A look at IRAs, 401(k)s, and other ticking tax time bombs
Jim Hallisey / Ozark Financial Services / Rogers
Thinking about retirement? There’s no need to read any further if you believe Federal income tax rates will be reduced going into the future; particularly by the time you are ready to retire. If, like me and many others, you think tax rates will be going up, this could be a “must read.”
Americans currently hold trillions of dollars in IRAs, 401(k)s, 403(b)s, and other retirement accounts. What do we like so much about such accounts? For one, we get to put pre-taxed dollars into the account. Second, those dollars grow tax-deferred. We don’t pay tax on those funds until we withdraw them.
That’s good isn’t it? Yes and no. No, because we easily forget we have a silent partner in all that tax deferred growth: the IRS. These tax-deferred accounts are ticking tax time bombs, and the longer we let them grow, the more we compound our tax burden. It is not a matter of whether we (or our heirs) will pay the taxes on these growing balances, but rather when and at what tax rate.
In 1998 the government offered an alternative called the Roth IRA. Here we pay the tax upfront on the smaller contribution amount, and when we take qualified withdrawals (from the hopefully much larger balance), the distributions are 100% income tax free. With the Roth IRA, the IRS is no longer silently waiting for its share, and we regain control of the amount and frequency of withdrawals, and even minimize or eliminate further tax liability on Social Security benefits.
With a traditional IRA (after you reach age 70 ½) the IRS dictates how much you withdraw each year; and of course you pay tax on that amount. The fine for not doing so is a staggering 50% of the Required Minimum Distribution (RMD).
The conventional wisdom for years has been to defer, defer, defer income taxes until you retired and settled into a lower tax bracket. Oops! If tax rates are continually increasing, that strategy may not be so wise.
Can you jump from a traditional IRA to a Roth IRA?
Yes, beginning in 2010 the IRS created a provision that allows a traditional IRA or a qualified retirement plan (such as a 401(k) from a former employer) to convert to a Roth IRA, regardless of your income. The price, however, is that you buy out your silent partner– the IRS– by paying taxes up front.
Determining whether a Roth conversion is right for you depends on many factors. It’s not a simple decision to make. However, your advisor should have special Roth analysis software that helps make the benefits and the costs crystal clear.
If it’s the right choice, converting could save you thousands or tens of thousands of dollars in taxes over your lifetime and that of your heirs.
Jim Hallisey has served 11 years with Ozark Financial Services helping people prepare to live their hopes, dreams, and goals in retirement. Learn more at www.jimhallisey.com or follow him on Facebook. This article provides general information and is not intended to provide legal or tax advice. Email Jim at jimhallisey@ozarktax.com
