By William Garrett
Ever noticed when you put the words "the" and "IRS" together they spell "theirs?"
Throughout their career, people are told how important it is to contribute to their employer retirement plan and/or an IRA. After all, we advise, look at the advantages: Tax deductible or pre-tax contributions and years of compounded earnings, growing tax-deferred, that can be taken in retirement when their tax bracket may be lower.
However, there's something many people don't consider until they approach age 70 ½: they have a silent partner whose initials are IRS. At the age of 70½, that partner requires them to begin taking required minimum distributions (RMDs) from their retirement account. If the government needs more revenue it can always increase the RMD levels.
RMDs may be enough to put people in a higher tax bracket. Also, Social Security benefits may be subject to taxation at a higher rate due to the increased retirement income from the RMD. If a married couple has provisional income between $32,000 and $44,000, up to 50% of their Social Security can be taxed and over $44,000 up to 85% can be taxed. For single people, the thresholds are $25,000 and $32,000 respectively.
Provisional income is the combination of adjusted gross income plus half the Social Security income and any interest from municipal bonds. The last two types of income, which are normally not subject to income tax, are brought back in for taxation.
The good news is there are some ways to generate tax-free income when receiving Social Security benefits that will be exempt from the provisional income calculation.
See Benefits Planner: Income Taxes And Your Social Security Benefits for more information.
To avoid this dilemma, people can consider converting their IRA to a Roth IRA. Roth IRAs are after-tax contributions that grow tax-deferred, but which don't have RMDs like a traditional IRA.
There are annual contribution limits ($5,500 or $6,500 for those age 50 and older) and income limits. The income limits for Roth contributions are $133,000 for single people and $196,000 for married filing jointly in 2017.
People working with their financial professionals can do some planning to avoid RMDs and, hopefully, higher income taxes. Those who are excluded from making contributions can get IRA money into a Roth no matter how much they earn or how old they are using an alternative method.
It is possible to convert all or part of an IRA to a Roth IRA in two ways: rollover or direct transfer.
People can take a rollover. This is a distribution from the IRA to a Roth IRA. One has 60 days to deposit the distribution into a Roth IRA to avoid taxation. One problem with rollovers is that "stuff happens" and people may end up spending the money and not rolling it over. It is possible with a rollover that the distribution will be taxable as ordinary income and possibly subject to pre-mature penalty if under age 59½. Unless there are other resources to pay the taxes on the distribution, part of the IRA will go to taxes. Also, if the rollover deadline is missed, also lost is the ability to continue tax-deferred growth. Only one rollover can be made in any 12-month period.
Perhaps a better method is by direct custodian-to-custodian transfer. Direct transfers avoid the pre-59½ early distribution penalty. Folks going this route will still incur ordinary income taxation as it is still considered a distribution of the IRA. The most tax efficient way to convert to a Roth, whether direct transfer or rollover is to pay the tax from non-IRA funds. People need to be sure and tell the custodians they are converting to a Roth IRA, so it's reported correctly, and keep an eye on how the account is set up to assure it's transferred to a Roth. Also, tax preparers need to know this was a conversion and not just an IRA to IRA transfer.
If the employer offers a Roth 401(k), people can do a transfer from their 401(k). Some employers allow in-service distributions which could be converted to a Roth IRA. This may be a better way to go if available. One reason to do this is that Roth 401(k)s are subject to RMD rules.
What is the difference between a Roth 401(k) and Roth IRA? Let's look:
- One of the biggest advantages of a Roth 401(k) is that it is covered by the Federal Creditor Protection Act. This makes it a great option for professionals who are at elevated risk of litigation
- Unlike a Roth IRA you can borrow from the account
- You can also purchase life insurance in the account
- Roth 401(k)s are subject to RMDs like a traditional IRA
Roth IRA Characteristics
- Not subject to RMD unless inherited by non-spouse
- If people convert from a traditional IRA, they can switch back to the traditional IRA up to Oct. 15 of the year following the conversion. This is called re-characterization.
- Withdrawals from the Roth are treated as after-tax contributions first, then earnings. The tax-deferred earnings can be withdrawn without taxation after the Roth has been established for 5 years. After-tax contributions can be taken anytime.
- It is likely there will be more investment options with a self-directed Roth than with a Roth 401(k). Finally, the funds are always available in a self-directed Roth IRA.
- Not covered by Federal Creditor Protection Act
- Cannot purchase life insurance inside a Roth
Planning is key in making the decision to convert an IRA to a Roth. An appropriate time to do a conversion is during retirement when income may be lower and early enough to convert the IRA money to a Roth before age 70½.
Make some projections of future income and taxation, factoring in RMDs and Social Security. If conversion looks good, consider it in stages so that all the IRA money has been moved by age 70½.
About the author: William B. Garrett, CFP®, is president of Garrett Wealth Management and a member of Ed Slott's Elite IRA Advisor Group. For more information about this group, or to find a member near you, visit IRAhelp.com.
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