When you change a traditional IRA to a Roth IRA, you must pay income taxes on the full amount you convert. Under the old law, you were able to “recharacterize,” or reverse, the conversion if it bumped you into a higher tax bracket or made your tax bill higher than you could afford, or if your investments lost value and you’d be left to pay taxes on investment gains you wouldn’t be able to realize. This ability to recharacterize has been eliminated under the new law.
What Hasn’t Changed
While retirement accounts can play a positive role in your overall tax strategy, keep in mind that there are also tax penalties for tapping into them too soon, since these funds are meant to be set aside for retirement. If you withdraw money from your 401(k) plan before age 59-1/2, you’ll likely face a 10 percent federal tax penalty. In addition, the Internal Revenue Service will take 20 percent of your withdrawal as an advance on your tax bill. The same goes if you cash out your 401(k) when you leave your job.
There can be negative tax consequences associated with taking 401(k) loans as well. If you leave your job and don’t pay back the loan, your outstanding balance is treated as a withdrawal, spurring a tax bill and potentially an additional 10 percent federal tax penalty.
It’s clear that, given today’s most commonly used retirement savings vehicles, retirement planning and tax planning are inextricably linked. Even if you’ve already filed your 2017 return, it pays to know how the actions you take with your retirement plans this year will impact your tax bill next spring. My best piece of advice as you’re navigating these decisions is to ask for help. Many workplace 401(k) plans include professional saving and investing advice services or other managed account services, and more employers than ever before are offering financial wellness programs. While both retirement and tax planning can be tricky for savers of all ages, a little guidance may go a long way in easing the challenge.
Catherine Golladay is senior vice president of 401(k) participant services and administration, Schwab Retirement Plan Services.