By Ben Eisen
Correction: An earlier version of this post misstated how much income would be subject to higher taxes.
The clock was ticking down to tax day when I realized that I made a huge mistake. I had picked a retirement investment a year earlier thinking I was being proactive about the future, but it was about to bite me back on April 15, and take a serious toll on my bank account.
As a millennial who’s also a journalist, I don’t have any illusions that a yacht or private island await me in retirement. I was always told that saving now gave me the best chance of having a substantial income once I no longer work. And why not do it while I don’t have the financial burden of a mortgage or children?
So when a job change last year gave me the chance to decide what to do with my old work-sponsored 401(k), I decided to convert the amount I had previously accumulated to a Roth IRA. Such investment vehicles require savers to pay taxes now but then savings can grow tax free so you aren’t paying taxes when you pull the money out in retirement, like you otherwise would with a traditional IRA. I figured that paying the taxes now, rather than later in life, might mean I pay while I’m in a lower bracket than I might be at the end of my career.
And it seems I’m not alone in this line of thought. People like me who are under 34 years old put $8 in Roth IRAs for every dollar they put in traditional IRAs, according to Financial Planning magazine. which cites T. Rowe Price customer data. IRS data from 2010 shows this same age group has four times as much money in Roth IRAs .
When tax season rolled around, I knew a bill would be in store on the Roth. But I didn’t know how much tax I would have to pay. When I put the Roth information into my online tax tool, my tax refund turned into a tax bill. And a big one at that.
The problem was quickly diagnosed in a call to the parents. What I didn’t know is that the Roth assets get lumped in with my regular income, which in this case bumped me into a different tax bracket. All of a sudden, a higher tax rate was being assessed on part of my income.
It looks like I’m not the only one. The tax-bracket issue is one of the key ways in which Roth IRAs trip up retirement savers, according to a Fidelity Investments explainer. With tax day approaching, I began to fret. But I had the good luck of mentioning the issue to my colleague, Jonnelle. MarketWatch’s resident tax expert. She immediately knew what to do.
For people like me who have second thoughts about their Roth conversion, the Internal Revenue Service
allows taxpayers to recharacterize Roth IRAs as traditional IRAs. she told me. In effect, you are taking some or all of the money in the Roth and postponing the taxes on it until a later date.
Then, if you want, you can slowly transfer it back to a Roth, paying taxes on it such that it doesn’t create the tax-bracket ripple I had experienced.
I was pretty relieved by the thought that the Roth conversion had a control-z key on it. Problem solved, I thought.
But not so fast, I was told by Dan Thomas, a CPA financial planner and partner at Thomas and Thomas in Orange County, Calif. “One of the things you have to do is look at the account and whether it has appreciated,” he said. “Given last year was a pretty darn good year, it may have gone up significantly.”
Thomas told me that I had made a smarter decision than I had given myself credit for. Because 2013 was such a great year in the stock market, my money had probably grown a substantial amount, and that income is free from future taxes. There was a good chance I made more in tax-free interest in Roth than I had to pay in additional taxes, and I’d lose that future tax benefit if I chose the recharacterization route. Put another way, it’s possible I would end up paying less in taxes by biting the bullet now than deferring the taxes over the course of a lifetime.
For young investors who can afford to pay the taxes out of pocket, it likely makes sense to skip the recharacterization, according to Ed Slott, an accountant and founder of IRAHelp.com , a website for retirement savers. “If you can keep the Roth, keep it. But do what you can afford,” he told me.
For those who can’t afford the additional taxes imposed by such a situation, it may make sense to recharacterize just enough to bring you back into your current tax bracket, he said. There’s no one way of taking care of this, so it depends on each situation.
Luckily for me, who, like many millennials, tends to procrastinate on my taxes. the recharacterization deadline doesn’t hit until Oct. 15, giving me another couple of months to think about what to do.
“One of the beautiful things about a Roth IRA is that you get a do-over,” said Thomas. “You get nine and a half months to decide if it was a good thing or a mistake after the fact.”
But the broader lesson for me was clear: Millennials live in a world that now requires financial planning acumen. Even putting aside our generation’s cardinal financial challenges of unemployment. underemployment. and student debt. we have more options than ever for managing our money, but more potential pitfalls as well. The time to become an expert is now.
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