Your IRA or 401k is partially yours and partially the property of the IRS. Unfortunately, the IRS doesn’t tell you what they get until you make a withdrawal.
RETIREMENT PLAN REALITY CHECK
IRA Balance Marginal Tax Rates Yours IRS
$1,000,000 30% $700,000 $300,000
Historically, marginal tax rates have been higher than they are today and it is quite possible that they could be higher when you need to pull out your money.
The best thing about a Roth IRA is that distributions are INCOME TAX-FREE
ROTHS MAY BE TERRIFIC FOR WORKERS OR RETIREES
No matter your age or income you should consider taking advantage of a Roth IRA. For those who are eligible to make new contributions, they make a ton of sense to fund year in and year out. For those who either make too much money or are retired, you should be thinking about converting some of your IRA money to a Roth every year.
Why might your tax rate go up in the future?
- The U.S. is seventeen trillion dollars in debt and growing with no end in sight.
- Social Security has under 3 people paying in for each collector (it started in 1940 with 159 workers paying in for each person collecting a benefit)
- Baby boomers are growing old and that means a growing reliance on Medicare and Medicaid. There are about 10,000 people turning 65 every day.
- The government has chosen to subsidize a portion or all of a person’s health care premium if they earn up to 4x the poverty level.
- THE ANSWER TO ALL THESE GROWING PROBLEMS COULD BE TO TAX US AT HIGHER RATES!
Retirees may want to convert some of their IRA money to a Roth IRA. This would mean paying tax on some of your IRA money now and reinvesting/converting it to a Roth IRA. By doing this, the money could continue to grow and never be taxed again. It may be advantageous to pay the tax now rather than later. If you converted, say $10,000 this year, you would have to add that amount to this year’s income for tax purposes and then reinvest the money into a Roth IRA so that money would never be taxed again. Depending on your current income, you may owe tax at a 20% marginal tax rate, where in the future that rate could be higher. This is also true if your children were to inherit the IRA; the distributions they take will be added to their income, which could have a much higher tax rate.
Quick Fact Sheet – Roth IRA Contributions (From Ed Slott)
- You have earned income
- You contribute already taxed funds (after-tax funds) to a Roth IRA
- You receive no tax deduction for your Roth IRA contribution
- You can continue to contribute to a Roth IRA after age 70 ½
- Qualified withdrawals are income-tax free (a withdrawal made after any Roth account has been established for 5 years and the Roth owner is over the age of 59 ½ or qualifies for the first-time homebuyer exception or the distribution is due to the account owner’s death or disability)
- You can also have and contribute to a spousal Roth IRA, based on your income even if your spouse has no income
- Withdrawals of converted amounts may be subject to the 10 percent early distribution penalty if the 5-year exclusion period has not been met (this is a separate 5-year period from the one noted above) and the Roth owner is under age 59 ½ at the time of the withdrawal
- There are no required minimum distributions for Roth IRA owners
- Roth IRA designated beneficiaries can stretch distributions over their lifetimes the same as traditional IRA beneficiaries
The key benefit of the Roth IRA is that distributions are entirely tax-free as long as you follow the rules. Those rules are complex, with different provisions covering your initial contribution versus the earnings from your Roth. Although penalties can apply to withdrawals before age 59 1/2 or within the first five years you have your Roth, you can avoid them in certain circumstances, such as withdrawals for costs related to an IRS-recognized disability, first-time home costs, or higher-education expenses.
Roths offer an attractive feature in that they can let the heirs you name get tax-free treatment for an inherited Roth IRA.
If you’re considering a Roth for the 2014 tax year, the Roth IRA contribution for singles is fully deductible if your income is under $114,000 and reduced when income is between $114,000 and $129,000. For joint filers, the Roth IRA contribution is fully deductible if your income is under $181,000, and reduced when income is in between $181,000 and $191,000.
That means you can contribute up to $5,500 to a Roth IRA in 2013 and 2014, with those 50 or older entitled to an extra $1,000 catch-up contribution.
By now you realize I am very leery of what might happen to tax rates in the future. I love the idea of paying the tax at current rates and creating a tax-free pot of money that I can draw from in the future.
Please feel free to share you comments below and share with your friends and family.
Make sure to consult with your income tax adviser before implementing any tax related strategy.