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Retirement
When saving money for retirement, taxes are not your friend. Their impact, even for those in lower tax brackets, can significantly reduce one’s retirement income.
One of the better vehicles Congress created to help people save money that can grow tax-free is the Roth IRA. Unlike a traditional IRA, there is no current tax deduction for funds contributed to a Roth, but the funds are not taxed when they are withdrawn.
How do you know when to use a traditional IRA and when to use a Roth? The primary strategy is to pay the tax rate when it is the lowest. For example, if your income tax bracket is higher today than it will be when you need to withdraw earnings in retirement, you want to use a traditional IRA. That results in you avoiding paying any taxes at your high rate today and paying the lower tax rate when you withdraw the funds.
Conversely, if you are in a low tax bracket today and will be in a higher tax bracket when you withdraw the funds, the clear choice is to contribute to a Roth account and pay the lower taxes today because there will be no taxes due at all when you withdraw the money.
You may wonder how this scenario could happen. Doesn’t everyone slip into a lower tax bracket when they no longer have earned income from a job? Not necessarily.
Income in retirement could go up for many reasons: income from multiple pensions, marrying someone in a higher income bracket, receiving an inheritance, or selling appreciated investments. Another scenario is when a job change or cutting back work hours reduces someone’s earnings in pre-retirement years to less than their retirement income will be.
Another possibility is that Congress raises taxes in the future on the lower and middle class. For example, the tax bracket on the middle and lower class could rise significantly if the popular thinking of the US expanding our social net to something like the Scandinavian model becomes a reality. In most of those countries the lowest tax bracket is 40%, which is considerably higher than what people pay in our lowest bracket. Getting as much wealth as possible today out of the reach of the taxman could be even more important.
A trickier question is what to do if you don’t expect to see your tax bracket change. In this case it depends on when you expect to start withdrawing a regular retirement income from your IRA. This scenario favors a Roth if you are very young or if you can reasonably predict you won’t need income from the Roth and can pass on the tax-free withdrawals to your heirs.
The withdrawal requirements on IRAs also can tilt the decision toward a Roth. Unlike traditional IRAs, Roths have no requirement to make annual distributions when you reach age 70 ½. The one requirement you must meet before withdrawing tax-free from a Roth is that it have been opened for more than five years. A good strategy to consider, according to Michael Kitces, editor of the Kitces Report, is to open a Roth early with a minimal amount like $100, even if you don’t intend to make immediate contributions. This starts the time clock ticking to meet the five-year rule. Kitces notes that the five-year rule only needs to be satisfied once per taxpayer to cover multiple Roth IRAs. He also recommends investing Roth assets in whatever has the highest expected return over time and is the least tax efficient.
Rick Kahler MSFS CFP®
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More Roth,
Last week above, I covered strategies for when to use Roth IRAs. An additional aspect of Roths is the benefit of being able to do a conversion from a traditional IRA to a Roth. It is best to consider doing a Roth conversion when your current tax bracket declines temporarily below the bracket you expect to be in when you will need to make withdrawals.
Examples of two ways you might suddenly find yourself in a lower tax bracket are losing a job or having a bad year in a business you own. The strategy is to estimate how much additional income would bring you to the top of the lower income tax bracket, then convert that amount from a traditional IRA into a Roth IRA. You will pay tax on the amount converted just as if you had made a withdrawal from the IRA, without the early withdrawal (before age 59 ½) penalty of 10%. To make this strategy worthwhile, it is very important that the dollars used to pay the income tax on the converted amount come from a source other than the IRA.
One of the challenges of negotiating a Roth conversion is knowing what your income will be for the year. This is something a person often doesn’t know until late in December, which is often too late for most custodians to start the mechanics of a conversion. There is an easy fix for this, according to Michael Kitces, editor of the Kitces report. Deliberately convert more than enough to fill the income gap to the next bracket. Then, when you or your accountant finishes your tax return, simply send any excess amount converted back to your IRA. This is known as a Roth recharacterization.
There are a few things you need to do in order to make a recharacterization work. You need to put the conversion amount into a separate Roth IRA, not commingle the funds with an existing Roth IRA. You also need to send the funds back to your traditional IRA by October 15 of the following year.
Another strategy related to a recharacterization is being able to “undo” the conversion when the investments in the recharacterized account significantly decline in value prior to the Oct 15 deadline. For example, consider a scenario where you converted $30,000 to a Roth and by September of the following year the value of those investments fell to $15,000. You might feel pretty sad to pay tax on $30,000 that is now only worth $15,000. If in this case you were in the 15% bracket, your tax would be $4,500, which is really a 30% tax on the current balance. In this case you would want to undo the conversion by returning the $15,000 in the separate Roth conversion account back to the IRA from whence it came.
If the opposite happens and your $30,000 grows to $60,000 by September, happy days are here! You will still only pay tax of $4,500 on the conversion amount of $30,000, meaning the growth completely escaped taxation.
To build on this strategy, Kitces suggest converting several multiples of the desired conversion amount, each into its own account with each account invested differently. Whichever account and investment performs the best by around September can be the one you keep, with the remaining accounts recharacterized in time to meet the October 15 deadline.
Some of these more complex strategies may not apply to many of you—and they may not be scintillating reading, either. Yet applying the information to your financial planning may provide exciting results 20 or 30 years from now.
Rick Kahler MSFS CFP®
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The Power of Compound Interest and Investing
Just invest a grand each year for your newborn child.
Now, assume an 8 percent average annual return over the next seven decades. This compares with the roughly 11 percent median return for the Standard & Poor’s 500 index over 19 separate 70-year stretches between 1928 and 2016.
Rest assured; he or she will be just fine at retirement.
Jada
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