.  This is where it is important to work with your tax advisor in the final months of the year to verify the effects of a conversion and to understand the tax consequences before it is done.
  2. Roth Conversions are most impactful if you are able to pay the taxes due out of pocket. You will lose most of the benefit of converting if you have to have additional IRA money withdrawn to pay the taxes.
  3. Once a conversion is done, it cannot be reversed. So be sure to have all the information needed to make an informed decision before proceeding.

As with any tax strategy, it is important to consult with a tax advisor. Neither Cetera Investment Services LLC nor any of its representatives may give legal or tax advice.