Much of the discussion about the fiscal cliff legislation passed by Congress has focused on tax rates, payroll taxes and deductions. But, several provisions in the new law could have important implications for retirement planning, whether you are nearing retirement age or not.
Even though we cannot be certain when or how often tax law is going to change in the future, right now is a good time to think about how to take advantage of the current law to maximize your retirement savings for later.
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Converting the 401(k)
Until the fiscal cliff bill passed, most people who contributed money to an employer-sponsored 401(k) had to keep the money in the account until they changed jobs or reached retirement age. Money contributed to such a plan is not taxed until it is withdrawn; it grows tax free until then.
However, a new provision in the fiscal cliff plan will allow employees to roll over their 401(k) money into a Roth IRA, assuming their plan documents allow such a conversion.
Relying on the Roth IRA
A Roth IRA differs from a traditional IRA or 401(k) in that the money is taxed at the current tax rate — before it is put into the fund — but is withdrawn tax free upon retirement.
Roth IRAs are particularly attractive for investors who expect their tax rate to be higher when they retire than it is now. By paying tax on the money they put into a Roth IRA now, at their lower rate, they do not have to worry about their tax rate going up before they withdraw the money later, as they would with a traditional IRA or 401(k).
Taxes now or money later
A conversion to a Roth IRA is a good idea for investors who are currently in a low tax bracket, with one caveat: you must have enough cash on hand right now to pay taxes on the money you are moving into the Roth.
Say you currently pay taxes at a rate of 25 percent, you will have to pay one-quarter of every dollar you move to the Roth IRA in tax –- this year. If you don’t have that kind of money available, you should consider converting only part of your 401(k) so that you don’t get stuck with a big tax bill.
Capital Gains Rates
If part of your retirement plan includes growing your portfolio through capital gains and dividends on stocks and mutual funds, those gains will now be taxed at a rate of 20%, up from 15% for individuals who earn more than $400,000 and jointly filing couples who earn more than $450,000.
This means that your retirement savings will grow at a slower rate than before, if you meet the income threshold. If you do not yet make enough money to be subject to the higher withholding rate (or even if you do), now is good time to talk to an experienced financial advisor about your portfolio. He or she can help you decide if it makes sense to rearrange your investment strategy to include products that pay qualified (non-taxable) dividends or are otherwise protected from the tax increase.
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