Now that November 5 has come and gone, we can turn to year-end planning for withdrawals from tax-deferred IRA and 401k accounts (and other tax deferred accounts such as 4013(b) accounts). My book, From Savvy Saver to Smart Spender
shows that If you are a retiree with a large tax-deferred 401(k), 403(b), and/or IRA balance who has not yet reached Required Minimum Distribution (RMD) age (between 72 and 75 depending on your birth year), there is a good chance you can save on income taxes over your retirement years. How? By starting withdrawals from tax-deferred accounts now, before RMDs are due. Your savings may be even more if you have not started taking Social Security yet.
The book also shows I am a fan of reviewing your financial situation near the end of the year. In particular, I like to review much I will transfer from my tax-deferred accounts to my taxable or Roth accounts (we call either transfer a “conversion” for present purposes).
The core question is: will conversion now save enough taxes later to be worth the tax increase I will experience now? Ideally, to answer that question we would know future tax rates. Higher future tax rates would increase the value of converting now. However, this involves predicting the future–not an exact science.
The election mattered to this question because the 2017 tax cuts are set to automatically expire at the end of 2025, unless Congress acts. If the cuts expired and current tax rates go up in 2026, that might make bigger conversions now more attractive, and more urgent. Whether they expire is up to Congress and the President.
The recent election results suggest that rates will not go up in 2026. The election “winners” favor extending the 2017 tax cuts past 2025. In fact, there is talk of an even bigger tax cut (although that may be a tough sell due to the likelihood of increasing the national debt). See article here.
For those of you who have not started Required Minimum Distributions (RMDs) from your IRAs and 401Ks, this means conversion now may still be warranted, but you may have more years over which to convert while still lowering taxes over the long haul.
Regardless of future tax rates, you may want to convert now. This might make sense, for example, if you expect to be in a higher tax bracket in future years, most likely because your RMDs and/or Social Security will push you into higher tax brackets later—not because tax rates will go up, but because your taxable income will.
The stock market surge this year (the S& P 500 index is up about 25% year to date) may well change the answer for how much to convert, compared to what you planned at the beginning of the year. You may want to increase your conversion if the value of your tax deferred accounts increased more than expected, increasing your expected future RMDs. That alone might push you into a higher future tax bracket, making a current conversion more compelling.
On the other hand, this year’s market may also provide reasons to be more restrained with respect to conversions. For example:
–You may have generated more interest income this year than you have in most recent years due to higher interest rates on savings. That might push you into a higher tax bracket now than you expected.
–If you sold or will sell appreciated stock or other assets this year, that will increase your adjusted gross income (AGI). Even if your gains are long-term capital gains taxed at a lower rate, your increased AGI could push you into a higher tax bracket for regular income. See article here.
The IRS treats conversions from tax-deferred accounts as regular income. High realized capital gains may make a large conversion this year less attractive.
–If you will have higher than expected dividends, interest, capital gains, and other investment income, beware of the 3.8% Net Investment Income surtax. The surtax applies, for example, to joint filers with (modified) AGI over a $250,000 threshold ($200,000 for single filers). A conversion from a 401(k) or IRA will not be directly subject to this tax. However, if your conversion moves your modified AGI above the threshold, you may trigger this additional 3.8% tax on the lesser of (1) your income in excess of the threshold and (2) your total net investment income. See further discussion of the net investment income tax here.
Personal life changes could be a factor in year-end planning for withdrawals from tax-deferred IRA and 401k accounts as well. For example:
–If you are moving from a high tax to a low tax state next year, you may want to delay bigger conversion(s) until you establish residency in the lower-tax state. Conversely, if you are moving to a higher-tax state, you might want to accelerate the conversion while you have a lower combined state and federal income tax rate.
–If you are single now but plan on being married by the end of 2025, congratulations! You may want to defer or lower any conversions until 2025. The tax rate is much lower for a married couple filing jointly than it is for a single person with the same AGI. Of course, your combined AGI may also increase and place you back in a higher bracket anyway. But if the combined-income bracket goes down, you may want to wait to convert until next year.
You can compare 2024 and 2025 federal income tax rates here.
You may like the idea of eliminating the risk of future tax increases with bigger conversions now. It may be more about control than math for you. Just remember that the bigger the conversion now, the bigger the tax hit now.
For any withdrawal from tax-deferred accounts, make sure to pay sufficient estimated taxes to avoid penalties and interest. Beware of other potential penalties if you are not yet 59 ½ years old. Ideally, you will pay those taxes from a non-tax-deferred account, to avoid triggering additional taxes. What source you use may also be a consideration in how much to convert.
My calculator at https://retirementtaxsaver.com/calculator/ can be a tool to help decide how much to withdraw from tax-deferred accounts to save on future taxes. However, it does not consider all the above factors, such as whether you are moving. You may find other useful calculators in my blog post on free calculator websites. An investment or tax advisor also may help you decide what to do.
At the end of the day (and the year), however, the decision is yours. How much of your tax-deferred accounts do you want to protect from future taxes, given how much more in taxes will you owe now? Disclaimer: This is not financial or tax advice. The above may not apply to your specific situation.
For other thoughts on retirement planning check out my blog.
Further disclaimers apply. See https://retirementtaxsaver.com/disclaimers/
