First, let’s review a few facts:
- The budget deficit and debt are at all time highs.
- Current tax rates are at a historic low.
Tax rates in the future are very likely to go up for
everyone. Either the marginal
rates will go up, or deductions will be lowered which will raise your average
tax rate.
With that in mind, your retirement nest egg is a ticking
time bomb. Yes, it’s true.
When you take money out of your 401(k) or traditional IRA,
you pay taxes on that money at that time.
But who know what the tax rate will be then? It could be lower, or more likely, it will be
higher than today.
The government would love to get their hands on that
money. The problem is that they need the
money NOW !
They would rather not wait until you retire years from now.
A few years ago, taxpayers of any income level could convert
their traditional IRA to a Roth IRA. For
people who only have a 401(k), it wasn’t feasible.
Now, with the passage of the ‘fiscal cliff’ deal, people who
have 401(k)s now can convert to a Roth 401(k) – as long as their 401(k) plan
offers the Roth option.
A nice article on this is here.
Previously, this conversion was only available to people who
were retiring, leaving the company, or had reached age 55. In other words, anyone who could withdraw the
money without paying an early withdrawal penalty is eligible.
Why is this a good deal, especially for younger people?
1.
Get a Groupon-like discount on future tax
rates.
On that deal site, you pay a discounted price for something
today, but you might not use it until later.
Well, you’re paying a discounted tax rate today on your
retirement. Plus you’re paying that
lower rate on a smaller retirement account balance. After all, hopefully your retirement account
will grow.
Think of it this way:
Would you rather pay 25% taxes on a 401(k) balance of $50,000 today or
35% taxes on a $250,000 when you retire?
This strategy works well if you have the cash outside your
retirement accounts to pay the tax. If
you have to use money from the retirement account to pay the taxes for the
conversion, this option is less attractive.
2.
The eggs and baskets thing –
diversification!
Don’t put all of your eggs in one basket. You can read all sorts of articles about
diversification of your investments to help reduce risk.
But there’s a thing called tax diversification:
Traditional IRA and 401(k)s get taxed upon withdrawal.
Roth IRA and Roth 401(k)s offer tax free withdrawals.
Social Security is tax free as long as you meet certain
income levels.
When you retire, you can get a lot more income – and pay a
lot less tax – if you can plan your withdrawals and from which source. By doing some planning, you can also get a
much bigger Social Security payout in your retirement years.
3.
Do you really want to pay extra for Obamacare?
Whether you agree with the health care law or not, do you
want to have to pay extra?
The health care law calls for a surtax of 3.8% to help pay
for the program. The income threshold is
$250,000. And that figure is not
adjusted for inflation, which means each year more and more people will be
subject to paying this tax.
In the future, traditional 401(k) withdrawals could push
your total income over $250k. But Roth
IRA and Roth 401(k) distributions are not counted as income for the purposes of
this surtax.
Think you’ll never hit $250K? Think again.
A perfect example is the Alternative Minimum Tax, or AMT. When Congress enacted that in 1969, the
intent was to make sure high income people pay something for taxes.
But AMT level was never indexed for inflation. So, if Congress did not ‘patch’ it each year,
and make it part of the fiscal cliff deal, the AMT income threshold this year
would have been $45,000 for married filing jointly.
Would you call $45,000 high income? I wouldn’t.
The point is that while you may think $250k is a long way
off compared to your income today, most of us will be there at some point
simply due to inflation over time.
Nobody likes to pay extra in taxes. And certainly, most accountants would tell
you why pay taxes today when you can push it off to tomorrow.
But with this conversion feature, as well as the Roth IRA
conversions, this is a good time to give the government what they want.
As always, please consult with your tax and/or financial adviser for your specific situation.
