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Money July 2017

Dollar Sense

Tax Deferred Is a Great Advantage… That Can Blow up in Your Face Tomorrow

By Teresa Ambord

It’s also common for working people to assume that when they retire, their tax rate will be lower. That might be true, but not always. So when you retire, or when you begin taking required minimum distributions beginning at age 70 ½, or after you pass away and your heirs inherit your accounts, there could be a nasty tax surprise waiting.

Most of us love the idea of a tax-deferred retirement account such as a 401(k) or an IRA. Who doesn’t want to save on taxes? But it’s common to forget that the tax is only deferred and eventually the tax man will be wanting his share. In my tax practice, it was common to prepare taxes for couples who were pretty savvy and had done well for themselves. Yet they were shocked to learn they had to pay taxes on money they took out of their IRAs or 401(k) accounts. It’s likely that they knew this when the accounts were originated, but by the time they started taking distributions decades later, they’d forgotten.

It’s also common for working people to assume that when they retire, their tax rate will be lower. That might be true, but not always. So when you retire, or when you begin taking required minimum distributions beginning at age 70 ½, or after you pass away and your heirs inherit your accounts, there could be a nasty tax surprise waiting.

 

Avoid Setting Off a Tax Time Bomb

According to Brett Sause, CEO of the Atlantic Financial Group (www.atlanticfinancialgroup.org) it might be time to consider other ways to invest that avoid the tax time-bomb. He suggests a few options that will either avoid tax altogether or get it over with early:

  • Municipal bonds, which are used to fund government projects, such as the schools your grandkids may attend. The interest income on municipal bonds is federal tax free, and may also be free from state tax.
  • Life insurance, which passes to beneficiaries income tax free. And, if you buy permanent life insurance you can withdraw the money or borrow against it while you’re still around.
  • Roth IRAs – which are not funded with deferred-tax contributions. That means when you withdraw your IRA funds, the money is tax free because you’ve already paid it. Or if your Roth IRA is inherited, your beneficiaries receive the money tax free (though they may still have to pay estate tax).

 

More about Roth Options

“When you defer taxes, eventually it catches up with you,” said Gary Marriage Jr., CEO of Nature Coast Financial Advisors (www.naturecoastfinancial.com). “Suddenly your IRA or 401(k) isn’t worth as much as you thought because every withdrawal you make potentially can be taxed.”

That’s why, he says, you might want to consider converting a traditional IRA or 401(k) to a Roth option. Of course, that means you need to be prepared to pay the related tax bite now, so it’s critical to have a financial advisor run the numbers to help you decide.

President Trump and Congress are pushing to lower tax rates in the near future. That means “taxes are about to be on sale,” said Marriage. “over the next four to five years, your tax bracket is probably going to be as low as it ever will be.” If that happens, you could get the tax bite out of the way at a discount. On the other hand, if you think taxes are more likely to go up (whether under President Trump or under his successor), it might be smart to act before tax increases take effect. Also keep in mind that some state governors are talking about raising taxes in the near future, which, should also factor in to your decision.

Here are a few points of advice from Marriage for those considering a conversion to a Roth option, to lighten the tax bite.

  • Space it out. Rather than taking the tax hit all at once, you can transfer money into a Roth account in increments over a period of years. According to Marriage, how much you can convert in the first year depends on several factors, so seek professional help to do this… just keep one eye on the future of tax rates.
  • Consider your age. There is no ‘right” age for converting to a Roth option. But Marriage said the greatest benefit usually is for people age 59 ½ to 74.
  • Start with a Roth. The best case scenario is to start with a Roth option if you can. That way the taxes are paid, and the interest grows tax free until retirement time.

Tax rates are fairly low now, and may soon be “on sale,” as noted earlier. If you have traditional IRAs or a 401(k) and want to take advantage of low tax rates, which could go lower under President Trump or alternatively could go higher under another president, talk to your financial advisor about the timing of a possible conversion. He or she can calculate the tax you will pay now and that will help protect your money in the future.

 

Traditional IRAs and 401(k) Plans vs. Roth Options: How Do They Compare?

Here’s a breakdown:

– Traditional 401(k): Contribution limits, $18,000 to $24,000 for those at least age 50. Contributions to qualified plans are made with pre-tax dollars. Withdrawals, therefore are taxed. Generally account holders must begin taking minimum withdrawals by age 70 ½.

– Roth 401(k): Contribution limits, $18,000 to $24,000 for those at least age 50. Contributions to qualified plans are made with after-tax dollars.  Withdrawals, therefore are free from federal tax and possibly state tax, if:

  • The account has been open for at least five years.
  • The account holder is at least 59 ½ years old.

Account holders must begin taking minimum withdrawals by age 70 ½. 

– Traditional IRA: Contribution limits, $5,500 and $6,500 for those at least age 50. Contributions to qualified plans are made with pre-tax dollars. Withdrawals, therefore, are taxed. Generally account holders must begin taking minimum withdrawals by age 70 ½. Contributions are subject to additional limitations for upper income individuals, so check with your financial advisor.
   
– Roth IRA: Contribution limits, $5,500 and $6,500 for those at least 50 years old.

Contributions to qualified IRAs are made with after-tax dollars. Withdrawals, therefore are free from federal tax and possibly state tax, if:

  • The account has been open for at least five years
  • The account holder is at least 59 ½ years old.

Account holders are not required to take minimum withdrawals, as long as the original owner is alive. For this reason, they are often considered a better vehicle for leaving money to heirs. Contributions are subject to additional limitations for upper income individuals so check with your financial advisor.

 

Teresa Ambord is a former accountant and Enrolled Agent with the IRS. Now she writes full time from her home, mostly for business, and about family when the inspiration strikes.

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