While 2020 is officially behind us (despite not feeling that way), there are still several weeks left to make retirement account moves that can both minimize your 2020 taxes and help you build long-term wealth.
And although certain strategies for 401(k)s, IRAs, and other tax-advantaged retirement accounts are available every year, recent legislation has opened up a few additional opportunities. Here’s what you need to know:
There’s still time.
The IRS will allow 2020 contributions to IRAs and workplace plans up to April 15. The more money you can stuff into these accounts right now, the more time it will have to grow into a comfortable retirement cushion. IRA limits are $6,000 per person, and people over age 50 can add a catch-up contribution of $1,000.
3 Points to Consider
- Solo 401(k)s, available to self-employed people with no other employees besides a spouse, have much higher limits: Participants under age 50 can contribute $57,000. People age 50 and older can add a $6,500 catch-up contribution.
- As a quick refresher, funding your workplace plan should typically be your first priority, especially if your employer matches your contributions. Once your 401(k) is maxed out, any additional retirement savings should go into your IRA.
- Contributions to traditional 401(k)s and IRAs are tax-deferred, meaning each dollar added into your account reduces your taxable income today for every dollar contributed. These contributions are subject to income thresholds and phaseouts. Additionally, investment gains on your contributions grow tax-free, while distributions are taxed as ordinary income. On the other hand, Roth 401(k)s and Roth IRAs are funded with after-tax dollars. While contributing to Roth accounts won’t reduce your taxable income for 2020, the money will grow and ultimately be distributed tax-free. That’s a significant advantage if you believe your tax rate will be higher in the future—which it may well be.
You’re not too old.
Bear in mind that the old rule forcing you to stop contributing to traditional IRAs after age 70½ was scrapped under the 2019 SECURE Act. As long as you or your spouse is earning income, you can continue contributing.
You can let it ride.
The SECURE Act also increased the age at which retirement savers are required to start taking distributions, from 70½ to 72. That’s good news because it gives your money more time to grow. In addition, required minimum distributions were suspended for 2020.
As mentioned above, a Roth IRA can make more sense than a traditional IRA if you think your tax rate will be higher in the future. President Biden has laid out a plan to raise taxes on wealthy households. Many Washington watchers agree that whether it happens during Biden’s presidential term or not, the country will eventually need to raise more tax revenue to pay its ballooning debts.
2 Points to Consider
- Converting a traditional IRA to a Roth now will generate ordinary income, which can lead to a substantial tax bill. But with rates at historically low levels, it may make sense to bite the bullet before they rise. In addition, your advisor may be able to help you offset the taxes using other tax strategies. And if you have the option to only convert an amount that doesn’t push you into a higher tax bracket, you should consider it.
- Check in with your advisor to ensure understanding of your total income before making any conversions.
The back door is open.
Eligibility for Roth IRAs is limited to individuals with 2020 modified adjusted gross income under $139,000 or couples earning less than $206,000. If you belong to a high-income household and want to convert your traditional IRA to a Roth, you may need to do what’s known as a back-door conversion: This is a two-step process in which you first fund a traditional IRA and then convert it to a Roth.
Recoup your tax payment.
Because of economic hardship related to the Coronavirus, many Americans were forced to prematurely tap their 401(k) or IRA accounts last year. Under the CARES Act, the usual 10% early withdrawal penalty was waived for distributions up to $100,000. But since the distributions are treated as ordinary income, you’ll still face a tax bill. The good news is that if you return those funds to your account within three years, any tax you paid will be refunded.
1 Point to Consider
- If you took a 2020 distribution and then returned the funds to the account, be sure to coordinate with your accountant to make sure this is correctly reflected in your tax return so that you avoid a tax hit.
At AdvicePeriod, we like to remind our clients that building wealth is not just about what you earn; it’s about what you keep. Taking full advantage of tax-advantaged retirement accounts is one of the most effective ways to build wealth over time. We recommend that you coordinate with your accountant and your financial advisor to make sure you’re making the best possible decisions for your situation and goals.