Hopping the Hurdles Toward Retirement (the series)
October 20, 2010I’ve been doing a lot of retirement workshops lately, and there’s a part in our workshop where we address the obstacles that stand in the way of you reaching your retirement goals. I thought I’d offer some suggestions to how you may be able to get over these hurdles, so here’s the first in a series:
Hurdle #1: Taxes
There’s a lot of debate over whether Congress needs to raise, lower, or keep taxes the same. One thing is certain: we have no idea what taxes will be in the future. So how do we prepare for such uncertainty? Diversify your tax strategy.
Most of your income sources in retirement are taxable: 401(k), IRA, Pension, even Social Security (up to 85%) is taxable in retirement. So to get over this hurdle, consider putting money in a Roth IRA.
If you own a Roth IRA for at least 5 years, and you are at least age 59½ when you start to withdraw funds, 100% of your distribution is income tax free!
For 2010, you may contribute up to $5,000 (or $6,000 if you are age 50+) to a Roth IRA. If you are married, you and your spouse can each contribute this amount as long as your total household earned income exceeds $10,000 (or $12,000 if age 50+).
There are income limitations, so check out this Roth eligibility article to see if you qualify.
What if my income is too high?
If your income is too high, you may still be able to contribute to a Roth IRA by converting a traditional IRA. Starting this year you can convert a traditional IRA to a Roth IRA regardless of income. How the conversion will be taxed depends on whether or not you already have an existing traditional IRA. Let’s look at two examples:
Example #1: You DO NOT have an existing IRA
This one is fairly easy. Let’s say you put $5,000 into a nondeductible traditional IRA and then immediately convert it to a Roth IRA. Since you have already paid income taxes on the initial $5,000 contribution, there are no tax implications for converting it to a Roth IRA. (I told you it was easy.)
Example #2: You DO have an existing IRA
This one gets tricky. Let’s say you rolled $95,000 from a previous 401(k) to a traditional IRA. 100% of that money is tax deferred. Now you put $5,000 into a nondeductible traditional IRA. You’ve already paid taxes on the $5,000 nondeductible contribution, so you decide to convert it to a Roth IRA. Here’s the rub: the IRS will add all of your IRAs together to determine the taxable portion of your conversion. Here’s how it looks:
Step 1) Add all IRAs together
$95,000 (IRA 1) + $5,000 (IRA 2) = $100,000 total
Step 2) Determine the ratio of taxable money
$95,000 (tax deferred) / $100,000 (total) = 95% taxable
Step 3) Compute the taxable portion of the conversion
$5,000 (conversion amount) X 95% (tax ratio) = $4,750 taxable portion
Converting the $5,000 to a Roth IRA would result in $4,750 of taxable income in the year of conversion.
Now these are two very simple examples, but as you can see, things can get a lot trickier if you have deductible and nondeductible contributions commingled.
Is there any way I can get around this?
I’m glad you asked. If you are currently working for an employer that offers a retirement plan (e.g. 401(k)) that accepts rollovers, you could roll the tax-deferred IRA into it, thus removing this account from the above equation.
Is there an advantage to converting to a Roth IRA this year?
As a matter of fact, there is! If you convert in 2010 the IRS will allow you to spread the taxable income from the conversion equally over 2011 and 2012, but only for conversions done in 2010.
Bottom line: A Roth IRA can provide tax-free income in retirement. If your income is too high, you may still be able to take advantage of the conversion rules, but this opportunity may not last forever, so check with your tax professional to see if it is right for you.