401k, Retirement, Roth, Stock Market
April 02, 2020
There is a tax-smart retirement move that just became less expensive due to the fact that the bear market for stocks has reduced your portfolio values.
Those of you who have done a lot of retirement savings in traditional 401(k) and traditional IRA accounts need to fast forward and think through what your finances will look like in retirement. Every penny you pull out of a traditional retirement account will be taxed as ordinary income. And even if you don’t need the money, you are required to make annual withdrawals –called required minimum distributions(RMDs)—once you turn 72. (A note for 2020: because of the bear market, the federal government has suspended RMDs during 2020. If you don’t need the money, you aren’t required to make an RMD in 2020.)
If you have money in a Roth 401(k) or a Roth IRA you will owe no tax on withdrawals you make in retirement. And you don’t have to worry about taxable RMDs.
I think it is so smart to have at least some of your retirement savings in Roth accounts, so you will have access to some money in retirement that will be tax-free. One way you can build up Roth 401(k) and Roth IRA assets, is to focus your future contributions on those accounts. Most employers now offer a Roth 401(k) option, and the income limits for contributing to a Roth IRA are generous. (You can contribute the max in 2020 if you file an individual tax return with modified adjusted gross income below $124,000 or you file a joint tax return with income below $196,000. The maximum 2020 contribution if you are younger than 50 is $6,000; Anyone at least 50 can contribute $7,000.)
And there’s another way to build up tax-free Roth assets: convert some of the money you currently have in a traditional account into a Roth account. This is called a Roth Conversion.
There are three ways to do a Roth conversion.
1) You can always convert money in a traditional IRA account into a Roth IRA account.
2) If you have traditional 401(k)s from an old employer you can do a rollover where you move your money out of the 401(k) and into what is called an IRA rollover account. When you do the rollover you can also convert the money from a traditional account into a Roth account.
3) Money you have in a traditional 401(k) with your current employer may also be eligible for what is called an in-plan conversion, but not all employer plans offer this.
The catch with a Roth Conversion is that you will owe income tax this year on every dollar you convert no matter what type of traditional account you are moving money out of.
The current bear market for stocks can make now a smart time to do a Roth Conversion. Because you will owe tax on the amount converted, my advice is to a convert relatively small amount of money for this tax year.
Let’s say you had $10,000 in a traditional account before the bear market started and you wanted to convert . Now the market has declined and your $10,000 is worth $7,500. Now is the time to convert it. Remember you now will only owe income tax on $7,500 which is far less than owing tax on $10,000. And now you have that money in an account that can grow for years and provide tax-free income in retirement.
I want to be clear, you can convert any amount each year. You do not need to convert the entire value of a given account in any single year. In fact, that may be a really bad idea if it boosts your taxable income so much this year you will end up in a higher tax bracket. My strong recommendation is to sit down with a trusted tax pro who can help you figure out how much you might convert this year without bumping you into a higher tax bracket.
Please only do this if you are confident you have the savings to cover the extra taxes you will owe when you file your 2020 tax-year return. What I don’t want you to do is convert your account, and then in the event you lose your job, or have reduced hours, you won’t have the money you need to pay the tax bill by April 2021. (I also recommend this strategy only if you have at least five years until you will need to start tapping the money.)
That said, if your household is hit with a layoff or reduced income this year, a conversion can be an even better deal, as your income tax bracket may be lower than last year. But again, this only makes sense if you will be able to pay the taxes due. Please work with a tax pro to think through all the angles.
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