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Be tax efficient in retirement

By Randy Neumann

A great vehicle to save for your retirement is using qualified retirement plans. You get an income tax deduction when you make the contribution. You get tax deferral on earnings in the account until you make withdrawals, but when you take money out of a retirement plan, you pay tax on every nickel (unless it’s a Roth IRA). However, as Meatloaf lamented, “Two out of three ain’t bad.”

Okay, everything that comes out of a retirement plan is taxable. What’s so bad about that? Nothing, if you are in a low tax bracket. But what are the chances of that? Not good, if you hear what is coming out of Washington.

Out of one side of their mouths, they talk of tax reform, lower rates and payroll tax cuts, which will further weaken an ailing Social Security. Out of the other side of their mouths, they talk of higher rates, fewer deductions, redistributing the wealth, wa wa wa wa wa.

Bottom line is that taxes will most likely go up because of money hungry local, state and federal governments. What can you do about that? Start planning. Here are a few ideas.

One possibility is to convert your Traditional IRA to a Roth IRA. This is not often a favored technique because you have to pay the tax now on the promise of no taxes in the future. However, in some cases, it works. But first, what is a Roth IRA?

It is a retirement plan named for the man who proposed it to Congress, Senator William Roth from Delaware. Basically, it works in the opposite way of a Traditional IRA: while you do not get an income tax deduction on contributions, you do not pay tax on withdrawals. There are also limits on contributions to these plans based on income. Simply stated, if you make too much money, you can’t make a contribution. Currently the limit is $125,000, if you’re single and $183,000 if you’re married.

A few years ago, the tax code was amended to allow for anyone to convert a Traditional IRA to a Roth, so let’s see how it works.

If you are in your 50s, generally your prime earning years, and you are gainfully employed, converting to a Roth would be futile. Here’s why. Assuming you are a married couple earning $212,000 annually (or single earning $84,000), you are in the 28 percent bracket. If you were to convert to a Roth, you would withdraw X amount of dollars from your Traditional IRA. This would put you into the next tax bracket(s) which could be 33 or 35 percent. You would pay the higher rate on the transaction and you would be left with 65 or 67 percent of the money you started with. This is why very few people convert Traditional IRAs to Roths.

However, there are situations in which the conversions can make sense. If a high income taxpayer is laid off for the better part of a year, they may find themselves in a lower tax bracket. In this situation, a Roth conversion might make sense.

Other examples would include a taxpayer who sells rental property at a loss, or claims major deductions and exemptions associated with charitable contributions, casualty losses or medical costs. But there is one situation that is more common and less stressful than any of the above.

I have seen many clients over the years retire prior to age 62. When presenting their financial plan, it is demonstrated that they are too young to collect Social Security, and without income, there is no tax. I had one client who lived in New Jersey and worked in New York, so the lack of paying three income taxes caused him to do handsprings around the conference room.

I cautioned him that despite the good news, there was bad news: he would lose several tax write-offs like his mortgage interest, property taxes, etc. These write-offs cannot be carried forward. They can only be used in the year that they occur, but there is a fix for that as well. How does one create income to offset tax write offs in retirement? That’s easy, take money out of qualified retirement plans.

Actually, we run cash flows to see how much money can be taken out of a retirement plan and still remain in a low tax bracket. If you’re single, you can take $34,500 in income and still be in the 15 percent bracket. If you’re married, the number is $69,000.

So, if you want to transfer funds from a Traditional IRA to a Roth IRA, you can put the $34,500 or $69,000 into the Roth and use other non-qualified income for your living expenses.

Where there’s a will, there’s a way.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual. Randy Neumann CFP (R) is a registered representative with securities and insurance offered through LPL Financial Member FINRA/ SIPC. He can be reached at 600 East Crescent Ave., Upper Saddle River 201-291-9000.

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