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Tax Guy: ‘I’m still not on the Roth IRA bandwagon’: Have you made these tax blunders?

With the May 17 filing deadline now in the past, you’ve probably filed your 2020 Form 1040. If so, mission accomplished. Good. But could you have done better? Probably. Let’s discuss.

I’m still not on the Roth IRA bandwagon

C’mon man! I’ve been telling you for years about the wonderfulness of Roth IRAs. But have you done anything about it? No? Then please get on the bandwagon this year for two reasons.

  • First, as explained immediately below, Roth IRAs have two big advantages over other tax-favored retirement accounts.
  • Second, waiting until next year to do a Roth conversion could result in a higher conversion tax bill.

Two big Roth IRA advantages

  1. You can take federal-income-tax-free Roth withdrawals after reaching age 59½ as long as you’ve had at least one Roth account open for more than five years. If you die, your heirs can dip into an inherited Roth account without owing any federal income tax, as long as the account has been open for more than five years. So open a Roth account now to start the five-year clock ticking. If federal income tax rates go up in the future, income and gains earned within your Roth IRA will be blissfully unaffected. Depending on what happens with the Biden tax plan, rates could go up this year, but I think next year is more likely. Think of your Roth IRA as insurance against future tax rate increases.
  2. Roth IRAs set up in your name are exempt from the dreaded required minimum distribution (RMD) rules, which force you to start taking taxable withdrawals from other types of tax-favored retirement accounts, including traditional IRAs, after reaching age 72. If you fail to withdraw the proper RMD amount for a year, you owe a 50% penalty on the difference between the amount you should have taken out and what you actually took out (if anything). Ouch! In contrast, you can leave Roth IRA balances untouched for as long as you wish and continue earning federal-income-tax-free income and gains. When you die, your remaining Roth IRA balances can be left to your heirs, who can then take out the money federal-income-tax-free.

Two ways to get money into a Roth account

  1. Start making annual contributions of up to $6,000 or $7,000 if you are age 50 or older. If you’re married, your spouse can join in the fun. The catches: you must have earned income at least equal to what you contribute, and the annual contribution privilege is phased out at higher income levels.
  2. Convert a traditional IRA into a Roth account. A conversion is treated as a taxable distribution from the traditional account with the money going into the new Roth account. So it will trigger a bigger federal income tax bill (and maybe a bigger state income tax bill too). However, the two positive factors mentioned earlier may greatly outweigh the one-time conversion tax hit. As long as the current relatively low rates are still in effect when you convert (maybe only for the rest of this year), the conversion tax hit will probably be as low as it ever could be in your remaining time on Earth. You don’t need any earned income to do a Roth conversion, and there’s no income restriction. Even retired billionaires can do Roth conversions.

What to do this year: Get on the Roth bandwagon, unless you believe your tax rates during retirement will be lower than the rates you’re paying right now.

I did not do any tax planning and it might have cost me

True. Lots of people talk about tax planning, especially year-end tax planning, but fewer actually follow through. Put this date in your daily planner right now: Saturday Nov. 27. Thanksgiving will be over (it’s on the 25th this year), and you don’t want to be out and about on that weekend anyway, because you might get crushed by all the folks who will choose to shop in the physical world this year —just for old time’s sake. Also, by Nov. 27 you should have a firm grasp on your 2021 tax situation. So you can consider selling some loser stocks and mutual fund shares held in taxable brokerage firm accounts to offset earlier gains, giving some appreciated securities to your favorite charity, and so forth. You should also check back here for additional year-end tax-saving tips. Finally, if you’re not really sure what tax planning means, stay tuned for my next column where I’ll explain chapter and verse.

What to do this year: See above.

I did not take full advantage of tax-saving deals at work and it cost me

True. Salary-reduction contributions to tax-favored employee benefit programs reduce your taxable salary. So, the contributions reduce your federal income tax bill, the federal payroll tax hit on your salary, and your state income tax bill if applicable. For 2021, the maximum salary-reduction contribution to a company 401(k) plan is $19,500 or $26,000 if you will be age 50 or older as of year-end.

You may also be able to make salary-reduction contributions to your company’s cafeteria benefit plan, which could include flexible spending accounts (FSAs) to cover: (1) up to $2,750 of out-of-pocket family medical costs with a healthcare FSA and (2) up to $10,500 of expenses to care for your under-age-13 children so you can work (or if you are married, so both you and your spouse can work) with a dependent-care FSA. Note that the $10,500 limit for 2021 contributions to a dependent-care FSA is temporary. Next year, the maximum contribution will go back to $5,000 unless future legislation allows a bigger limit. Finally, it’s important to understand that the tax savings from participating in FSA plans are permanent rather than temporary, so failing to sign up is like leaving cash on the table. Don’t do that!

Key point: Depending on how your company FSA plans work, it may or may not be too late to sign up for a tax-saving FSA contribution for 2021 or sign up for a bigger contribution for 2021, unless you have a qualifying event (like getting divorced and becoming ineligible for coverage under your ex-spouse’s employee benefit plans). But for 2021, employers can choose to allow FSA contribution changes even if you don’t have a qualifying event. So, check with your company’s personnel department to see what you can do for this year. If it’s too late to do anything for this year, sign up for 2022 contributions during the open enrollment period, which may begin as early as sometime in October.

What to do this year: See above.

I did not consult a tax pro before major transactions

Obviously, you cannot plan your whole life around taxes. That said, most major life events have significant tax consequences, and over the long run taxes may be by far your highest expense category. So tax planning is important. Also, there is often a “right way” and a “wrong way” to do things tax-wise, whether it’s selling your home, transferring funds from one retirement account into another, getting married, getting divorced, adopting a child, whatever. To make sure you do things the right way instead of the wrong way, consult your tax pro before the deal is done. Take it from me: our beloved Internal Revenue Code is riddled with traps for the unwary, and the tax savings from obtaining competent professional advice will dwarf the fees over the long haul.

What to do this year: See above.

The last word

To repeat, my next column will be devoted to explaining what tax planning really means and why you should care. Please stay tuned.

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