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Taxes on retirement savings are inevitable — it’s really a question of now or later.
President Joe Biden’s tax plan may make it better to pay Uncle Sam now.
Taxpayers can do that by saving in a Roth account or converting a traditional, pre-tax account to a Roth account. They’d pay taxes on the savings up front instead of in retirement.
“Roths have all of a sudden become a better flavor than they were before,” said Leon LaBrecque, an accountant and certified financial planner at Sequoia Financial Group, based in Troy, Michigan.
“We’re on a full-board tilt trying to get everyone converting [to a Roth account] that we can,” he said of clients.
Biden tax plan
Generally, Roth accounts make sense if taxpayers think their income-tax rate will be higher when they withdraw money in retirement.
In that case, it would yield a financial benefit to pay the tax now at a lower rate.
Biden’s tax plan may make Roth accounts more attractive, especially for wealthy households.
The Biden administration has signaled its intent to raise taxes for people whose income exceeds $400,000 a year to help finance its legislative agenda.
The White House hasn’t officially proposed increases on the individual-tax ledger. The administration recently proposed a corporate-tax hike to fund an infrastructure measure.
But Biden is expected to propose raising the top income-tax rate to 39.6% from the current 37%. That would restore the top rate to its level before the 2017 Tax Cuts and Jobs Act.
“I think we kind of almost know, or by end of the year we’ll know, the [top] rate will jump from 37% to 39.6%,” said Robert Keebler, a certified public accountant based in Green Bay, Wisconsin.
The White House will also likely call for a lower estate-tax exemption, subjecting more wealthy estates to tax at death.
A 40% federal estate tax currently applies to estate values that exceed $11.7 million (or $23.4 million for a married couple).
Biden has proposed lowering that threshold to $3.5 million in bequests at death. Sen. Bernie Sanders, I-Vt., proposed taxing estates valued over $3.5 million at 45%, rising to 65% for those over $1 billion.
That’s significant in the context of retirement savings. A Roth conversion shrinks the size of an estate by the amount of income tax paid on that conversion.
Wealthy individuals can therefore use a Roth account to reduce the size of their taxable estate and potentially avoid federal estate tax, LaBrecque said. A similar concept applies in states that levy an estate tax.
Not just the rich
But Roth accounts may not just benefit the super-rich.
As a presidential candidate, Biden proposed changing the tax treatment of savings in traditional, pre-tax 401(k)s, individual retirement accounts and other retirement accounts.
Savers currently get a tax deduction that rises for those in higher brackets. For example, someone in the 12% bracket would deduct $12 from their taxable income for every $100 of savings; someone in the 37% tax bracket would get a $37 benefit.
Biden’s plan would instead create a tax credit for retirement contributions that translates to a 20.5% deduction for all taxpayers, regardless of income, according to the Tax Foundation.
If [larger conversions] make sense at 37%, they’ll make more sense at 39.6%.
certified public accountant
That structure would benefit lower earners. (A taxpayer in the 12% tax bracket would get a 20.5% deduction, for example.)
The highest earners would get the equivalent of a 20.5% tax deduction now on their pre-tax savings, but would pay tax at a higher, 37% rate later.
That dynamic means earners in the 22% tax bracket or higher would likely be affected. That would encompass single taxpayers with about $40,500 or more of annual income and married couples who make over $81,000.
That reduced tax break may make Roth accounts more attractive instead, Keebler said.
However, a pre-tax 401(k) may be helpful within the context of other proposals, like one to raise the Social Security tax for those earning more than $400,000.
Someone over that threshold may be able to avoid the payroll-tax hike by using savings in a pre-tax 401(k) to reduce taxable income below $400,000.
Beyond Biden’s tax plan, Roth accounts may be beneficial for other reasons.
They don’t come with required minimum distributions, for example. New rules also mean people who inherit retirement accounts must withdraw assets within 10 years. Inheritors of traditional accounts would need to pay tax on those withdrawals.
There are caveats for those who wish to convert a traditional account to a Roth. For one, they need the cash on hand to pay the associated tax on the conversion.
It may also make sense for those doing conversions of modest amounts to wait until the end of 2021, when there’s a little more clarity around changes to tax law, Keebler said. At this point, these are just proposals and may not become law.
Larger conversions may be best accomplished by doing it piecemeal over the year — perhaps split between April, July, October and year-end, Keebler said.
“For larger conversions, if they make sense at 37%, they’ll make more sense at 39.6%,” he said.
Taxpayers should also be aware that a Roth conversion will raise their taxable income and could potentially push them into a higher tax bracket.
There are also income limits on Roth IRA contributions. Taxpayers are barred from making any contributions if their modified adjusted gross income exceeds $140,000 this year. (It’s $208,000 for married joint tax filers.)
Income limits don’t apply to a Roth conversion or 401(k).