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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.

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Income Tax Planning Social Security

Increase Your After-Tax Social Security Benefits – Part 3 of 4

Retirement Income Center

Since it’s Super Bowl Sunday as I write this post, let’s discuss strategy as it pertains to winning the Social Security benefit game. If you want to be successful at increasing your after-tax Social Security benefits, you need to have a winning strategy. Hopefully you read Part 1 of this post and if you’re not yet receiving benefits, you’ve begun to implement your pre-benefit receipt game plan.

Once you’ve begun receiving your retirement benefits, there are two halves to winning the game when it comes to increasing after-tax benefits: (1) reduce taxable benefits, and (2) reduce the tax attributable to your benefits. If you’ve read Parts 1 and 2 and/or the previous two-part Say Goodbye to Up to 30% of Your Social Security Benefits series, you know that reduction of taxable benefits is all about minimizing the three components of “combined income,” i.e., (1) 50% of Social Security benefits, (2) adjusted gross income, and (3) tax-exempt income. Components #1 and #3 were addressed in Part 2.

Let’s turn our attention to component #2 – adjusted gross income, or “AGI.” As defined in Retirement Income Visions‘ Glossary, “adjusted gross income” is equal to gross income from taxable sources less deductions from gross income that are allowable even if you don’t itemize deductions. To the extent that you’re able to (a) reduce your gross income from taxable sources and/or (b) increase your deductions from gross income, you will reduce the amount of your adjusted gross income and, in turn, reduce your “combined income.”

Reduce Gross Income From Taxable Sources

Even though you can reduce your taxable Social Security benefits by reducing your gross income, why would you want to do this? After all, don’t you want to maximize your salary, self-employment income, pension income, rental income, partnership income, interest and dividend income, capital gains, etc.? Absolutely — with a caveat. Your goal should always be to maximize cash flow while minimizing taxable income. For those of you who receive annual Schedule K-1’s from entities in which you are a partner, shareholder, or limited liability company member, you know that quite often there’s a difference between what shows up on your K-1 as taxable income vs. the cash distributions you receive.

How do you reduce your gross income when you’re receiving Social Security benefits without negatively impacting your cash flow? Here are six ways to do this:

  • For taxable investments, i.e., nonretirement accounts, invest in immediate and/or deferred income annuities since a portion (sometimes substantial) of the distributions will be nontaxable.
  • Sell assets with unrealized losses to offset capital gains recognized earlier in the year.
  • Minimize distributions in excess of required minimum distributions (“RMD’s”) from self-managed non-Roth IRA retirement plans.
  • Minimize taxable Roth IRA conversions.
  • If you have net rental income from your rental property(ies), transfer mortgage balances from your home to one or more of your rental properties to increase your rental property interest deduction up to the amount of your net rental income. Even though your overall mortgage interest deduction may be unchanged, you may be able to reduce your taxable Social Security benefits.
  • Look for opportunities to sell properties that have passive activity loss carry forwards in order to recognize the losses.

Increase Deductions From Gross Income

When we think of tax deductions, what comes to mind most often are “itemized deductions,” including mortgage interest, real estate taxes, charitable contributions, etc. While these types of deductions reduce taxable income, they don’t reduce adjusted gross income. Although the opportunities in this area are limited, and assuming you’re not paying alimony, here’s three possibilities:

  • If you’re less than 70-1/2, maximize your IRA deduction.
  • If you’re self-employed, maximize your self-employed pension plan, i.e., SEP-IRA deduction.
  • If you’re not eligible for Medicare, establish and maximize contributions to a health savings account (“HSA”).

By the time you read this post, Super Bowl Sunday will be a memory. If you’re receiving Social Security benefits, your game and associated battle to reduce the taxation of your benefits is ongoing. Do you have a winning strategy in place to maximize your after-tax Social Security benefits?

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Income Tax Planning Social Security

Increase Your After-Tax Social Security Benefits – Part 2 of 4

Retirement Income Center

Given the fact that Social Security benefits are taxable when you exceed certain income thresholds, your financial professional(s) should design a Social Security plan for you that includes strategies for minimizing Social Security taxation and maximizing your after-tax Social Security benefits.

As pointed out in Part 1 of this post, there are two types of planning opportunities: (1) Pre-benefit receipt and (2) Ongoing benefit receipt. Part 1 discussed various pre-benefit receipt strategies, including mentioning the importance of analyzing and potentially implementing them beginning in one’s 40’s. Once you flip the Social Security switch and start receiving your benefits, while you generally won’t be able to control the amount or timing of your benefits, there are nonetheless opportunities available to reduce the amount of taxable benefits as well as the amount of tax attributable to your benefits that you ultimately pay. Strategies for reducing taxable benefits will be discussed in this post and Part 3. Part 4 will address reduction of income tax attributable to benefits.

Due to the fact that the thresholds are relatively low, reduction of taxable Social Security benefits can be challenging, to say the least. As shown in Exhibit 1 of the January 17, 2011 post, Say Goodbye to Up to 30% of Your Social Security Benefits – Part 2 of 2, assuming that your filing status is single, once your “combined income” exceeds approximately $49,000, 85% of your Social Security benefits will be taxable.

As discussed in the last three posts, there are three components of “combined income:” (1) 50% of Social Security benefits, (2) adjusted gross income, and (3) tax-exempt income. Components #1 and #3 will be addressed in this post, with adjusted gross income reserved for Part 3.

50% of Social Security Benefits

Unless the benefit start date has been deferred (see the five-part Do Your Homework Before Flipping the Social Security Switch series beginning on October 11, 2010 and the November 15, 2010 post, Wait Until 70 to Collect Social Security?) or the “file and suspend” strategy (see the December 13 and 20, 2010 posts, Breadwinner Approaching Social Security Retirement Age? – File and Suspend – Parts 1 and 2) has been employed in the case of a married couple to suspend the receipt of the breadwinner’s Social Security benefits, component #1, 50% of Social Security benefits, cannot be controlled once payment of benefits begins. Whatever amount of Social Security retirement benefits you and your spouse, if married, receive, 50% of the gross amount will be included in the calculation of “combined income.”

Tax-Exempt Income

Component #3, tax-exempt income, was discussed in Part 1 of this post. Since the calculation of taxable Social Security benefits is unfavorably impacted by tax-exempt income, while it may be beneficial to you for other reasons, inclusion of tax-exempt investments as part of your investment portfolio won’t be of much use to you when it comes to minimizing taxable Social Security benefits. While this factor generally isn’t considered by most investment professionals when designing an investment portfolio, it should be.

The third component of “combined income,” adjusted gross income, provides for the most opportunities for reducing “combined income” and, in turn, the greatest potential for reducing taxable Social Security benefits. Part 3 is devoted to a discussion of strategies for reducing adjusted gross income.

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Annuities Income Tax Planning Retirement Income Planning Roth IRA Social Security

Increase Your After-Tax Social Security Benefits – Part 1 of 4

Retirement Income Center

The last two posts, Say Goodbye to Up to 30% of Your Social Security Benefits – Parts 1 and 2 discussed taxation of Social Security benefits. As explained in both posts, up to 50% or 85% of Social Security benefits can be taxable depending upon the amount of one’s “combined income” (50% of Social Security benefits plus adjusted gross income increased by tax-exempt income) compared to specified thresholds that are dependent upon one’s tax filing status (i.e., single, head of household, married filing separate, or married filing joint) and one’s tax rates.

Although, as pointed out in last week’s post, taxation of Social Security benefits has been a thorn in Congress’ side ever since it came into being in 1984, it appears that it’s here to stay. Income taxation of Social Security benefits can be reduced or, in some cases, eliminated, in one or more years with proper planning. While much of the planning is ongoing throughout the years that one is collecting benefits, there are several opportunities that should be analyzed and potentially implemented beginning in one’s 40’s, many years before the receipt of one’s first Social Security check. This post focuses on pre-benefit receipt planning and Parts 2, 3, and 4 address planning strategies during the Social Security benefit receipt years.

Before discussing strategies that can be implemented to reduce taxation of Social Security benefits, let me make clear one strategy that generally isn’t effective. Although it hasn’t been given as much attention the last several years in our low-interest rate environment, income tax and investment planning strategies often include an analysis of after-tax return returns from taxable vs. tax-exempt investments. As mentioned in the previous two posts as well as the beginning of this one, “combined income,” which is the starting point for calculating taxable Social Security benefits, is increased by tax-exempt income. As a result, assuming that your goal is to reduce taxable Social Security benefits, other than the fact that the amount of income from a tax-exempt investment is generally less than the income from a similar taxable investment, inclusion of tax-exempt investments as part of your investment portfolio won’t be of much benefit to you.

Perhaps one of the greatest opportunities for reducing taxable Social Security benefits and ongoing associated taxation of same that can be implemented beginning 20 or more years before the receipt of one’s first Social Security check is a Roth IRA conversion or series of conversions over several years. This strategy was featured in the March 15, 2010 post, Want to Reduce Taxable Social Security Benefits? Consider a Roth IRA Conversion as part of Retirement Income Visions™ extensive Roth IRA conversion series.

As discussed in that post, to the extent that a Roth IRA conversion reduces the amount remaining in your traditional IRA, your required minimum distributions (“RMD’s”) that you must take from your traditional IRA’s beginning when you turn 70-1/2 will be reduced. Reduced RMD’s result in less “combined income” which can reduce the amount of taxable Social Security benefits and can also reduce the marginal tax rate that is applied to the taxable portion of your benefits, resulting in less taxes. It’s important to keep in mind that this strategy, in order to be effective, needs to be implemented before receipt of Social Security benefits. To the extent that it is executed while one is receiving benefits, it will generally increase taxable income and taxation of benefits.

Another strategy than can be implemented well before receipt of Social Security is investment in one or more non-qualified (i.e., not within an IRA or other retirement plan) deferred income annuities, or “DIAs”. For an introduction to this powerful retirement income planning investment strategy, please refer to the November 23, 2009 post, Deferred Income Annuities: The Sizzle in a Retirement Income Plan. When structured as a nonqualified annuity, there are two potential ways that DIAs can be used to reduce taxation of Social Security benefits. First, the payout start and end dates from one or more DIAs can be selected to plan for the amount of income that will be paid out to reduce taxation of Social Security benefits. Secondly, a portion, sometimes very sizeable, of DIA payouts from nonqualified investments are tax-favored since they aren’t subject to income taxation by virtue of an “exclusion ratio.” Furthermore, unlike tax-exempt investment income, the portion that is excluded isn’t added back to “combined income” when calculating taxable Social Security benefits.

Permanent life insurance is another strategy that can be implemented many years before receipt of Social Security retirement benefits to reduce taxation of those benefits. To the extent that there is build-up of cash value within whole life, universal life, or variable universal life insurance policies, this cash value, when not subject to modified endowment contract, or “MEC,” taxation rules, can be distributed either through loans and/or withdrawals during one’s retirement years, often with little or no associated income taxation. To the extent that this is achieved, this will favorably affect taxation of Social Security benefits.

When you get into your later 50’s and get closer to the earliest potential start date for receipt of your Social Security benefits, i.e., age 62, a key Social Security tax-reduction strategy that has been discussed extensively in several of the Social Security posts beginning with the October 4, 2010 post, Plan for the Frays in Your Social Security Blanket – Part 2 of 2, is the choice of benefit start date for you and your spouse if married. While a delay in start date can result in increased total benefits received during one’s lifetime, it will also result in delay of taxation of benefits as well as potential increased after-tax benefits once commencement of benefits occurs.

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Income Tax Planning Social Security

Say Goodbye to Up to 30% of Your Social Security Benefits – Part 2 of 2

Retirement Income Center

Taxation of Social Security benefits has been a thorn in Congress’ side ever since it came into being in 1984. As aptly stated by one of Retirement Income Visions’™ readers after reading Part 1, it’s a tax on a tax. After having one’s earnings, up to a maximum limit, reduced by a payroll tax of 6.2% for all of one’s working life, it’s difficult for Social Security recipients to stomach the fact that their benefits may be reduced by yet another tax — income tax.

Per last week’s post, since 1984, up to 50% of Social Security benefits became subject to income tax, with this percentage increasing to 85% beginning in 1994. Although the “combined income” (50% of Social Security benefits plus adjusted gross income increased by tax-exempt income) thresholds are relatively low for having up to 85% of one’s benefits subject to tax (i.e., greater than $34,000 if you use single, head of household, or married filing separate filing status and over $44,000 for married filing joint status), and, furthermore, haven’t ever been increased for inflation, you will never forfeit 85% of your benefits.

As explained last week, the maximum percentage of your Social Security benefits that you will lose to federal income tax is 29.75%. Furthermore, this will only occur if your “combined income” is several hundred thousand dollars. Even if up to 85% of your Social Security benefits are subject to taxation, it’s possible that you may only lose 5% of your benefits to income tax if your combined income is low.

To demonstrate this and to help you better understand the taxation of Social Security benefits, I have prepared Exhibit 1. This exhibit includes nine different scenarios for nine hypothetical people who receive Social Security income of $20,000, other income ranging from $15,000 to $270,000 depending upon the scenario, uses single filing status, and claims one exemption and the standard deduction.

“Combined income” is calculated in each scenario, which is equal to 50% of Social Security benefits, or $10,000 (50% x $20,000), plus adjusted gross income increased by tax-exempt income. Since single filing status is being used, the maximum taxable Social Security benefits percentage will be as follows:

Combined Income

Maximum Taxable Percentage
Less Than $25,000

0%
$25,000 – $34,000

50%
$34,001+

85%

It’s important to note that the maximum taxable percentages per the above table are exactly that – maximum percentages. As examples of this:

  1. Even though the maximum taxable Social Security benefits percentage is 50% in scenario #2, only $3,000, or 15% ($3,000 divided by $20,000), is taxable.
  2. Even though combined income exceeds $34,000 beginning with Scenario #3, it isn’t until Scenario #5 when combined income is equal to $48,706, that 85% of Social Security benefits of $20,000, or $17,000, is taxable.

After calculating the amount of combined income and taxable Social Security benefits, each scenario shows the amount of federal income tax including and excluding the taxable Social Security benefits. The difference between these two amounts is the tax that is attributable to the taxable Social Security benefits. The amount of tax that is attributable to the taxable Social Security benefits is then subtracted from the Social Security benefits of $20,000 to arrive at “Social Security Benefits Net of Federal Income Tax,” or net Social Security benefits. This is the amount of Social Security that the hypothetical person in each scenario gets to keep after paying the income tax that is attributable to the taxable portion of his/her benefits.

As a final step, the “Social Security Benefits Net of Federal Income Tax” is divided by the Social Security benefits of $20,000 in each scenario to determine the percentage of Social Security benefits that is retained after paying the tax that is attributable to the taxable portion of benefits. Based on the maximum taxable Social Security benefits percentage, the percentage of benefits retained is greater than what one might envision before running the calculations. As examples of this:

  1. 97.8% of benefits are retained in scenario #2 even though the maximum taxable Social Security benefits percentage is 50%.
  2. 94.7% and 90.3% of benefits is retained in scenario #3 and #4, respectively, even though the maximum taxable Social Security benefits percentage is 85%.
  3. Approximately 75% to 80% of benefits are retained in scenarios #5 through #8 even though the maximum taxable Social Security benefits percentage is 85%.

It isn’t until we get to scenario #9 where we get close to the maximum percentage of Social Security benefits that you can lose to income tax, i.e., 29.75%. It is in this scenario with combined income of $280,000 that 28% of Social Security benefits are lost to federal income tax and 72% is retained.

While it seems unfair to most Social Security recipients that their retirement benefits are subject to taxation, hopefully it’s somewhat comforting to know that the percentage of benefits lost to income taxation in most cases isn’t as high as one might have thought before reading this post.

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Income Tax Planning Social Security

Say Goodbye to Up to 30% of Your Social Security Benefits – Part 1 of 2

Retirement Income Center

Retirement Income Visions™ began a series of posts on the topic of Social Security on September 27th, focusing on various little-known strategies for maximizing Social Security benefits. In addition to the strategies not receiving a lot of publicity, when they are discussed, income taxation is often overlooked. Given the fact that a large portion of Social Security benefits can be subject to income tax, maximization of after-tax Social Security benefits should be your goal with each strategy.

Prior to 1984, Social Security benefits were nontaxable. Beginning in 1984, up to 50% of Social Security benefits became subject to taxation. The percentage was increased from 50% to up to 85% beginning in 1994. Since 1994, up to 85% of Social Security benefits are taxable, depending upon the total of two individual calculations: (1) 50% of Social Security benefits plus (2) adjusted gross income increased by tax-exempt income. While tax-exempt income generally isn’t taxable, it comes into play when calculating the taxable amount of one’s Social Security benefits. Whenever the total of these two amounts, otherwise referred to as “combined income,” exceeds a specified threshold, a portion of Social Security benefits is taxable.

The amount of the threshold is dependent upon your tax filing status. If your status is single, head of household, or married filing separate, the threshold is $25,000. If, on the other hand, your status is married filing joint, then your threshold is $32,000. The greater the excess of “combined income” over the specified threshold, the greater the amount of taxable Social Security benefits.

The $25,000 and $32,000 thresholds are the floor amounts for calculating taxable Social Security benefits. Up to 50% of Social Security benefits are taxable if your combined income is between $25,000 and $34,000 if you use single, head of household, or married filing separate filing status. The combined income level for married filing joint status for taxation of up to 50% of Social Security benefits is between $32,000 and $44,000. Once the upper limits of these respective thresholds are exceeded, up to 85% of Social Security benefits are taxable.

So, if up to 85% of Social Security benefits are taxable, why is the title of this post, Say Goodbye to Up to 30% of Your Social Security Benefits? As with taxation of all income, the amount of income tax that you pay is dependent upon the amount of your taxable income. Taxable income is calculated by subtracting itemized deductions or the standard deduction and personal exemptions from adjusted gross income. Once you determine your taxable income, income tax rates are applied to specified ranges of taxable income that are dependent upon your tax filing status. Federal income tax rates currently range from a low of 15% to a high of 35%.

Assuming that your situation is such that 85% of your Social Security benefits are taxable and assuming that you’re in the top tax bracket of 35%, then you will lose 29.75% (85% x 35%), or approximately 30%, of your Social Security benefits to federal income tax. Conversely, you will retain 70.25% (100% – 29.75%), or approximately 70%, of your benefits after paying the income tax attributable to them.

In an effort to help you better understand taxation of Social Security benefits, next week’s post will include calculations of taxable Social Security benefits, federal income tax attributable to taxable benefits, and Social Security benefits net of federal income tax for various income levels. All of you analyticals will love this one!