Most people have heard the terms `IRA? and ?Roth IRA?. Many are familiar with the idea of an IRA to Roth IRA conversion, and may have completed these already on some accounts.
The first issue to be address, is do you qualify? If Modified Adjusted Gross Income (MAGI) is below $100,000, and you are not married filing separately, you qualify.
Be careful here. If you are slightly under $100,000 this year, but your income is increasing, you may have only a small one or two year window of opportunity to Roth accounts before you become ineligible for years to come.
If you are over $100,000, do not despair. Just a few subtle changes in how you structure taxable income may easily allow you to drop below the $100,000 threshold enabling you to qualify after all for the current year.
Then it comes down to a matter of weighing the future benefits versus the preset tax costs in your situation.
Attempt to realistically forecast what will be your future taxable retirement income stream. Will it include taxable company pensions, mostly taxable distributions from annuities or pre-tax payroll savings accounts, IRA's etc. Will your taxable income be over the current $32,500 threshold that will subject 50-85% of your Social Security to income tax too?
This will help to determine if in reality, your income tax bracket will indeed be any lower in retirement than in pre-retirement as if often ?assumed? incorrectly.
If it is clear your after retirement tax bracket will not decrease, it may make sense to begin the conversion process with what you can afford to do. Any conversions will be included in taxable income for Federal and State income tax purposes in the year it is converted. If you are under age 59 ? at the time of the conversion, no extra 10% Federal penalty will be charged. Do not rob retirement funds to pay these tax bills. There are some creative ways to absorb or finance these tax bills.
The ultimate goal is to have two distinct sources of funds in retirement, taxable and non-taxable. Why? So you may have some control over what your retirement tax bill will be. How do you do that? You structure your income needs between the taxable and non-taxable accounts to minimize your income tax bracket from year to year, and to take advantage of tax favored liquidation opportunities as they arise. This helps you to keep retirement dollars invested and working for you as long as possible before withdrawal.
Here is an example. Suppose a retired couple needs $25,185 from either their IRA or Roth IRA to buy a new car, pay sales taxes, and all the fees to attain ownership. They are in a 25% Federal tax bracket, and a 6% state Income Tax Bracket, for a total tax bracket of 31%.
They will need to withdraw a gross amount of $36,500 to net out the $25,185 needed from the IRA so they can pay the tax load generated by the withdrawal.
We will not even address what future earnings will be lost on the extra $11,315 withdrawal in this example used to pay income taxes.
If they withdraw the funds from the ROTH IRA, they need only $25,185. In this case, they have a choice of whether they want to pay the tax bill in this tax year because they have two distinct sources of funds, taxable and non-taxable.
This can also be worked from another angle. Suppose the couple wanted to pay only about $5,000 in extra taxes on a withdrawal. Then we would withdraw $16,000 from the IRA generating a $4,960 tax bill netting $11,040 in proceeds plus $14,145 from the ROTH IRA for the total amount needed of $25,185.
In either example, the couple is in control of when and how much income tax is paid. Are you?
Amy Rose Herrick, ChFC, IAR is a Registered Representative of and offers securities and investment advisory services through, Woodbury Financial Services Inc. Member NASD, SIPC and a Registered Investment Adviser