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6 Proven Retirement Income Planning Strategies Beginning at Age 62

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

When you contemplate your life, you can usually pinpoint pivotal moments that changed the trajectory of who you are today. Often times, there are one or more magical moments that you will never forget.

In the retirement planning world, age 62 is that moment. Until then, you accumulate assets for some unspecified future date when you will transition from working full time to perhaps part time, and then, in most cases, fully retire. Your primary source of income, i.e., employment, will eventually come to a grinding halt.

Beginning at age 62, several things will begin to quickly unfold that will require you to change your retirement planning mindset from asset to income accumulation. You will need to figure out how to convert the assets that you worked hard to save into a predictable income stream beginning on a specified date, or within a range of dates, that will enable you to match your projected financial needs in retirement. Furthermore, you will need to develop various strategies for creating after-tax retirement income in order to optimize the longevity of your assets for the rest of your life. Needless to say, this is no small task.

This article provides an overview of six proven strategies that can be implemented beginning at age 62 that are at the core of the transition from retirement asset to retirement income planning. Strategies #4 and #5 should be considered before age 62 whenever possible and strategy #6 when applicable. Most important, all potential strategies should be evaluated as part of a holistic retirement income plan.

Strategy #1:  Defer Social Security Start Date

You can start your Social Security retirement benefits as early as age 62 or as late as age 70. Unless you’re no longer working and have no other sources of income or you have a life-threatening illness, it generally isn’t advisable to start receiving Social Security at age 62. This is due to the fact that benefits may be 30 percent less than what they would be at your full retirement age which is between 66 and 67 depending upon the year you were born.

Your Social Security benefits will increase by 8% per year plus cost-of-living adjustments for each year that you defer your start date between full retirement age and age 70. Social Security can be used to insure your, and, if married, your spouse’s longevity risk.

The decision regarding when to begin receiving Social Security retirement benefits should be carefully analyzed, especially if you’re married. In addition to locking in the amount of your benefit, you are also potentially establishing the amount of your spouse’s monthly payment in the event that you die first.

Strategy #2:  Gain Unrestricted Access to Home Equity

As discussed in my 5 Key Financial Metrics When Evaluating a HECM Reverse Mortgage article, housing wealth, although it represents about one half of an average household’s net worth, is often ignored as a retirement income planning tool. There are numerous strategies that can be used to provide readily available tax-free liquidity to pay for planned and unforeseen expenses throughout retirement by monetizing a portion of the equity in one’s home.

Several of the strategies can be used in conjunction with home equity conversion mortgages, or HECMs, the most popular reverse mortgage program. You can qualify for a HECM beginning at age 62. All homeowners age 62 or older with or without a mortgage should evaluate a potential HECM for its ability to provide unrestricted access to an increasing tax-free line of credit without the downsides of a home equity line of credit, or HELOC.

When implemented early and used strategically to unlock illiquid home equity, a HECM reverse mortgage can be used to increase after-tax cash flow at opportune times throughout retirement while providing peace of mind.

Strategy #3:  Reduce Medicare Part B and D Premiums

Medicare Part B and D premiums are determined using modified adjusted gross income (MAGI) from your federal income tax return two years prior to the current year. Assuming you enroll in Medicare when you become eligible at age 65, your MAGI from two years prior, or age 63, will determine your Medicare premiums at 65. 2021 Medicare Part B monthly premiums range from $148.50 to $504.90 per person depending upon tax filing status and 2019 MAGI

Medicare Part B and D premium planning should begin at age 62 when you’re one year away from having your income determine your premiums when you turn 65. You should incorporate the Medicare income brackets into your income tax projections every year for the rest of your life to determine the amount of your projected Medicare Part B and D monthly premiums. Using this information, you can develop strategies to reduce your projected MAGI and associated premiums.

You need to always keep in mind when planning Medicare premium reduction strategies that it’s a year-by-year proposition given the fact that premiums are determined using your MAGI from two years prior to the current year. If your income in a particular year is projected to experience an unusual spike that’s attributable to a one-time or infrequent event that will otherwise optimize your projected after-tax retirement income for several years, it will usually make sense to pay the increased Medicare Part B and D premiums in that year. Examples include a sizable strategic or market-sensitive Roth IRA conversion or an unusual increase in a business owner’s income that will enable a larger qualified business income (QBI) deduction that will result in a large amount of income tax savings.

Strategy #4:  Roth IRA Conversion Window of Opportunity

A multi-year, or staged, Roth IRA conversion strategy is a great example of a retirement income planning technique that should ideally be implemented beginning 20 years before retirement. A ten-year window of opportunity begins at age 62 for doing a Roth IRA conversion, creating a greater sense of urgency for implementing this strategy. This corresponds to the ten years prior to the age 72 commencement of lifetime annual required minimum distributions, or RMDs, from retirement plans.

Roth IRA conversions beginning at age 62 will reduce your annual RMDs for the rest of your life. This can, in turn, potentially reduce your annual taxable income, Medicare Part B and D premiums, taxable Social Security benefits, and net investment income tax. To the extent that this occurs, this will increase after-tax retirement income and contribute to the overall goal of optimizing asset longevity. Reduced RMDs also reduce the survivor’s exposure to the widow(er)’s income tax penalty for couples.

Reduced RMDs can also reduce the value of taxable retirement plan accounts at death and, in turn, reduce taxable income for non-spouse beneficiaries. Given the fact that most non-spouse beneficiaries are subject to a 10-year payout rule for taking distributions from retirement plans and IRA accounts, a reduction in the value of taxable accounts will often result in less tax liability for children and other non-spouse beneficiaries.

Per Strategy #3, taxable income from Roth IRA conversions needs to be balanced against potential higher Medicare Part B and D premiums beginning at age 63. The reduction in RMDs and associated lifetime income tax savings beginning at age 72 can more than offset increased Medicare Part B and D premiums between age 63 and 72 if done strategically.

Strategy #5:  Lock in Sustainable and Potentially Tax-Favored Lifetime Income

The fifth strategy – locking in sustainable and potentially tax-favored lifetime income, has gained in popularity as a result of the virtual demise of corporate pension plans. Besides Social Security, opportunities for receiving a sustainable lifetime income stream with built-in longevity insurance to reduce the risks associated with the stock market have dwindled in the private sector.

Immediate and deferred fixed income annuities are a natural fit for filling this gap in a holistic retirement income plan beginning at any age. Purchase of fixed income annuities takes on more urgency at age 62 due to the fact that the income start date for the majority of fixed income annuities will occur by age 72, leaving less time for deferred growth and increased lifetime income. The income start date is subject to the RMD rules when purchases are made from qualified accounts and traditional IRAs.

Income optimization is the appropriate benchmark that should be used when evaluating fixed income annuities for inclusion in a retirement income plan. The goal is to design a comprehensive strategy that uses the least amount of assets to purchase the greatest amount of sustainable after-tax lifetime income that’s projected to pay for expenses not covered by Social Security, pensions, and distributions from investment and other assets.

Fixed income annuities come in three flavors:  single premium immediate annuities (SPIAs), deferred income annuities (DIAs), and fixed index annuities (FIAs) with income riders. SPIAs and DIAs enjoy a unique income tax advantage when purchased in a nonqualified, or nonretirement account.

Unlike FIAs with income riders that distribute ordinary income that’s fully taxable, SPIAs and DIAs are annuitized. Periodic payments include income and a return of premium, or investment. When held in a nonqualified account, the return of premium portion of each payment, which can be 50% or greater, is nontaxable. Once 100% of one’s investment has been received, future payments are fully taxable.

Strategy #6:  Achieve Sizable Tax Savings and Tax-Favored Lifetime Income When Selling Highly Appreciated Nonretirement Assets

The sixth strategy, although it can be used by anyone at any time, tends to be implemented by individuals in their 60’s. Generally speaking, they’re the ones with highly appreciated nonretirement assets who are looking for a tax-favored lifetime income exit plan. This includes real estate, investment securities, and businesses.

This strategy is designed to reduce or eliminate income tax liability attributable to the capital gain that owners will realize from the sale of the highly appreciated asset by transferring a portion, or all, of the ownership of the asset from one or more individuals to a charitable remainder trust, or CRT, prior to the sale while providing tax-favored lifetime income. A CRT, which is a tax-exempt trust, is a long-standing IRS-blessed strategy when properly structured.

There are six benefits associated with a CRT:

  1. The capital gain on the sale of assets owned by a CRT is exempt from taxation.
  2. CRT funding creates a sizable income tax deduction equal to the projected remainder interest of the CRT that will eventually pass to one or more charities.
  3. The proceeds from the sale of CRT assets can be reinvested to provide a lifetime income stream for the beneficiaries.
  4. Most of a CRT’s annual income will be taxed at favorable long-term capital gains tax rates.
  5. A CRT is an excellent philanthropic tool since the remainder interest of the assets will be distributed to one or more chosen charities following the death of the surviving lifetime income beneficiaries.
  6. CRT assets avoid estate tax.

Six Proven Strategies

The six strategies that are highlighted in this article are proven strategies for creating and optimizing after-tax retirement income that can individually and collectively prolong the longevity of one’s assets in retirement. Each strategy can be implemented beginning at age 62 as part of a holistic retirement income plan.

Deferring Social Security start date (strategy #1) is a time-sensitive strategy. Once you start receiving Social Security, with some limited exceptions, it’s an irrevocable decision that, with the exception of potential cost of living adjustments, will lock in the amount of your periodic and lifetime payments and can also affect your spouse’s payments.

Gaining unrestricted access to home equity (strategy #2) through a HECM reverse mortgage should be implemented at age 62, the qualifying age, whenever possible to optimize the growth of, and after-tax distributions from, the credit line. Planning for reducing Medicare Part B and D premiums (strategy #3), which is an annual strategy, should be implemented beginning at age 62 since income from your federal income tax return beginning at age 63 will be used to determine your Medicare Part B and D premiums when you’re 65.

Roth IRA Conversions (strategy #4) and locking in sustainable and potentially tax-favored income (strategy #5) should be considered before age 62 whenever possible since there’s no restriction on the start date and earlier vs. later implementation can optimize after-tax lifetime income in retirement.

Achieving sizable tax savings and tax-favored lifetime income when selling highly appreciated nonretirement assets (strategy #6) is dependent upon (a) owning highly appreciated assets such as real estate, investment securities, or a business and (b) a desire to sell those assets.

Let the magic begin!

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Income Tax Planning Retirement Income Planning Roth IRA

Six Stealth Taxes That Can Derail Your Retirement

Greedy Leprechaun on the pile of money with thumb up - finance concept isolated on white

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

The goal of retirement income planning is to optimize the longevity of your after-tax retirement income to pay for your projected inflation-adjusted expenses. In addition to having adequate retirement assets, there are two ways to achieve this goal: (a) maximize income and (b) minimize income tax liability.

There are six stealth taxes that can increase your income tax liability and reduce your lifetime after-tax retirement income. All of them, except for one, have been in existence for several years. A couple are difficult to avoid due to their low-income thresholds. Although several taxes may not kick in until retirement, planning for each of them should begin long before and continue throughout retirement.

Stealth Tax #1:  10-Year Payout Rule

Let’s start with the new kid on the block – the 10-year payout rule. This was created by the SECURE Act and is generally effective for deaths after December 31, 2019. It applies to beneficiaries of retirement plans and IRA accounts.

Surviving spouses, minor children who are not grandchildren, and other “eligible designated beneficiaries” are unaffected by the 10-year payout rule. They can continue to take distributions from retirement plans and IRA accounts over their lifetime using the required minimum distribution, or RMD, rules.

Children after reaching the age of majority and grandchildren are classified as “non-eligible designated beneficiaries.” They are no longer required to take RMDs from their retirement and IRA accounts. They are instead subject to the new 10-year payout rule whereby they must empty these accounts by the end of the tenth year after death.

Distributions can be taken evenly over ten years or in random years so long as there’s no balance remaining in any retirement or IRA accounts by the end of the tenth year after death of the individual from whom you inherited the accounts.

Two potential types of stealth taxes have been created by the 10-year payout rule. The first type comes in the form of accelerated and potentially increased income tax liability compared to the RMD rules. The second type is a potential penalty assessed by IRS as an “additional tax on excess accumulations” of 50% plus interest on the balance of funds remaining in any retirement plan or IRA accounts at the end of the tenth year.

Stealth Tax #2:  Social Security

Taxation of Social Security benefits, which began in 1984, is one of the stealth taxes that is difficult to avoid due to its low-income threshold. The threshold, which is referred to as “combined income,” is the total of adjusted gross income, nontaxable interest, and half of your Social Security benefits.

Single individuals with combined income of $25,000 to $34,000 are taxed on up to 50% of benefits, and up to 85% on amounts above $34,000. Joint return filers with combined income of $32,000 to $44,000 are taxed on up to 50% of benefits, and up to 85% on amounts exceeding $44,000. Unlike other income-sensitive thresholds, Social Security combined income amounts have never been increased for inflation.

Taxation of Social Security benefits is often a double stealth tax. The inclusion of up to 85% of benefits in taxable income, in addition to potentially increasing tax liability, can also increase marginal and long-term capital gains tax rates. Other potential fallouts include increased Medicare Part B and D premiums, increased exposure to net investment income tax, and increased widow/widower’s income tax.

Stealth Tax #3:  Increased Medicare Part B and D Premiums

Medicare Part B and D premiums are determined using modified adjusted gross income (MAGI) from your federal income tax return two years prior to the current year. Assuming you enroll in Medicare at age 65, you will want to project and track your MAGI every year beginning at age 63.

Monthly premiums begin at $148.50. An Income Related Monthly Adjustment Amount (IRMAA) is added to this amount if your income is greater than $88,000 for single taxpayers and $176,000 for joint tax filers. Monthly premiums can be as high as $504.90 for those in the top income threshold, resulting in increased annual Medicare premiums of as much as $4,276.80 per person or $8,553.60 per couple.

Medicare Part B and Part D monthly premiums can increase significantly in a particular year because of an unusually large amount of income two years prior to the current year. This can include taxable gains from the sale of a residence or rental property or income from a sizable Roth IRA conversion.

Stealth Tax #4:  Net Investment Income Tax

The net investment income tax has gone under the radar for a lot of taxpayers since its introduction in 2013. The tax is a surtax that is generally paid by high income taxpayers with significant investment income.

Single taxpayers with investment income and MAGI greater than $200,000 and married filing joint taxpayers with MAGI more than $250,000 are subject to a surtax of 3.8% on net investment income. This includes capital gains, interest, dividends, rental income, royalties, and nonqualified annuity income.

The net investment income tax effectively increases the 15% and 20% long-term capital gains tax rate by 3.8% for higher income taxpayers.

Stealth Tax #5:  Widow(er)’s Income Tax Penalty

Stealth tax #5, the widow(er)’s income tax, is the stealthiest of all stealth taxes since most people aren’t aware of it, it’s the most difficult to plan for, and it can potentially increase tax liability significantly each year going forward once it applies.

Unfortunately, the income tax law is not kind to surviving spouses who don’t remarry. A widow or widower who has the same, or even less, income than the couple enjoyed will often be subject to higher federal, and potentially, state, income tax liability. This results from the transition from the use of married filing joint tax rates to single tax rates and a standard deduction of 50% of the married filing joint amount of $25,100, or $12,550, beginning in the year following the year of death of one’s spouse.

Stealth Tax #6:  $10,000 Limitation on Personal Income Tax Deductions

Unlike the first five stealth taxes that directly increase income tax or Medicare premiums in the case of stealth tax #3, stealth tax #6 indirectly achieves the same result. The $10,000 limitation on the personal income tax deduction accomplishes this by eliminating a potentially large amount of one’s overall tax deductions for those affected by it. This has translated to reduced itemized deductions of tens of thousands of dollars or more in many cases since 2018.

This change, combined with the doubling of the standard deduction and reduced mortgage interest deductions, has reduced the percentage of taxpayers itemizing their deductions from approximately 31% in 2017 prior to the enactment of the Tax Cuts and Jobs Act to approximately 14% in 2019.

Stealth Tax Planning Opportunity:  Staged Roth IRA Conversions

Although there are various retirement income planning strategies that can be implemented to address each of the six stealth taxes discussed in this article, there is one strategy that can reduce income tax liability attributable to the first five. The strategy to which I am referring and have espoused for many years, is a staged, or multi-year Roth IRA conversion plan.

The current low historic income tax rates that will expire after 2025 and potentially sooner provide a window of opportunity for Roth IRA conversions that many of us may never see again in our lifetime. If you’re in your 50’s or 60’s and you have traditional 401(k) plans, SEP-IRAs, and traditional IRAs, why wait until age 72 when the value of your plans has potentially doubled, and tax rates are potentially higher to pay income tax on your distributions?

When you do a Roth IRA conversion, or a series of Roth IRA conversions using a staged Roth IRA conversion plan, you eliminate taxation on the future growth of converted assets, reduce required minimum distributions (RMDs) beginning at age 72, and reduce dependency on taxable assets in retirement. This, in turn, allows you to reduce your exposure to the first five stealth taxes throughout your retirement years as follows:

  • Reduce the value of taxable assets impacted by the 10-year payout rule
  • Decrease the Social Security “combined income” threshold, potentially decreasing your percentage of taxable Social Security benefits
  • Decrease modified adjusted gross income (MAGI) which can potentially reduce your Medicare Part B and D premiums beginning at age 65
  • Potentially decrease your net investment income tax since this is calculated using MAGI
  • Reduce the value of taxable retirement assets and your exposure to the widow(er)’s income tax liability if you’re married

Look Beyond Current Income Tax Rates When Planning for Retirement

The six stealth taxes discussed in this article can impact the success of your retirement in various stages of your life beginning long before you retire and continuing throughout your retirement. It behooves you to not get lulled into a false sense of security by today’s low federal income tax rates since they are scheduled to sunset after 2025 and this may occur sooner. While it is difficult, if not impossible, to predict future rates, it is better to err on the conservative side when planning for a long-term event like retirement that may not begin for many years.

Furthermore, it is crucial to look beyond rates to understand how stealth taxes can potentially derail your retirement. None of them is likely to be eliminated since each is responsible for billions of dollars of annual tax revenue. On the contrary, additional stealth taxes will be imposed as part of future tax legislation based on historical precedent. This is likely given the out-of-control federal deficit and the fact that stealth taxes are confusing and often fly under the radar – hence their name.

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Income Tax Planning Roth IRA

Keep Your Eye on QBI Before You Rothify

Close up view of an eye of a woman. Eyesight concept

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

As stated in the introduction to my last Retirement Daily article, “Should You do a Roth IRA Conversion After Age 62?,” Roth IRA conversions are an excellent tool for optimizing after-tax income throughout retirement when done strategically as part of a holistic retirement income plan. The timing and amount of Roth IRA conversions needs to be carefully analyzed as part of a multi-year, or staged, Roth IRA conversion plan.

The article makes a case for accelerating the execution of a Roth IRA conversion plan given the backdrop of current historical low federal income tax rates and wide tax brackets favoring higher conversion amounts through 2025. While this strategy often makes sense, there are situations where reduced income tax savings can offset potential long-term benefits otherwise achievable with larger conversion amounts in a particular year.

Watch Out for the QBI Minefield

One situation where income tax savings can be reduced or eliminated by income from Roth IRA conversions comes into play with eligible owners of pass-through entities. If you’re an owner of a profitable sole proprietorship, Subchapter S corporation, or partnership, you’re probably familiar with the qualified business income, or QBI, deduction that became an important part of income tax law beginning in 2018.

The QBI, or Internal Revenue Code Section 199A, deduction provides owners of these types of entities with a tax deduction of the lesser of (a) 20% of the individual’s qualified business income or (b) 20% of taxable income minus net capital gains. The QBI deduction is a special deduction that’s unaffected by above-the-line deductions, itemized deductions, or the standard deduction. Like current favorable income tax rates and wide tax brackets, the deduction is scheduled to sunset after 2025.

Service Business QBI Income Limitations

The QBI deduction is potentially reduced or eliminated by income limitations for individuals who fall under the category “specified service trade or business” (SSTB). This includes a trade or business involving the performance of services in 11 specified fields:  health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investment and investment management, trading, and dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees.

The income limitations for SSTB individuals in 2020 range from $163,300 to $213,300 for single filers and $326,600 to $426,600 for joint filers. Income limitations are essentially taxable income before the QBI deduction. The QBI deduction phases out beginning at the lower respective income levels and is eliminated at the top thresholds.

There’s potentially a lot at stake if you can keep your taxable income below the applicable income thresholds. Maximum QBI deductions are currently $32,660 ($163,300 x 20%) for single individuals and double this amount, or $65,320 ($326,600 x 20%), for joint filers.

QBI Roth IRA Conversion Example

This brings us to our question du jour:  How can a Roth IRA conversion reduce or eliminate a QBI deduction and associated income tax savings? The best way to illustrate this is with a multiple-case example.

In our example, we have two individuals, Jim and Sheila, who are both attorneys unrelated to each other with identical employment income of $351,400. Jim is an associate attorney who receives a W-2. Sheila is a general partner in a law firm and receives a K-1 reporting her share of the firm’s income. Jim and Sheila take the standard deduction of $24,800 and use married filing joint tax status.

Case #1 – Jim: W-2 of $351,400

Jim receives a W-2 in the amount of $351,400. As an employee, Jim isn’t entitled to the QBI deduction. His taxable income is $326,600. Jim’s federal income tax liability, including Medicare tax on high-income taxpayers of $913, is $67,456.

Case #2 – Sheila:  K-1 of $351,400

Sheila receives a K-1 in the amount of $351,400. As an owner of her law firm, Sheila is entitled to a QBI deduction in the amount of $65,320. Her taxable income is $261,280. Sheila’s federal income tax liability is $50,866, or $16,590 less than Jim’s federal tax of $67,456.

Case #3 – Sheila:  K-1 of $351,400 and Roth IRA Conversion of $50,000

The facts in Case #3 are identical to those in Case #2 with one difference. On March 23rd, after the Dow Jones declined 38.4% from its all-time high of 29,569 on February 12th to a year-to-date low of 18,214, and knowing that Sheila and her husband are paying federal income tax at a historically low rate, Sheila did a Roth IRA conversion in the amount of $50,000.

Sheila’s QBI deduction decreased from $65,320 in Case #2 to $17,570 as a result of the QBI limitation on specified service trade or business individuals, increasing her taxable income from $261,280 to $359,030. This increased Sheila’s federal marginal tax rate from 24% to 32% and her federal income tax liability from $50,866 to $76,921. The difference of $26,055 represents a 51% increase.

Don’t Disqualify Your QBI Deduction with Excess Roth IRA Conversions

What appeared to be a timely move on Sheila’s part, i.e., doing a sizable Roth IRA conversion following a 38% decline in the stock market, with associated elimination of income tax liability on future appreciation of her conversion while in a historically low tax bracket, proved to be ill-advised, at least in the short run.

$48,000, or 73%, of Sheila’s otherwise allowable QBI deduction was eliminated by doing a Roth IRA conversion of $50,000, resulting in an increase in taxable income of $98,000. The increase in Sheila’s income tax liability of 51% significantly exceeded her marginal tax rate of 24% without the conversion and 32% with the conversion.

In Sheila’s defense, it’s possible that when she did her conversion on March 23rd, her projected 2020 K-1 income may have been much less than $351,400, resulting in a higher projected QBI deduction.

Illustrate Multiple What-If Scenarios

If you’re a profitable service business owner, you should balance the strategy of accelerating income to take advantage of low tax rates in effect through 2025 against the potential phaseout and loss of the QBI deduction. This especially applies to large Roth IRA conversions that can’t be offset with losses and other deductions such as a rental property passive loss carry forward when the property is sold.

Although I didn’t illustrate it, there are situations where it makes sense to increase taxable income in order to increase the QBI deduction and reduce federal income tax liability. The lesson to be learned is that it’s important to do income tax planning using multiple what-if scenarios to minimize tax liability and increase the longevity of after-tax retirement income. This applies to QBI as well as other complicated tax planning situations.

Categories
Retirement Income Planning Roth IRA

Should You Do a Roth IRA Conversion After Age 62?

Traditional IRA and Roth IRA text on a book isolated on office desk.

This article was originally published in, and has been reprinted with permission from, Retirement Daily. 

Roth IRA conversions are an excellent tool for optimizing after-tax income throughout retirement when done strategically as part of a holistic retirement income plan. Roth IRA conversions are under-utilized even though they can provide greater after-tax retirement income than would otherwise be possible.

The primary reason for this is a reluctance to plan for and prepay income tax liability attributable to conversions. This is the case even though current historic low-income tax rates and wide income brackets favoring Roth IRA conversions are slated to be replaced by higher pre-2018 tax rates and narrower income brackets beginning in 2026.

Potential Medicare Part B Premium Reduction

One of the benefits of converting taxable retirement income to nontaxable Roth IRA income through Roth IRA conversions is the potential reduction of Medicare Part B premiums beginning at age 65. After-tax retirement income will be increased to the extent that this can be accomplished.

Medicare Part B premiums are income sensitive. They’re determined using modified adjusted gross income (MAGI) from your federal income tax return two years prior to the current year. You can potentially reduce your spouse and your Medicare Part B premiums to the extent that you’re able to reduce your income beginning at age 63 through prior year Roth IRA conversions.

There are six income brackets that are used to determine monthly Medicare Part B premium amounts. In 2020, the premium amounts range from $144.60 to $491.60 per person. An Income Related Monthly Adjustment Amount (IRMAA), or surcharge, is assessed beginning when your MAGI exceeds $87,000 for an individual return or $174,000 for a joint return.

2020 Medicare Part B Premiums

Per the table, the IRMAA surcharge can increase monthly Medicare Part B premiums by as much as $347.00 ($491.60 – $144.60), or $4,164 per year for those in the highest tax bracket. This can result in additional annual premiums of double this amount, or $8,328 for a couple.

Medicare Part D drug plan monthly premiums are also subject to an IRMAA surcharge that ranges from $12.20 to $76.40 per person with the same income brackets as Medicare Part B.

Roth IRA Conversion Surcharge After Age 62

Although timely Roth IRA conversions can be used to decrease Medicare Part B and D premiums and increase after-tax income throughout retirement, there’s a potential price to pay if the conversions occur after age 62. You and your spouse, if married, will pay higher Medicare Part B and D monthly premiums two years after the year of the conversions if the taxable amount of your conversions causes you to jump into a higher Medicare income bracket.

As an example, suppose John and Mary, age 64 and 63, respectively, are married, and their 2018 modified adjusted gross income, or MAGI, is $228,000 prior to doing any Roth IRA conversions. Let’s assume that John and Mary do conversions of $23,000 and $22,000, respectively, for a total of $45,000.

Fast forward two years to 2020 when John and Mary are 66 and 65, respectively, and are both on Medicare Part B. Using John and Mary’s 2018 MAGI of $228,000 prior to their Roth IRA conversions of $45,000, their monthly Medicare Part B premiums would be $289.20 each. They would pay a total of $3,470.40 each for the year, or $6,940.80 for both.

John and Mary’s actual 2018 MAGI is $228,000 increased by their taxable Roth IRA conversions of $45,000, or $273,000. This causes John and Mary to jump into the $272,001 to $326,000 Medicare income bracket, increasing their monthly Part B premiums from $289.20 to $376.00 each.

John and Mary’s total 2020 Medicare Part B premiums are $4,512.00 each, or $9,024.00 for both. In summary, John and Mary’s 2018 taxable Roth IRA conversions of $45,000 resulted in an increase in their 2020 Medicare Part B premiums of $2,083.20 ($9,024.00 – $6,940.80).

Should You Do Roth IRA Conversions After Age 62?

John and Mary’s situation begs the question, should you do Roth IRA conversions after age 62 given the fact that they can potentially increase Medicare Part B and D premiums that you would otherwise pay without the conversions?

Assuming your goal is to minimize potential increases in Medicare premiums resulting from Roth IRA conversions, a staged Roth IRA conversion plan should be established 15 to 20 years before age 62. By starting your plan when you’re in your 40’s, you take the pressure off since you can convert smaller amounts and pay less tax each year on your conversions than would otherwise be possible if you begin your plan later.

Conversion amounts don’t have to, and generally shouldn’t, be the same each year. Current historic low federal income tax rates and wide tax brackets favor higher conversion amounts through 2025. In addition, strategic Roth IRA conversion opportunities, which can be discovered and analyzed through tax planning, as well as market-sensitive conversions, should always be on your radar.

Although the timely establishment and implementation of an ongoing staged Roth IRA conversion plan won’t necessarily result in the conversion of 100% of taxable retirement plan assets to Roth IRA accounts by age 63, it can provide the following nine benefits:

Given the fact that the foregoing nine benefits of a staged Roth IRA conversion plan work together to optimize lifetime after-tax retirement distributions, it makes sense to continue doing income tax-sensitive strategic Roth IRA conversions after age 62. Paying increased Medicare Part B and D premiums in one or more years, the amount of which can be minimized through Medicare income bracket planning, is usually a small price to pay to accomplish this goal.

Finally, remember to include your Part B, Part D, and supplemental Medicare premiums in the above-the-line deduction for health insurance premiums on your income tax returns if you’re self-employed. This will soften the blow in years when Roth IRA conversions increase your premiums and throw you into a higher Medicare income bracket.

Categories
Income Tax Planning IRA Retirement Income Planning Roth IRA

Contribute Your 2020 RMD to a Roth IRA

Childlike seniors wearing superhero costumes

Less than four weeks ago on March 27th, President Trump signed the Coronavirus Aid, Relief, and Economic Security (CARES) Act. This 880-page legislation includes four pages that waive required minimum distributions, or RMDs, for 2020 for traditional IRAs, workplace retirement plans, and inherited traditional and Roth IRAs.

As was the case in 2009 when RMDs were also waived, if this wasn’t done in 2020, many individuals, especially older ones, would be upset that they would be forced to sell deflated assets to satisfy their RMD and avoid a 50% penalty.

What if you have already taken your 2020 RMD, a portion of your RMD, or IRA or other retirement plan distributions greater than your RMD? You have three options, with #2 and #3 inapplicable to distributions from inherited traditional and Roth IRAs:

  1. Keep
  2. Return
  3. Contribute to a Roth IRA

Let’s examine the pros and cons of each of the three options.

Keep

If you have already taken distributions from taxable retirement accounts, including RMDs, you can simply keep them. If you took a distribution before February 1st, this is your only option.

Any distributions that you keep are subject to ordinary income tax to the extent that the distribution exceeds your basis. Basis includes a pro-rata amount of nondeductible contributions in the case of an IRA and after-tax contributions if the distribution came from a 401(k).

Options #2 and #3 generally aren’t viable planning strategies for retirees who depend on RMDs to cover basic expenses. Although the amount changes from year to year, it’s a systematic payout and, as such, is comparable to a structured distribution from a variable annuity.

Return

As discussed in my April 6th post, 2020 Required Minimum Distributions Waived, the CARES Act applies the “60-day rollover rule” to determine if you can return your RMD to your Traditional IRA or other retirement plan account. Under this rule, you can rollover, or return, your distribution to the account from which it came within 60 days from the date that you received it provided that you haven’t done any other rollovers within the previous 365 days.

It’s critical to review all IRA and retirement plan transactions within the previous 365 days to determine if any other rollovers have occurred. If there was another rollover, the return of your 2020 distribution will be taxable and will be subject to a potential 10% early distribution penalty and a 6% per year excess accumulation penalty if it isn’t timely removed from the account.

On April 9th, IRS released Notice 2020-23, one of the sections of which supersedes the 60-day rollover rule, indirectly extending the 2020 RMD waiver to distributions taken between February 1, 2020 and May 15, 2020 to July 15th. As noted in the “Keep It” section, if you took distributions before February 1st, your only choice is to keep it and include it in your 2020 gross income.

The advantage of rolling over, or returning, distributions to IRAs or other retirement plan accounts is that they won’t be subject to taxation in 2020. Distributions that are rolled over, or returned, to IRAs will continue to enjoy tax-deferred growth provided that there have been no other rollovers within the previous 365 days.

Potential disadvantages of returning distributions to retirement plans outnumber those of keeping them depending upon one’s situation. They include the following:

  • Increased RMDs in subsequent years
  • Increased income tax liability in subsequent years due to increased RMDs
  • Potential increased Medicare Part B Premiums and taxable Social Security due to increased RMDs
  • Increased exposure to likely higher income tax rates for you and your heirs beginning in 2026 when current tax rates expire or potentially sooner depending upon results of the upcoming presidential election
  • Increased exposure to increased income tax liability in future years for surviving spouses due to the widow(er)’s penalty
  • Increased exposure to 10-year vs. lifetime distribution requirement and associated potential increased income tax liability for non-minor children, grandchildren, and other nonspouses who inherit traditional IRAs and other retirement plans resulting from the SECURE Act that went into effect on January 1st

Contribute to a Roth IRA

When most people think about doing a Roth IRA conversion, they expect to transfer assets directly from a traditional IRA account to a Roth IRA account. Furthermore, while it’s possible to do a transfer between accounts located at different financial institutions, most transfers are done within the same financial institution.

There’s another way to do a Roth IRA conversion that can be used to leverage its benefits in light of the waiver of 2020 RMDs. It’s a strategy that’s been part of the income tax law since the Taxpayer Relief Act of 1997 which created the Roth IRA. If you receive a distribution from a traditional IRA, you can contribute, or roll it over, to a Roth IRA within 60 days after the distribution as a Roth IRA conversion.

The once-per-year rule discussed in the “Return” section doesn’t apply to rollovers to Roth IRAs. Furthermore, the 60-day rollover time frame has been extended to July 15th for 2020 Roth IRA conversions of distributions taken from IRAs and other retirement plans between February 1st and May 15th by IRS Notice 2020-23.

There are many advantages of employing this strategy, the first several of which are mirror images of the disadvantages of returning distributions to retirement plans discussed in the previous section. The advantages of contributing or rolling over 2020 distributions to a Roth IRA include the following:

  • Reduced RMDs in subsequent years
  • Reduced income tax liability in subsequent years due to reduced RMDs
  • Potential reduced Medicare Part B Premiums and taxable Social Security due to reduced RMDs
  • Reduced exposure to likely higher income tax rates for you and your heirs beginning in 2026 when current tax rates expire or potentially sooner depending upon results of the upcoming presidential election
  • Reduced exposure to increased income tax liability in future years for surviving spouses due to the widow(er)’s penalty
  • Reduced exposure to 10-year vs. lifetime distribution requirement and associated potential increased income tax liability for non-minor children, grandchildren, and other nonspouses who inherit Traditional IRAs and other retirement plans resulting from the SECURE Act that went into effect on January 1st
  • Elimination of taxation on appreciation of funds used for the Roth IRA conversion
  • Opportunity to do a market-sensitive Roth IRA conversion to optimize lifetime after-tax distributions to the extent that the conversion is done before the stock market recovers from its recent 38.4% downturn

The primary disadvantage of rolling over a distribution from a traditional IRA to a Roth IRA vs. returning it to the traditional IRA is that it will be subject to taxation in 2020. The other potential disadvantage is increased Medicare Part B monthly premiums in 2022 if the conversion is done when you’re 63 or older depending upon the conversion amount and your adjusted gross income in 2020.

Given the prospects for higher income tax rates in the future, the potential long-term benefits of doing a Roth IRA conversion are likely to exceed additional 2020 income tax liability and potential increased 2022 Medicare Part B premiums attributable to the conversion.

The Three Options Aren’t Mutually Exclusive

As is often the case with income tax planning strategies, the three options discussed in this post aren’t mutually exclusive. It may be in your best interest to use a combination of two or three of them to optimize your and your heirs’ lifetime after-tax retirement income depending upon your situation.

Categories
Income Tax Planning IRA Retirement Income Planning Roth IRA

The Roth IRA Conversion Trifecta

Race for the prize of the Summer in Pyatigorsk,Caucasus.

Those of you who have read my Retirement Income Visions™ posts and MarketWatch Retirementors articles over the years know that I’m a big fan of Roth IRA conversions. A Roth IRA conversion, when implemented timely, can be one of the most effective strategies for optimizing retirement income.

As a result of a series of three events, the most recent of which is unfortunately in response to the coronavirus pandemic, there’s an unprecedented opportunity to do a sizable Roth IRA conversion this year. Taking advantage of this opportunity is predicated on availability of cash to pay the income tax liability attributable to the conversion.

Event #1:  Stock Market Downturn

In less than six weeks, The Dow Jones Industrial Average (DJIA) plummeted 11,355 points, or 38.4%, from its high of 29,569 on February 12th to its recent low of 18,214 on March 23rd. While it recaptured 3,423 points this past week to close at 21,637 on Friday, the DJIA is down 26.8% from its high.

Keeping in mind that any appreciation in a Roth IRA account following a Roth IRA conversion will permanently escape taxation, this is one of those market-sensitive conversion opportunities, the likes of which we haven’t experienced in 11 years. Assuming that you’re healthy and you have a reasonably long planning timeframe, you or your financial advisors should be examining how you can take advantage of this.

Event #2:  Low Income Tax Rates Expire After 2025

The current historically low income tax rates and widening tax brackets to which they’re applied that went into effect in 2018 will end after 2025. Prior to the economic meltdown triggered by the coronavirus pandemic, there was widespread agreement that tax rates will increase in 2026, if not sooner. The signing of the $2 trillion coronavirus relief bill, or CARES Act, by President Trump on Friday piled on top of our national debt of $24 trillion makes this inevitable.

Knowing that you only have six years, including 2020, to pay income tax at a lower rate than you’re likely to pay in the future, Roth IRA conversions should be a high priority for most employees who have Traditional 401(k) plans with a Roth 401(k) option as well as Traditional IRA account owners.

Event #3:  Inherited Retirement Plan Lifetime Distributions Eliminated for Non-Minor Children

In addition to the likelihood of being subject to higher income tax rates, adult children and grandchildren will no longer be able to take distributions from inherited retirement plans over their lifetime. The “stretch IRA” has been replaced with a 10-year rule for most beneficiaries with the enactment of the SECURE Act that went into effect this year.

Most nonspouse beneficiaries, including non-minor children and grandchildren are now required to withdraw 100% of the funds from their inherited retirement plans by the end of the tenth year following the year of death for deaths occurring after 2019. This will accelerate distribution of assets and taxation at higher rates for beneficiaries of 401(k) plans and Traditional IRA accounts. Although distributions won’t be taxed, this change also applies to inherited Roth IRA accounts.

With the elimination of the “stretch IRA,” it no longer makes sense in many cases to leave sizable taxable retirement plan accounts to children and grandchildren. An aggressive Roth IRA conversion plan is one way to reduce, or potentially eliminate, this problem.

Transfer Securities When Doing a Roth IRA Conversion

I have had a number of clients and other individuals tell me that they thought that they need to sell securities in their Traditional IRA account in order to do a Roth IRA conversion. This is generally not a good idea given the fact that appreciation in a Roth IRA account following a Roth IRA conversion will permanently escape taxation.

Instead, you want to specify on your Roth IRA conversion form a number of shares of one or more securities that you would like to transfer from your Traditional IRA account to your Roth IRA account. These should ideally include equity securities, e.g., large or small cap value exchange traded funds or mutual funds, which are likely to appreciate. The total value of the securities being transferred should approximate the desired amount of your conversion, keeping in mind that the value and associated tax liability is likely to change between the time that your form is submitted and your conversion is processed, especially in the current volatile environment.

Unprecedented Opportunity

As a seasoned financial advisor, I’ve experienced, and have presented to clients, several windows of opportunity to create and optimize retirement income. The three events discussed in this post, two of which didn’t exist three months ago, are a Roth IRA conversion trifecta, or perfect storm.

The three events can be leveraged to do a sizable Roth IRA conversion this year as part of a staged, or multi-year, Roth IRA conversion plan subject to availability of cash to pay the income tax liability attributable to the conversion. This is an unprecedented opportunity that many of us probably won’t experience again in our lifetime.

Categories
Annuities Deferred Income Annuities Long-Term Care Retirement Income Planning Roth IRA Social Security

5 Lifetime Valentine’s Day Gifts for Your Spouse

Valentine day background with red hearts, top view - Image

The mad scramble is on. With Valentine’s Day just around the corner, what should you buy your spouse to show him/her your everlasting love and appreciation? Forget about traditional gifts such as roses and chocolate that are short-lived and just as quickly forgotten.

Here are five unique ideas you won’t find on Amazon that are designed to fulfill you and your spouse throughout your life. A word of caution:  Brush up on your presentation skills since each one will likely be met with dead silence or outrage depending upon the mood of your spouse.

VD Gift Idea #1:  Eliminate Your Mortgage by Retirement

One of the biggest cash flow challenges for many retirees is their mortgage. When you apply for a mortgage while you’re working, the mortgage amount and associated monthly payment is determined using your employment income.

Although your employment income generally increases, so do your expenses. When you retire, your guaranteed sources of income that are available to cover your mortgage payments are often a small percentage of your former employment income.

Given this common scenario, you should design a plan to eliminate your mortgage by retirement whenever possible. This can include an increase in your monthly payment amount, making bi-weekly payments, or using a portion of bonuses to reduce your outstanding balance. Your plan should be part of an overall strategy that includes various savings vehicles.

VD Gift Idea #2:  Defer Your Social Security Start Date

When your spouse dies, you can generally receive 100 percent of his/her Social Security retirement benefit if (a) the amount exceeds your benefit and (b) you have reached your full retirement age, which is between 66 years and two months and 67 depending upon when you were born. This is the good news.

The bad news is that the monthly amount that you receive for your lifetime could be significantly less than what you would otherwise qualify for depending upon when your spouse began collecting his/her benefits. The difference could be as much as 77% if he/she began collecting benefits at age 62 vs. waiting until 70.

Assuming that your Social Security benefit will be greater than your spouse’s, you’re in good health, you have other financial resources, and your goal is to maximize your spouse’s benefit in the event that you predecease him/her, it behooves you to defer your Social Security starting date as long as possible, up to age 70.

VD Gift #3:  Start a Staged Roth IRA Conversion Plan

While there are several benefits of a staged, or multi-year, Roth IRA conversion plan, one of the least publicized is the ability to reduce a widow or widower’s income tax liability. This is due to the fact that surviving spouses who don’t remarry are subject to higher income taxes.

Distributions from Roth IRA accounts, unlike traditional 401(k) plans and IRAs, generally aren’t taxable. A staged Roth IRA conversion plan can be used when both spouses are alive to convert otherwise taxable assets to nontaxable assets. Although income tax will probably need to be paid on the conversion amounts, the amount will be less in many cases than what will be payable by the surviving spouse, especially if income tax rates increase which is likely after 2025.

VD Gift #4:  Include Sustainable Lifetime Income in Your Retirement Plan

When you retire, you want to minimize sleepless nights by knowing that you have, and will continue to have, sufficient income to cover your expenses. Designing a plan that will provide you and your spouse with sustainable after-tax income streams to cover your non-discretionary expenses throughout different stages of retirement is an effective way to accomplish this goal.

There are five reasons for including sustainable lifetime income in your retirement plan that will benefit you and your spouse:

  • Hedge against longevity
  • Match income to projected expenses
  • Protect against the sequence of returns
  • Increase cash flow from potential income tax savings
  • Simplify your financial life

VD Gift #5:  Create an Extended Care Plan

I saved this idea for last since, although it’s potentially the most beneficial one, it’s also likely to be met with the most resistance. Previously suggested as a birthday gift for parents, it’s also suitable for one’s spouse on Valentine’s Day.

Extended care is the least understood and most under-planned for life event. When it’s needed, extended care takes its biggest toll on family and friends in the absence of a plan. Studies have shown that providing extended care for an individual who is chronically ill can have a devastating effect, both emotionally and financially, on caregivers.

An extended care plan may or may not include long term care insurance. When included, long term care insurance provides a predictable, readily available, tax-free source of funds that can be used to pay for a portion, or potentially all, of one’s extended care expenses without disrupting one’s retirement income plan.

The Gifts That Keep on Giving

While the foregoing Valentine’s Day gift suggestions aren’t traditional and won’t provide immediate gratification, each one is designed to fulfill you and your spouse throughout your life. Furthermore, all of them will eventually be appreciated by both of you, even after the other is gone.

If you’re looking for the ultimate gift, include each one as part of a comprehensive retirement income plan. Financial advisor sold separately. Finally, don’t forget the card. Happy Valentine’s Day!

Categories
Income Tax Planning IRA Retirement Income Planning Roth IRA

7 Reasons to Start a Staged Roth IRA Conversion Plan Today

- ‘A goal without a plan is just a wish’ written on a blackboard. Blurred styled background.

If you want to succeed at chess, you need a plan for evaluating positions and setting short- and long-term goals. This includes being willing to strategically sacrifice pawns, knights, bishops, and even rooks in order to achieve the object of the game, i.e., checkmating your opponent’s king.

Just like chess, when planning for retirement you need to keep the ultimate goal in mind if you want to win — optimizing the longevity of your assets. With retirement, your opponent is the IRS as well as your state tax agency if you’re subject to state income tax. Similar to chess, you need to be willing to sacrifice pieces to achieve success. The pieces in the game of retirement planning come in the form of strategic income tax prepayments.

If you’re in your 50’s or 60’s and you have traditional 401(k) plans, SEP-IRAs, and traditional IRAs to which you’re contributing, why wait until 70-1/2 when the value of your plans have potentially doubled and tax rates are potentially higher to pay income tax on your distributions? Wouldn’t you rather use prudent retirement income planning strategies today to pay less tax for the rest of your life and have more funds available when you need them the most – during your retirement years?

One underutilized strategy for accomplishing this is with a staged, or multi-year, Roth IRA conversion plan. The length of the plan needs to be flexible with the number of years dependent upon many variables, a discussion of which is beyond the scope of this post. The following are seven reasons to start this type of plan today.

1. Eliminate taxation on the future growth of converted assets.

Assuming that you will be subject to taxation during your retirement years, eliminating taxation on the future growth of converted assets is the most important reason for implementing a staged Roth IRA conversion plan before you retire. 100% of the value of Roth IRA assets, including appreciation, will be permanently exempt from taxation.

Appreciation is typically responsible for the majority of the value of retirement plan assets over time. Suppose that you did a $60,000 partial Roth IRA conversion using a moderately aggressive equity portfolio in the beginning of March, 2009 when the Dow Jones Industrial Average was 7,000. Let’s further assume that you paid income tax at a rate of 25%, or $15,000, attributable to your conversion. Assuming that you retained your portfolio, it could potentially be worth $240,000 today.

To keep the example simple, let’s further assume no additional growth and a current tax rate of 25%. If you didn’t do the Roth IRA conversion in 2009, you would have net assets of $240,000 less income tax of $60,000, or $180,000. As a result of doing the Roth IRA conversion, you have $225,000 ($240,000 less income tax liability of $15,000 paid in 2009) or an additional $45,000 available for your retirement needs.

2. Take advantage of low federal tax rates scheduled to expire after 2025.

While there have been numerous changes in the federal tax law over the last 35 years making for a difficult comparison, the income tax rates that took effect in 2018 are historically on the low side. This is especially true when you also consider the widening of the various tax brackets. A bonus for business owners was the reduction of the Subchapter “C” corporate tax rate to 21% and addition of  a qualified business income (QBI) deduction of up to 20% for other business entities. The latter change reduced the effective tax rate for affected individuals.

With federal tax rates scheduled to expire after 2025 and higher rates likely thereafter, there’s a window of opportunity for Roth IRA conversions. You can potentially benefit from paying taxes on conversions at a low rate for up to seven years if you implement a multi-year staged Roth IRA conversion plan in 2019.

3. Reduce required minimum distributions beginning at age 70-1/2.

Minimum distributions, or RMDs, are required to be taken from non-Roth retirement plans beginning at age 70-1/2 based on the value of your accounts using an IRS table life expectancy factor. The income tax liability attributable to RMDs can be significant, reducing spendable income in retirement.

Why let your opponent, i.e., IRS, control your retirement income plan? A staged Roth IRA conversion plan can go a long way toward minimizing the value of taxable retirement plan accounts subject to RMDs while growing your nontaxable Roth IRA accounts.

4. Potentially reduce Medicare Part B premiums.

Reducing RMDs has a domino effect. One example is Medicare Part B premiums which are determined using modified adjusted gross income (MAGI) from two years prior to the current year. Medicare Part B annual premiums currently range from $1,626 to $5,526 depending upon income. Couples pay double this amount, or $3,252 to $11,052.

To the extent that you successfully execute a staged Roth IRA conversion plan and reduce your taxable retirement plans and RMDs, you can also reduce your MAGI. This can result in significant Medicare Part B premium savings over the course of one’s retirement.

Income tax planning, which is always recommended when considering Roth IRA conversions, is especially important beginning at age 63 since the amount of your conversions in a particular year can potentially increase your Medicare Part B premiums that you would otherwise pay beginning at age 65.

5. Reduce widow or widower’s income tax liability.

A second example of the domino effect of reducing RMDs is the ability to reduce the negative effects of the widow or widower’s income tax penalties. Surviving spouses who don’t remarry are subject to higher income taxes. An example of this was illustrated in Is Your Widow(er) Included in Your Income Tax Plan?.

A staged Roth IRA conversion plan executed while both spouses are alive can reduce the survivor’s ongoing income tax liability. If you’re married, own non-Roth retirement accounts, and you recognize that there’s a realistic possibility that one of you may outlive the other for several years, a staged Roth IRA conversion plan makes sense.

6. Reduce dependency on taxable assets in retirement.

In addition to reducing or potentially eliminating RMDs, a Roth IRA conversion plan reduces your dependency on taxable assets in retirement. The easiest way to illustrate this is with an example.

Let’s suppose that you’re retired and you want to do some major home improvements that you’ve been putting off, the cost is $100,000, you have $600,000 in traditional IRA accounts, and you’re in a combined 35% federal and state income tax bracket. You would need to withdraw $154,000 from your traditional IRA accounts in order to net $100,000 after tax.

If you instead had Roth IRA accounts, you could withdraw $100,000, or $54,000 less, since income tax liability wouldn’t be an issue. To the extent that you can reduce your dependency on taxable assets in retirement, you will optimize the longevity of all of your retirement assets.

7. Stay focused on retirement income planning.

The seventh reason for starting a staged Roth IRA conversion plan today, while not obvious, is very important. Given the multi-year nature of this type of plan, you’re forced to get in the habit of focusing on retirement income tax planning as long as you continue to own non-Roth retirement assets.

Whenever you visit your staged Roth IRA conversion plan, it’s an opportunity to examine and implement other retirement income planning and protection strategies that can also optimize the longevity of your assets. Given the fact that it’s difficult at best to do this yourself and a single mistake can be costly, an investment in a qualified team of income tax, investment, insurance, and legal professionals who specialize in retirement income planning is prudent.

Retirement income planning, much like chess, requires a great deal of patience and focus to be successful. If executed well, you can optimize the longevity of your assets while accomplishing another goal — stalemate IRS!

Categories
Income Tax Planning Retirement Income Planning Roth IRA

Is Your Widow(er) Included in Your Income Tax Plan?

Widow looking at the photo of her dead husband

Most of the time when we do income tax planning it’s motivated by one or more transactions that have occurred or may occur in the current year. A common example would be the proposed sale of a rental property. Depending upon the particular facts, the sale could trigger income tax liability or savings, the latter occurring when there are passive loss carryovers. Either way, preparation of an income tax projection to determine the appropriate course of action given one’s financial situation and financial goals would be prudent.

Rarely do we look ahead and do income tax planning for multiple years. In addition, married couples, especially those who are young and in good health, don’t like to think about, let alone plan for, the possibility of losing their spouse.

Married vs. Surviving Spouse Example

Unfortunately, the income tax law isn’t kind to surviving spouses who don’t remarry. A widow or widower who has the same, or even less, income than the couple enjoyed will often be subject to higher federal, and potentially, state, income tax liability. The best way to illustrate this is with an example.

Let’s assume that John and Susan, who live in California, have the following income that they will report on their 2019 income tax returns:

  • Qualified dividends – $5,000
  • Rental property net income – $40,000
  • John’s Social Security – $20,000
  • Susan’s Social Security – $40,000
  • Traditional IRA required minimum distributions – $56,000
  • Fixed income annuity income distribution – $24,000

Let’s also assume that John and Susan’s standard deduction, the amount of which is $27,000, exceeds their total itemized deductions. After excluding 15%, or $9,000, of their Social Security benefits from taxation, John and Susan’s taxable income is $149,000. Their federal and California income tax liability is $24,200 and $4,300, respectively, for a total of $28,500.

Suppose instead that John died in 2018 and Susan hadn’t remarried as of the end of 2019. No matter which day John’s death occurred, Susan would have been allowed to use married filing joint status for 2018.

Assume that all income items are unchanged in 2019 with the exception of John’s Social Security of $20,000 which is eliminated. This would result in a reduction in total income of $17,000 after the 15% Social Security exclusion. As an aside, the exclusion can be as much as 100% depending upon one’s other income.

Widow(er) Penalties

As a surviving spouse, Susan will be subject to several widow penalties that will result in greater 2019 federal and California income tax liability than would have been the case had John not died in 2018. The first penalty that Susan encounters is a 49% reduction in the standard deduction she can claim, going from $27,000 if John was still alive to $13,850. This results in taxable income of $145,150 for Susan.

Even though Susan’s taxable income is $3,850 less than John and Susan’s taxable income of $149,000, Susan is hit with widow penalty #2, i.e., increased marginal federal tax rate. This is now 24% vs. 22% when Susan was married. This increases her federal income tax liability by $4,400, or 18%, going from $24,200 to $28,600.

The state of California is also unsympathetic toward widows and widowers. Although Susan’s California adjusted gross income of $125,000 is identical to when she was married due to the fact that California doesn’t tax Social Security benefits, she is subject to three penalties as a single taxpayer:

  • 50% reduction in allowable standard deduction, decreasing from $8,802 to $4,401
  • Higher effective tax rate of 7% vs. 4.6%
  • 50% reduction in personal exemption credit

The foregoing penalties increase Susan’s California income tax liability by $3,700, or 86%, going from $4,300 when she was married to $8,000. Susan’s total 2019 income tax liability is $36,600 which is $8,100, or 28.4%, greater than John and Susan’s 2019 income tax liability of $28,500.

Income Tax Planning Opportunity

Surviving spouses, especially older ones, often don’t remarry. This needs to be considered in income tax plans knowing that widow(er) penalties often result in increased income tax liability. This approach also dovetails with the retirement income planning goal of optimizing after-tax retirement income to cover projected expenses and prolong the life of investment assets.

The use of income acceleration strategies increases in importance when you combine widow(er) penalties with the window of opportunity offered by the Tax Cuts and Jobs Act of 2017. The wider income tax brackets and lower income tax rates that went into effect in 2018 end in 2025. Many income tax professionals, including myself, are of the opinion that income tax rates will increase in 2026 given the multiple financial and associated budget challenges we face as a country.

Timely Roth IRA conversions are at the top of my list of income acceleration strategies for clients who understand that it can make sense to prepay income tax in order to increase longevity of investment assets. There are two types of timely Roth IRA conversions:  strategic and market-sensitive.

Strategic conversions take advantage of opportunities to minimize income tax liability associated with the conversion, e.g., a rental property suspended loss.  Market-sensitive conversions take advantage of sizable stock market declines without attempting to time the market.

The goal of Roth IRA conversions is to optimize lifetime after-tax distributions. Strategic and market-sensitive Roth IRA conversions can accomplish this in four ways:

  • Elimination of income tax on appreciation of Roth IRA accounts
  • Reduction of required minimum distributions (RMDs) and associated income tax liability to the extent that funds have been transferred from tax-deferred non-Roth qualified retirement plans and traditional IRA accounts to nontaxable Roth IRA accounts
  • Potential reduction of taxable Social Security benefits as a result of reduced RMDs subject to amount of other income
  • Potential reduction of Medicare Part B premiums as a result of reduced RMDs and modified adjusted gross income

Elimination of income tax on appreciation of Roth IRA accounts and reduction of RMDs and associated income tax liability can potentially reduce widow(er) penalties. If you’re married and are hesitant about prepaying income tax in connection with a proposed Roth IRA conversion, think about the increased income tax liability your widow(er) may incur.

Categories
401(k) Plans Income Tax Planning IRA Roth IRA

RMDs: Recapture My Deductions – A Questionable Strategy

Pebbles in the form of a arch on the coast

Although most non-tax professionals don’t appreciate it, there’s a fair amount of symmetry throughout the tax law. This is especially true when it comes to retirement plan contributions.

Deductible, Nondeductible, or Partially Deductible Contributions

Employers, employees, and self-employed individuals can make deductible, nondeductible, or partially deductible contributions to retirement plans. Deductibility depends upon the type of plan.

Contributions to traditional 401(k), 403(b), and SEP-IRA plans are deductible with the exception of after-tax employee 401(k) contributions. Contributions to Roth 401(k) plans and Roth IRAs are nondeductible. Traditional IRA contributions are deductible, nondeductible, or partially deductible depending upon filing status, income level, and participation in other retirement plans. All contributions are subject to specified limits.

Age 70-1/2 – The Party’s Over

Once you turn 70-1/2, you’re no longer allowed to contribute to a traditional IRA. In addition, account owners generally must begin taking annual withdrawals from their retirement plans. Exceptions to this requirement include non-inherited Roth IRAs and 5% owners of businesses sponsoring a retirement plan. The first payment can be delayed to April 1 of the year following the year in which you turn 70-1/2.

Required minimum distributions (RMDs), is the technical term for the annual minimum amounts that must be withdrawn from retirement plans beginning at age 70-1/2. While the title of this post euphemistically refers to RMDs as “Recapture My Deductions,” the required distribution rules make no distinction between previously deductible vs. nondeductible contributions.

RMD Calculation and Taxation

RMDs are calculated by dividing the prior December 31 balance of the retirement plan or IRA account by a life expectancy factor published by the IRS in tables in Publication 590-B – Distributions from Individual Retirement Arrangements.

The life expectancy factor for RMDs for noninherited retirement plans for most people is generous, beginning at 27.4 at age 70 and decreasing gradually to 1.9 at age 115 or older. This allows individuals who only take RMDs to retain balances in their retirement plan accounts at death to transfer to their heirs.

Distributions from non-Roth accounts are fully taxable with the exception of those arising from nondeductible IRA and after-tax employee 401(k) plan contributions. A special calculation must be performed to determine the taxable portion in the latter situation.

Plan for Distributions When Making Retirement Plan Contributions

There’s symmetry between the fact that contributions to retirement plans, with the exception of non-inherited Roth IRAs, are subject to the required minimum distribution rules. What goes in, plus earnings, must eventually be withdrawn.

What most people, overlook, however, when deciding whether to make deductible vs. nondeductible contributions to retirement plans, especially 401(k)s, is the fact that cumulative distributions from retirement plans often exceed cumulative contributions. Furthermore, the difference can be significant.

When deciding between making contributions to a traditional vs. Roth 401(k) plan, most people assume that the current tax savings from making a deductible traditional 401(k) contribution will exceed any long-term benefit to be derived from nontaxable distributions from a Roth 401(k) plan. This is often untrue, even in situations where your marginal tax rate when making contributions exceeds your rate at the time of withdrawals. This is illustrated in my How to Put Some Muscle Into Your Roth 401(k) September 2, 2016 MarketWatch article.

Reduce RMDs with Roth IRA Conversions

RMDs are taxed at ordinary income tax rates. This can be as high as 37% for federal purposes plus applicable state income taxes which can be as much as 13.3% in California under current tax law.

To the extent that you do strategic or market-sensitive Roth IRA conversions, you will reduce your RMDs and eliminate taxation on the growth of your conversions. Furthermore, you can also potentially reduce taxation of your Social Security benefits and Medicare premiums.

Optimize Your After-Tax Retirement Plan Distributions

When you retire, you should optimize after-tax retirement plan distributions for you and your heirs. While you can play the game of making deductible retirement plan contributions and “recapture my deductions” beginning when you turn 70-1/2, this may not be the best strategy for accomplishing this goal.

Categories
Income Tax Planning Roth IRA

Strategic Roth IRA Conversions Still Make Sense

As my clients and those of you who have read my MarketWatch RetireMentors articles and Retirement Visions blog posts know, I’m a huge fan of Roth IRA conversions. One caveat:  they must be timely. There are two types of timely Roth IRA conversions:

  1. Strategic
  2. Market-sensitive

Strategic Roth IRA Conversion

The goal of a strategic Roth IRA conversion is to discover opportunities that will allow you to do a conversion while minimizing income tax liability associated with the conversion. This requires preparation of a detailed income tax projection comparing income tax liability with and without a conversion of varying amounts.

Roth IRA conversions create taxable income to the extent that the value of the traditional IRA being converted exceeds its cost basis. Nondeductible IRA contributions create cost basis.  Just because a Roth IRA conversion will result in taxable income doesn’t mean that you will incur additional tax liability by doing the conversion. It depends on your tax situation.

As an example, suppose you sell a rental property with suspended losses of $110,000 and a long-term capital gain of $60,000, you have other income totaling $70,000, and itemized deductions totaling $40,000. Assuming that you’re married with no dependents, your taxable income will be -$28,000 and you will incur no income tax liability.

Let’s suppose that you do a Roth IRA conversion of $100,000. Although this will increase your taxable income to $72,000, your federal income tax liability will be less than $1,000 due to the favorable tax rate on your rental property capital gain. This is an example of a strategic Roth IRA conversion since you’re recognizing additional income of $100,000 from the conversion while incurring minimal income tax liability.

Multi-year strategic partial Roth IRA conversions are also possible. I have some retired clients who take withdrawals from nonretirement investment accounts to meet their living needs. They also have other sources of income such as Social Security, a modest pension, or a fixed income annuity and a fair amount of itemized deductions.

Due to the fact that the withdrawals from these clients’ nonretirement accounts often generates capital gains, most of which are long-term resulting in favorable tax treatment, their federal income tax liability is generally negligible. This creates an opportunity to do a Roth IRA conversion with minimal tax liability.

Once again, income tax planning is the key to determining an optimal conversion amount. Since these clients are retired and their tax situations are relatively stable, strategic partial Roth IRA conversions are a possibility each year that they continue to have traditional IRA accounts or retirement plans that can be rolled over into a traditional IRA.

Market-Sensitive Roth IRA Conversion

With any Roth IRA conversion, 100% of the appreciation of the conversion amount that’s transferred into a Roth IRA account permanently escapes income taxation. Given this reality, the optimal time to do a Roth IRA conversion is following a sizable decline in the stock market. This is a market-sensitive conversion.

An important distinction needs to be kept in mind. A market-sensitive conversion doesn’t involve market timing. Market timing is a strategy whereby you make buy or sell decisions by attempting to predict future market price movements. This is very difficult to do and can backfire on you if your prediction is off the mark.

A market-sensitive strategy is more straightforward. Unlike market timing where prediction of future market price movements is the objective, a market-sensitive strategy simply looks in the rear-view mirror. If there has been a sizable drop in stock prices, say 15%, that could be an opportunity to do a Roth IRA conversion. Obviously, a 50% decline such as the one that we experienced between September, 2007 and March, 2009 would have been ideal for doing a Roth IRA conversion.

How much of a market-sensitive Roth IRA conversion you should do depends upon the value of your traditional IRA and the percentage decrease. Partial Roth IRA conversions are generally preferable, especially if the value of your traditional IRA is significant and the stock market decline is 20% or less.

I haven’t recommended a market-sensitive Roth IRA conversion to any clients since the first quarter of 2016 when the Dow lost 5% in the first two months of the year. It has since increased by 27%, making the current environment unfavorable for doing a market-sensitive Roth IRA conversion.

Mark Twain’s saying, “If you don’t like the weather in New England now, just wait a few minutes” needs to be kept in mind when waiting for an opportunity to do a market-sensitive Roth IRA conversion. The stock market, with its 220% increase since March, 2009, is ripe for a sizable correction.

Optimize Lifetime After-Tax Distributions

Whether you do a strategic or market-sensitive Roth IRA conversion, the primary objective should always be to optimize lifetime after-tax distributions. Lifetime in this context refers to the life of all investment accounts since they often extend beyond the lives of the original owners.

Strategic and market-sensitive Roth IRA conversions can both increase lifetime after-tax distributions in five ways:

  • Elimination of income tax on appreciation of Roth IRA accounts
  • Reduction of required minimum distributions (RMDs) and associated income tax liability to the extent that funds have been transferred from qualified retirement plans and traditional IRA accounts to Roth IRA accounts
  • Potential reduction of income tax liability through increased allowable itemized deductions resulting from a reduction of adjusted gross income
  • Potential reduction of taxable Social Security benefits as a result of reduced RMDs subject to amount of other income
  • Potential reduction of Medicare Part B premiums as a result of reduced modified adjusted gross income

Don’t be afraid to pay some income tax from nonretirement funds in order to achieve this objective. The amount that you pay at the time of a Roth IRA conversion is often a fraction of what is ultimately paid on distributions that are taken from qualified retirement plans and traditional IRA accounts without any Roth IRA conversions.

While the ability to do market-sensitive conversions is dependent upon the performance of the stock market, strategic Roth IRA conversions are always in vogue. Any time that you can do a Roth IRA conversion with minimal income tax liability is worth pursuing. To the extent that your strategic Roth IRA conversion is also market-sensitive, it’s a home run.

 

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Roth IRA

Hedge Against Longevity with a Roth IRA Strategy

The title of my most recent MarketWatch RetireMentors article that was published on June 6th is 5 Reasons to Include Sustainable Income in Your Retirement Plan. Reason #1 is hedge against longevity.

Although sustainable, or predictable, income from Social Security, pensions, and fixed income annuities provide lifetime income that can build a solid floor for any retirement income plan, there’s another way to prepare financially for living a long life. Not traditionally touted as a longevity tool, a Roth IRA, when used strategically, can potentially extend the life of your portfolio.

It’s All about Optimizing After-Tax Income

Roth IRAs are the golden goose or Cadillac if you prefer, of the investment world. With their two distinct advantages, i.e., tax-free growth and tax-free withdrawals beginning after age 59-1/2, there’s no competition.

When you’re retired, unless (a) your taxable income is less than approximately $10,000 if single or $20,000 if married or (b) you have taxable income less than approximately $38,000 if single or $75,000 if married that’s comprised mostly of long-term capital gains, your income will be reduced by income tax.

Sustainable income isn’t immune. Depending on the amount of total income, up to 50% or 85% of Social Security benefits is potentially taxable. If you’re lucky enough to receive a pension, 100% is subject to tax. Fixed income annuity distributions are also taxable if they’re held in retirement accounts, e.g., 401(k) plans and IRAs, or if the source is fixed index annuities. A portion of distributions from single premium immediate annuities, or SPIAs, and deferred income annuities, or DIAs, held in nonretirement accounts is nontaxable as a return of principal.

Disadvantages of Roth IRAs

If optimizing after-tax income was all about tax-free growth and tax-free withdrawals, everyone would do everything possible to maximize Roth IRA account investments. There are four disadvantages, however, of Roth IRAs that need to be considered when using them as a tool to optimize after-tax retirement income. They are:

1. Non-401(k) Roth IRA contributions limited by income

Your ability to make a non-401(k) Roth IRA contribution is limited by the amount of your income. If your income exceeds certain thresholds ($132,000 if single and $194,000 if married), contributions are prohibited.

2. Low contribution limit for non-401(k) Roth IRA contributions

If you’re a participant in a 401(k) plan and your plan allows for Roth IRA contributions, you can contribute up to $18,000 to your Roth 401(k) up to age 49 and up to $24,000 beginning at age 50. With a non-401(k) Roth IRA, however, the contribution limit is $5,500 up to age 49 and $6,500 if 50 or over.

3. No income tax deduction for contributions

Whether you make a non-401(k) or 401(k) Roth IRA contribution, a notable disadvantage is that you will receive no income tax deduction for your contribution. This can work to your advantage to the extent that you’re in a lower income tax bracket when you make contributions compared to when you take distributions from your retirement plans.

4. Taxable income when using Roth IRA conversions

The fourth disadvantage of Roth IRAs comes into play when you transfer funds from a traditional IRA into a Roth IRA, otherwise known as a Roth IRA conversion. Unless the source of funds is nondeductible IRA contributions, 100% of the transfer is taxable.

Don’t be Afraid to Pay Income Tax on Roth IRA Conversions

Many people get hung up on paying income tax at the time of a Roth IRA conversion, saying that they’re prepaying tax they wouldn’t otherwise pay until they’re required to take distributions from their traditional IRAs beginning at age 70-1/2. While this may be justified in certain situations, particularly if there’s a high probability that one’s tax rate will be lower in retirement, many times it’s a knee-jerk, short-sighted reaction.

There are three things that are often overlooked or underestimated when doing a Roth IRA conversion analysis:

1. Tax-free growth of converted funds

Once you convert a traditional IRA to a Roth IRA, all future growth is nontaxable. To the extent that your conversion coincides with a downturn in the stock market, you can increase the amount of tax-free growth that you will experience. Generally speaking, the more time that you have between a Roth IRA conversion and retirement plan distributions, the more beneficial the conversion will be for optimizing after-tax retirement income.

2. Reduction or elimination of required minimum distributions

Required minimum distributions, or RMDs, beginning at age 70-1/2 from traditional IRAs will be reduced or eliminated to the extent that funds are converted from traditional to Roth IRAs. Annual reductions in taxable income can exceed the reduced amount of RMDs due to the interplay and intricacies of tax law. This includes, but isn’t limited to, potential reductions in taxable Social Security benefits and increased allowable itemized deductions from lower levels of adjusted gross income, or AGI. Medicare Part B premiums can be reduced since they’re also determined by AGI.

3. Partial conversions are allowed

Roth IRA conversions aren’t an all-or-nothing proposition. Partial conversions are allowed, encouraging the use of a multi-year strategy for doing conversions in years when income tax liability is lower and/or there’s a stock market downturn.

Roth IRA Strategy Can Extend the Life of Your Portfolio

Roth IRA contributions and conversions can potentially optimize after-tax retirement income, extend the life of a portfolio, and provide a hedge against longevity. The key is to use them strategically, looking for ongoing opportunities to maximize the leverage that they can provide for increasing after-tax retirement income compared to non-Roth IRA investments.

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Roth IRA

Don’t Miss Your Roth IRA Conversion Opportunity

If you have a traditional IRA or a traditional 401(k) plan that can be rolled over into a traditional IRA, you’re sitting on a potential gold mine. You might ask yourself how this is possible given the fact that (a) you generally can’t take withdrawals from a traditional IRA before age 59-1/2 without a 10% penalty, (b) withdrawals are taxable as ordinary income, and (c) you must begin taking minimum distributions each year beginning at age 70-1/2.

Transitional Opportunity Accounts

You should always think of your traditional IRA accounts as transitional opportunity accounts™, or “TOAs” for those of you who prefer acronyms. They have the ability to be upgraded to a much more powerful IRA known as a Roth IRA. Unlike a traditional IRA, Roth IRA withdrawals are tax-free and there are no required minimum distributions, or RMDs, during your lifetime.

But what about the cost associated with making this change otherwise known as a Roth IRA conversion? Isn’t the value of the funds converted from a traditional IRA to a Roth IRA taxable as ordinary income? Isn’t this the same tax treatment that occurs when you eventually take withdrawals from your traditional IRA? Why should you prepay income tax that you might not otherwise pay for several years?

Great questions. Ignoring the opportunity to do a Roth IRA conversion following a stock market decline, there are circumstances that occur from time to time where your taxable income is less than normal. Either your income is lower and/or your itemized deductions are higher due to an aberration in your tax situation. When this occurs, your income tax liability on additional income is less than what it would be otherwise.

Look for Opportunities

Seven situations that are conducive for partial or full Roth IRA conversions, depending upon the specific facts, are as follows:

  1. Pre-age 70-1/2 retiree with low to moderate taxable income
  2. Large amount of long-term capital gains relative to other income
  3. Sale of rental property with large passive loss carry forward
  4. Sizable charitable contribution deduction
  5. Substantial basis in IRA
  6. Surviving spouse in low tax bracket not dependent on IRA with children in high tax bracket
  7. Net operating loss

The presence of each scenario presents an opportunity for analysis to determine if a Roth IRA conversion is appropriate, and, if so, the amount that should be converted from a traditional to a Roth IRA. The key is to be aware of each of them and keep them in mind if you have a traditional IRA or a traditional 401(k) plan that can be rolled into a traditional IRA.

Income Tax Planning is Essential

Unlike the deadline for traditional IRA contributions which is generally April 15th of the year following the year for which a contribution is credited, the Roth IRA conversion deadline is December 31st.  If one of the seven Roth IRA conversion situations applies to you, you need to prepare an income tax projection well before year-end. The earlier in the year you prepare your projection, the better.

Your projection should include a base facts case calculating your federal and state income tax liability without any Roth IRA conversion. Additional cases should be prepared with different conversion amounts to determine the additional amount of income tax liability attributable to a potential conversion scenario. Remember to include cost basis attributable to nondeductible or after-tax contributions in your calculations, taking into consideration the value of all of your traditional IRA accounts.

The ability to spot, and take advantage of, Roth IRA conversion opportunities will be enhanced to the extent that you make it a practice to do income tax planning each year. Be on the lookout for the seven situations in this post and others. If the stock market has declined and your taxable income is lower than normal, it’s your lucky year. Don’t miss your Roth IRA conversion opportunity.

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Roth IRA

Escape the Roth 401(k) Trap

I’m a big fan of 401(k) plans that allow Roth contributions, especially for employees who are in low income tax brackets. You can contribute up to $18,000 of after-tax salary in 2016 to a designated Roth account for 401(k) plans that allow such contributions. The limit is increased to $24,000 if you’re 50 and older. These are the same limits as traditional 401(k) plan contributions.

Although you won’t reduce your taxable salary when you have Roth 401(k) contributions withheld from your paychecks, your Roth 401(k) account and employer matching contributions will grow tax-deferred. In addition, withdrawals will never be taxed provided that they’re taken after age 59-1/2 or in the event of death or disability and the first contribution to the Roth 401(k) account was made at least five years ago.

The Roth 401(k) Trap

There’s one advantage of Roth IRAs that you won’t find with designated Roth 401(k) accounts that needs to be kept in mind.  Roth IRAs are exempt from the required minimum distribution rules that kick in at age 70-1/2 for qualified retirement plans and traditional IRAs. You can let your Roth IRA accounts grow without ever taking any distributions from them during your lifetime. It’s not until you die that your beneficiaries must take required minimum distributions (“RMDs”) over their lifetime.

Unlike Roth IRAs, designated Roth 401(k) accounts aren’t exempt from the RMD rules. RMDs must be taken annually from Roth 401(k) accounts beginning at age 70-1/2 unless you continue to work for the employer who sponsors your 401(k) plan and you’re not a five percent owner. Like all RMDs, they’re calculated using a life expectancy factor from an IRS table and the value of the account as of December 31st of the previous year.

Roth 401(k) RMDs are nontaxable provided that the first contribution to the Roth 401(k) account was made at least five years ago. Like all RMDs, you don’t have to spend them; they just need to be withdrawn from the account in which they’re held.

Avoiding the Trap

If you have a designated Roth 401(k) account and you want to avoid being subject to IRS’ RMD rules, there’s an easy solution:  roll your Roth 401(k) account into a Roth IRA account before January 1st of the year that you turn 70-1/2.

You can roll your Roth 401(k) account into a Roth IRA account if you’ve left your employer or when you meet the in-service withdrawal provisions of your 401(k) plan assuming your plan contains these stipulations. Plans that allow you to take withdrawals while still working for the employer who sponsors the plan specify a minimum age for doing so, e.g., 60.

Not all assets in 401(k) plans may be eligible for in-service withdrawals. Plans typically specify assets by their origin, including after-tax contributions, rollover amounts, company match contributions, and pre-tax contributions. All types of assets that can be used for in-service withdrawals typically include earnings on those assets.

Designated Roth 401(k) accounts are a great option for diversifying retirement assets. Assuming that your goal is to avoid the required minimum distribution rules, subject to other considerations, you should roll your Roth 401(k) plan to a Roth IRA using your plan’s in-service withdrawal provisions, after you leave your employer, and, in any event, no later than December 31st of the year before the year that you will turn 70-1/2.

 

 

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Roth IRA

5 Ways to Reduce Your Tax Liability Using Roth IRA Conversions

One of the most important financial goals for retirees is maximization of after-tax income. There are two ways to accomplish this: (a) maximize pre-tax income and (b) minimize income tax liability. A Roth IRA can go a long way toward helping you achieve the latter.

There are two ways to fund a Roth IRA: (a) annual contributions and (b) conversions. Annual contributions, in and of themselves, generally won’t result in a significant source of retirement income due to the relatively low limitation – currently $5,500 or $6,500 if you’re age 50 or older. In addition, eligibility to make Roth IRA contributions is limited to the extent that your income exceeds defined limits.

Roth IRA conversions, on the other hand, have the ability to generate substantial after-tax income while also reducing income tax liability for up to 20 to 30 years or more of retirement. Since income tax liability on the value of Roth IRA conversions will need to be paid, timing of conversions is key. See the May 10, 2010 post, Be on the Lookout for Roth IRA Conversion Opportunities, for a discussion of this topic.

There are five ways that you can potentially reduce your income tax liability and increase your after-tax income during your retirement years by doing Roth IRA conversions.

1. Never pay income tax on the growth of your Roth IRA

While you’re required to include the value of your IRA, 401(k) or other qualified plan assets that you convert to a Roth IRA in your taxable income in the year of conversion, 100% of the growth of your Roth IRA is excluded from taxation. This is true whether or not you ever take any distributions from your Roth IRA.

Individuals who did Roth IRA conversions in March, 2009 when the Dow dipped below 7,000 didn’t mind paying income tax on those conversions in retrospect given the fact that the Dow is currently hovering over 17,000 less than six years later. The income tax savings on the growth of the equity portion of their converted accounts over this period of time plus future potential growth is significant for those in this situation.

2. Roth IRA accounts aren’t subject to required minimum distribution rules

If you don’t do a Roth IRA conversion, 100% of the value of your traditional IRA, 401(k), and other qualified plan assets, including appreciation, will be subject to IRS’ required minimum distribution, or RMD, rules. These rules require you to take annual minimum distributions from your retirement plan accounts beginning by April 1st of the year following the year that you turn 70-1/2. 100% of distributions reduced by any allowable portion of nondeductible contributions are taxable.

As an example, suppose you were born on January 7, 1940 and you own a traditional IRA account with a value of $500,000 on December 31, 2013, you would be required to take a minimum distribution of $21,008.40 from your account by December 31, 2014 and include it in your 2014 taxable income. If instead you owned a Roth IRA account with the same value, you wouldn’t be required to take any distributions from your account.

3. Potentially reduce net investment income tax

The RMD rules sometimes force people to take distributions from their taxable IRA accounts that they don’t need. Often times, they transfer RMDs from their taxable IRA account to a nonretirement investment account and leave them there. For individuals with high levels of income, this can result in additional taxation as a result of subjecting the earnings on their nonretirement account to the net investment income tax of 3.8%. This isn’t an issue for Roth IRA account holders since the RMD rules don’t apply to them.

4. Roth IRA distributions aren’t included when calculating taxable Social Security benefits

The taxation of Social Security benefits is dependent upon your combined income and tax filing status. Combined income includes adjusted gross income, nontaxable interest, and 50% of Social Security benefits.

Single filers are subject to tax on 50% of their Social Security benefits for combined income between $25,000 and $34,000 and up to 85% of benefits when combined income exceeds $34,000. Married filing joint taxpayers are subject to tax on 50% of their Social Security benefits for combined income between $32,000 and $44,000 and up to 85% of benefits when combined income exceeds $44,000.

Roth IRA distributions aren’t included in adjusted gross income, therefore, they don’t affect taxation of Social Security benefits.

5. More opportunities for income tax bracket planning

For all taxpayers, taxable income is subject to seven different rates of tax ranging from 10% to 39.6% depending upon the amount of taxable income. Given the foregoing four potential ways of reducing taxable income and associated income tax liability, Roth IRA conversions can also reduce the income tax rates that are used to calculate income tax liability on other sources of income. This allows for more opportunities for income tax bracket planning to potentially further reduce income tax liability in one or more years.

Although it’s not income-tax related, one other potential benefit of Roth IRA conversions that shouldn’t be overlooked is their impact on the calculation of Medicare Part B premiums. Monthly Medicare Part B premiums currently range from $104.90 to $335.70 depending upon tax filing status and the amount of modified adjusted gross income from two years ago. Roth IRA distributions aren’t included in the calculation of adjusted gross income. As such, they don’t affect the amount of Medicare Part B premiums paid.

As you can see, assuming (a) you can get over the hurdle of prepaying a portion of your income tax liability when you do Roth IRA conversions and (b) you have sufficient nonretirement funds to pay the tax, this can create several tax reduction opportunities as well as a potential reduction of Medicare Part B premiums throughout your retirement years. These benefits, combined with the ability to eliminate taxation on the growth of Roth IRA accounts, can result in greater and longer-lasting after-tax retirement income compared to not doing any Roth IRA conversions.