It’s 2021. How good does it feel to say that? I don’t think there has ever been a year that everyone has wanted to end so badly. After all, 2020 was a year full of uncontrollable events. The coronavirus brought us uncertainty, volatility, and required us to ask the “what if” questions. As the new year begins, all eyes are on vaccines and elections, which are things out of our control. It is now time to shift things into our control. What we can control is what we do with our money. Something to consider is converting your traditional IRA to a Roth IRA. There are many reasons to do this but also many factors to consider, one being the deadline of April 15, 2021 to convert, establish or contribute to your Roth IRA.
In 2020 alone, the United States government spent about $12 trillion on coronavirus relief. The government will need to eventually start repaying this debt. The big question that all of us should be asking is, “How are they going to pay for this?” Most of the wealth in this country is being held through qualified accounts. Qualified accounts include your own 401(k), 403(b), TSP and your traditional IRA accounts. Taxing that money is a major source of where the government can take back what they borrowed. One way to protect yourself from that possibility is by converting to a Roth IRA.
Before converting, it is important to know what a Roth IRA is. A Roth IRA is a retirement account where instead of investing pre-tax dollars, you are actually contributing after-tax dollars. As long as the account has been open for at least five years, the gains made on your account are tax-free upon withdrawal. That differs from a traditional IRA or 401(k) where all proceeds are taxable upon withdrawal at income tax rates, which is a key benefit. What direction do you suspect income tax rates to go?
Anyone can convert qualified funds to a Roth IRA, but it is important to determine the benefits prior to conversion. Unlike contributing, there are no income restrictions to converting to a Roth IRA. The different part of the process is paying your taxes upon the conversion. For example, if you have $100,000 in a traditional IRA and you want to convert that money into a Roth IRA in 2020, you could owe upward of $30,000 on that conversion based upon what your income tax rate is. For someone making between $80,251 and $171,500 who is filing taxes jointly, they would pay $22,000 in federal taxes for that conversion! You might say that's a considerable amount of money, but the benefit is never paying taxes on that account again.
Giving money to the IRS is taxing on Americans, no pun intended. One strategy in making the Roth conversion more palatable is doing a partial conversion. Instead of converting the entire amount in your account, you would convert only a portion of your qualified money into the Roth IRA. There are no current limitations to the number of years or the amount you convert into the Roth IRA. In my same example, we could convert that $100,000 over four years at $25,000 a year and the tax liability is being spread out over those four years at $5,500 per year. My suggestion is to meet with your accountant or tax advisor to evaluate your income and determine if a conversion will benefit you and your tax bracket.
Three reasons make 2021 an attractive year to do the conversion. The first thing to note is that the deadline to establish and contribute to your 2020 Roth IRA is April 15, 2021. Congress has not outlawed the ability to convert, which is thereby creating a tax-free account. The second reason is many of you, due to COVID-19, have potentially lost money and contributed a lower amount than previous years. The third reason is that the tax reductions imposed by the Trump administration are set to expire at the end of 2025. Conventional wisdom tells us that tax rates are likely to increase if you are currently paying the lowest in taxes you would ever pay.
The final factor to consider is President Biden. As of this writing, it's not official that the Democratic party has taken control of the Senate, but it looks as though that is highly probable. A big part of Biden's platform is tax increases. For most of us, managing taxes is a more important factor in protecting your wealth than most other risks, even market risks. Converting to a Roth can be a great tool in offsetting this risk.
The coronavirus has been one of the biggest threats we have faced as a nation, and the potential financial consequences could be immense as we begin to pay for it. Right now, you should do everything you possibly can to protect what's yours so you can enjoy your brightest future possible.
Interested in learning more about these factors or want help with opening and managing an established IRA? Call me at 443-837-2542 to set up an appointment!
Jason LaBarge, Financial Advisor and Managing Partner at Premier Planning Group
115 West Street, Suite 400 Annapolis, MD 21401 443-837-2531 www.jasonlabarge.com
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Asset allocation is an investment strategy that will not guarantee a profit or protect you from loss.
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A Roth IRA offers tax free withdrawals on taxable contributions.
To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 1/2 or due to death, disability, or a first-time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
Before deciding whether to retain assets in a 401(k) or roll over to an IRA, an investor should consider various factors including, but not limited to, investment options, fees and expenses, services, withdrawal penalties, protection from creditors and legal judgments, required minimum distributions and possession of employer stock. Please view the Investor Alerts section of the FINRA website for additional information.