Please note the information below is intended to provide generalized information that is appropriate in certain situations. It is not intended or written to be used, and it cannot be used by the receipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer. The contents of the information provided below should not be acted upon without specific professional guidance. Please call us if you have any questions.
IRAs mainly come in two broad categories: traditional and Roth.
Traditional IRAs may be funded with pre-tax or after-tax dollars and are often funded largely with pre-tax dollars. Withdrawals of pre-tax money and earnings from the IRA are taxed at ordinary income rates. Once the IRA owner reaches age 70½, required minimum distributions (RMDs) from the account begin and last as long as there is money in the account. Any shortfall in a taxpayer’s RMDs for a year is subject to a 50% penalty.
Roth IRAs are always funded with after-tax dollars. Account owners never have RMDs. Once a Roth IRA has been in place for five years and the account owner reaches age 59½, distributions are tax-free.
Astute combining of these two IRA varieties can result in a substantial stream of cash flow, moderately taxed, for you or your beneficiaries, or both.
Conversion calculation
IRA contributions are now capped at $5,500 per year ($6,500 for those 50 or older). In addition, many people roll over large amounts into IRAs from a 401(k) account when they leave a job.
Example 1: Sue Baker leaves her long-time employer at age 55 to start a consulting business. While employed, Sue accumulated $400,000 in her 401(k) account, all pre-tax. She rolls the entire amount into a traditional IRA, maintaining the tax deferral.
At this point, Sue does not expect to heavily depend on her IRA for retirement spending. However, Sue realizes that she eventually will face RMDs. After more than 15 years of tax-deferred buildup, the RMDs could be substantial, generating sizable tax bills for withdrawals that Sue might not need.
Sue naturally would prefer to have her money in an RMD-free, potentially tax-free, Roth IRA. However, a complete Roth IRA conversion of her $400,000 traditional IRA would add $400,000 to her taxable income this year and trigger a six-figure tax obligation. Considering that her RMDs might last for many years, Sue would be vulnerable for future tax rate increases. Therefore, Sue decides to execute a partial Roth IRA conversion. The next step is determining the amount to convert.
Partial projection
One way to approach a partial Roth IRA conversion is to estimate an amount that will keep taxable income in the current tax bracket.
Example 2: Sue, who is unmarried, reported taxable income of about $75,000 in 2016. She expects her 2017 income to be about the same. This year, the 25% tax bracket for single taxpayers goes up to $91,900. Thus, Sue converts $15,000 of her traditional IRA to a Roth IRA in 2017. She believes that will keep her in the 25% tax bracket and generate $3,750 of added federal income tax (25% of $15,000), which Sue feels is reasonable.
If Sue makes similar partial Roth IRA conversions for the next 15 years, she probably will convert over half of this traditional IRA to a Roth IRA. Her RMDs will be reduced, and she’ll have access to a substantial amount of untaxed cash flow.
Looking back
A more precise method of implementing Roth IRA conversions is to use recharacterization, an IRS-approved method of reversing Roth IRA conversions, in full or in part. A Roth IRA conversion can be recharacterized up to October 15 of the following year, regardless of whether a taxpayer has requested an extension of time to file his or her return.
Example 3: Sue converts $100,000 of her traditional IRA to a Roth IRA in December 2017. When her 2017 tax return is prepared in early 2018, she discovers that her taxable income would be $73,200 without her Roth IRA conversion. Therefore, Sue recharacterizes enough of her 2017 conversion to wind up with an $18,700 conversion (the $91,900 upper limit of the 25% tax bracket minus Sue’s $73,200 of other taxable income).
Sue uses the full amount of the 25% tax bracket, moving as much money as possible from the traditional to the Roth side without moving into a higher bracket. Our office can help you calculate the amount to recharacterize and the amount to leave in the Roth IRA if you are interested in this strategy.
Once money is in the Roth IRA and the qualifications are met, Sue can withdraw as much or as little as she needs tax free. Amounts still in the account at Sue’s death usually can be withdrawn by her beneficiaries tax free, although RMDs will be in effect.