Using IRAs to Avoid the Fiscal Cliff
Taxes will increase, especially for investors, in 2013 and beyond. The only question is how high they will increase. The 3.8% tax on investment income that was enacted as part of health care reform will go into effect. The Bush tax cuts, payroll tax reduction, and other tax breaks are scheduled to expire at the end of 2012. Congress might extend them, but it also might extend only some of them, enact some new taxes, or do nothing. Much depends on the election results.
Other taxes also are likely to rise in coming years, because state and local governments still have revenue shortfalls.
Those planning for retirement or in the early years of retirement should expect to pay higher tax rates and lose tax breaks during their post-career years. Taxes at all levels are among the top three expenses for many retirees, and that will continue.
You can act to avoid the worst effects of the fiscal cliff, taxmageddon, or whatever you wish to call it. Plan now to reduce your taxes in the coming years with these strategies.
Convert to a Roth IRA. In 2009 and 2010 I was an early leader in encouraging people to consider converting traditional IRAs into Roth IRAs. We laid out in detail the factors to consider, who was likely to benefit from a conversion, and who should avoid a conversion. Tax law changes at the time encouraged the move by removing the $100,000 income limit on conversions and allowing tax payments to be delayed one-year and then paid over the next two years.
Because of the likelihood of higher future taxes, 2012 and 2013 are good years for many to consider converting to Roth IRAs.
When a traditional IRA is converted to a Roth IRA, there’s a price to pay. The amount that is converted (you can convert all or any portion of an IRA) is included in gross income and faces ordinary income taxes. So you pay taxes now instead of later. In return, all future withdrawals after a five-year waiting period are tax free. Income and gains also compound tax-free within the IRA.
A big benefit is there are no required minimum distributions for the owner of a Roth IRA. RMDs are a big problem for many people with traditional IRAs. The RMDs increase as you age, whether you need the money or not. That increases income taxes each year, possibly pushing you into a higher tax bracket, and takes away the tax deferral benefit of the IRA. This isn’t a worry with a Roth IRA. You take distributions only when you want to, and they are tax free.
Beneficiaries who inherit a Roth IRA also can take distributions free of income taxes. They must take RMDs, but can spread them over their life expectancies. If they’re relatively young and earn a decent return on the account, it can grow over the years despite the RMDs.
There are several factors to consider before deciding whether or not to convert an IRA to a Roth IRA. I discussed these in detail in Retirement Watch and in my books, The New Rules of Retirement and Personal Finance for Seniors for Dummies. In addition, you can purchase a spreadsheet on my web site under the Bob’s Library tab that will help make the calculations for you to show results under different assumptions and scenarios.
You don’t have to be correct when you convert to a Roth IRA, because the tax law allows you to reverse a conversion, a transaction known as a recharacterization. When your tax return for the year of the conversion is filed on time, you have until Oct. 15 of the year after the conversion to decide whether or not to recharacterize.
One smart way to convert to a Roth IRA is to put each different asset class in your traditional IRA into a separate Roth IRA. Then, when the recharacterization deadline nears, you leave in their Roth IRAs the investments that have done well and recharacterize those that didn’t. The recharacterized IRAs can be converted again later, and ultimately you can consolidate the different Roth IRAs into one.
You don’t have to convert all of your IRA at once. You can convert in stages over the years. You might want to do this when you don’t have enough cash outside the IRA to pay the taxes for converting all your IRA balances or when you are converted different asset classes as just described.
A conversion will increase gross income for the year. Be aware that could increase income taxes on Social Security benefits, Medicare premiums, reduce some tax breaks, and cause other effects.
Seek tax diversification. You can’t forecast accurately what the tax law will be in five, 10, or 15 years. So, don’t try. Instead, diversify your tax attributes. That way, you won’t be burned badly regardless of what happens with the tax law. Some of your holdings will benefit, and some won’t.
You need the three basic types of accounts: taxable, tax-deferred (traditional IRAs and 401(k)s), and tax-free (Roth IRAs). Some people argue that you shouldn’t have a Roth IRA, because Congress will change the law and make them taxable. Maybe it will. In that case you likely haven’t lost anything, because the taxes imposed on a Roth likely wouldn’t be any higher than if the money had remained in a traditional IRA. But if Congress doesn’t change the law, or if it grandfathers Roth IRAs that already exist, you’ll have lost a great opportunity to reduce taxes.
Tax diversification gives you options over the years. The goal in the future will be to minimize your taxes on the money you need to spend in retirement, and that will mean managing distributions to keep from rising to a higher tax bracket.
When you own the range of different accounts, you can adjust distributions annually to avoid being bumped into a higher tax bracket. In years when you’re in danger of being pushed into a higher tax bracket, you can sell assets from the taxable account that face either no taxes or only long-term capital gains. In other years you can withdraw more from the traditional IRA and pay ordinary income taxes. You won’t have the options if you don’t have tax diversification.
Withdraw in the right order. For most people, one of their goals is to make their nest eggs last as long as possible. One way to stretch the life of your retirement funds is to withdraw from the accounts in the right order.
The general advice is that you should allow tax-free accounts, such as Roth IRAs, to compound untouched for as long as possible. Tax-deferred accounts, such as traditional IRAs, should be the second-to-the-last to touch. Taxable accounts should be drawn down first, because they have the fewer tax advantages. You also can manage taxable accounts to minimize taxes on distributions.
These are the general rules, but they don’t work for everyone. For example, as I reported in past issues of Retirement Watch, you should drawn down taxable accounts last when their annual return is four percentage points or more greater than for other accounts. There are other situations in which the general rule isn’t best.
You’ll also want to modify the rules from year to year to avoid being pushed into a higher tax bracket by, for example, taking too much money from a traditional IRA. Of course, this is another reason to have tax diversification. You won’t be able to use this strategy to stretch the nest egg when you have only one type of account.
Invest in the right place. You increase after-tax wealth and extend your nest egg by holding the right assets in the right types of accounts. (Another reason you should practice tax diversification.)
The general rule here is that assets that qualify for long-term capital gains or the 15% dividend rate should be owned in taxable accounts. These include stocks and real estate. Income-earning assets should be held in tax-deferred accounts such as IRAs and annuities. Assets to include in these vehicles are bonds and real estate investment trusts. Stocks and mutual funds that are growth-oriented but that you generally sell after less than a year so they don’t qualify for long-term capital gains also should be in tax-deferred accounts.
Pay attention to rules changes. The IRS recently issued rules that allow more annuities to be purchased by IRAs and 401(k)s and provide a guaranteed stream of income without violating RMD rules. The IRS soon is likely to approve other uses of annuities in IRAs. Changes such as these provide important tools for your retirement planning, and more are likely to come as Congress either reforms the tax code or tinkers with the current code to raise revenue.