Under the current tax code the standard deduction and personal exemptions can neutralize some of your taxable income during retirement. So some taxable monies, around $20,000 a year, can be assimilated into your retirement plan.
But Roth IRAs more than likely fit the financial profile of most middle class Americans who are saving for retirement. For this group, deductions lack the economic value.
Positioning “after tax” distributions as your first option before your qualified monies may have significant tax favored results, such as lower capital gains treatment as one example. Again distributions from reverse mortgages, cash value life insurance, Roth IRAs and HSA accounts are not taxed and are not includable in the provisional income test or Social Security benefit taxation.
Deferring your Social Security benefits to age 70 will maximize your Social Security income and delaying qualified plan monies to age 70½ will allow an additional investment or savings cycle that potentially could increase your account just before retirement.
Roth IRAs are not deductible, but they do accumulate tax deferred and at the approved time for distributions are tax-free. Roth IRA income is not includable in the provisional test for Social Security benefit taxation. An individual’s annual contribution to a Roth IRA is $5,500. If you are age 50 or older you can contribute an additional $1,000 under the “catch up” provision. There are phase out income ranges for individuals and married couples that can affect contribution amounts, so ask your tax accountant for your modified adjusted gross income. Keep in mind that Roth IRAs are not subject to required minimum distributions. The five-year rule for Roth IRA distributions covers the first 5 years after your first Roth IRA contribution before you can withdraw the earnings in the account tax-free. On the event of death, the funds inside the Roth IRA may pass tax-free to beneficiaries if the five-year holding period is met. Roth IRAs can be a powerful component of your tax diversification strategy. Most Roth IRAs are funded with mutual funds and ETFs.
Converting your qualified plan monies to Roth IRAs is a tempting proposition; especially if you think tax rates will be higher in retirement. But the conversion of your 401(k) and IRAs needs to be performed under the scrutiny of your tax consultant to minimize the tax bill generated from this transaction. There is nothing free in life. There is always a price tag with every transaction. Once you reduce the cost of converting from a taxable retirement plan to a tax free Roth IRA, you need to determine how to pay the tax bill.
You could pay the tax out of the conversion proceeds. That’s taking a direct hit on your retirement today, but confirming that you’ll be able to recapture the taxes paid during retirement. And not just a marginal recapture of taxes paid, but one that includes the time value of money.
If you’re age 62 or older and have equity in your home, you could apply for a Home Equity Conversion Mortgage (HECM) appreciating line of credit. Unlike the traditional HELOC lines of credit, seniors can use monies from the HECM appreciating line of credit to fund anything without repayment. There are rules here in addition to being at least age 65. The house utilizing the HECM appreciating line of credit must be your prime residence and most advisers recommend staying in the home for life. If you sold your home the equity loans would be deducted from the sale of the house.
Another option germane to Baby Boomers is starting a home business or small business in the community. The start up costs of a new business with the purpose of generating a profit could offset the tax bill from the conversion of your traditional retirement plan to a Roth IRA. Charitable giving could also lower your adjusted gross income (modified adjusted gross income). So whether you are starting a business as an entrepreneur or considering being benevolent as a philanthropist, there may be deductions that could soften the tax blow of the Roth IRA conversion.