For individuals who have large government or military pensions and/or Social Security payments that will place them in high tax brackets, the idea of receiving a portion of your retirement income tax-free is very appealing. For people fortunate enough to be in these situations, a Roth individual retirement account should be at the top of their financial "to-do lists" because the tax savings over a number of years can be significant. If you have not already established a Roth IRA and will have a guaranteed retirement income greater than $50,000 per year, then you want to do a conversion before April 15.
Taxes, taxes, taxes. Unless your retirement income is coming from a Roth IRA or a permanent life insurance policy, you will likely be subject to ordinary income taxes on any distributions from a traditional IRA, 401(k) or pension. Most folks assume that they will be in a lower income tax bracket during their retirement because their expenses will go down once they do not have additional costs associated with their preretirement lifestyle. Unfortunately, this is not always the case, and even when it is, a 15 percent decrease in spending does not always mean that your income drops into a lower tax bracket. Remember, you lose valuable deductions in retirement, such as 401(k) contributions, and many retirees have contributed significant funds to paying down their mortgage, leaving a smaller mortgage interest deduction to be taken. Add up your pensions and Social Security benefits before you go to file your taxes this year. Take these numbers to your CPA for a "projected" tax obligation in retirement with a lower spending figure and fewer deductions. The result may surprise you.
Put your gains to use. The biggest drawback to converting a traditional IRA into a Roth IRA is the tax bill that goes to the Internal Revenue Service for your privilege to do so. Remember, any amount that is converted is essentially additional income that you earned for the year. Therefore it is subject to ordinary income tax. This can have a significant impact on your tax bill, so you'll want to work closely with your CPA and financial adviser when doing so. However, given that the stock market continues to chug along and raise the value of people's portfolios, this could be a good opportunity to take some of the gains from your winning positions to pay for the cost to convert your funds to a Roth IRA. Have your adviser evaluate which positions have had the biggest increases in the past few years and determine if it's appropriate to sell those shares and funds to get into other opportunities. The money will still be invested for retirement purposes, but rebalancing your portfolio on a regular basis is critical to successful investing. The gains from your winning positions could be reinvested in more lucrative opportunities within a Roth IRA, giving you the benefit of tax-free distributions, potentially from a larger asset base.
Time value of money. By taking money from your portfolio to pay taxes for the conversion, you are going to notice the decrease in the portfolio's value. One way to combat this "loss" in value is to structure your Roth IRA to include positions that have more potential to appreciate in value over a longer time horizon (five years plus). This may include small or mid-cap stocks that have not produced a consistent dividend, but have appreciated in price. It could also include positions in more volatile areas such as technology stocks or commodities. You should withdraw money from your least tax-efficient vehicle first in order to maximize the benefits of tax deferral. Since you will not owe any taxes once funds have been converted to a Roth IRA, these funds should be earmarked for providing income at the tail end of your retirement. Capitalize on this opportunity by including shares in companies or funds that have greater potential to increase in value over the long run.
Transferability. If you are in a position where you may never have to take withdrawals from your Roth IRA, consider the possibility and benefits of it being transferred to your children. This can be a powerful way to leverage the existing rules to transfer funds that will receive tax deferral, and never owe any tax on any gains.
In short, a Roth IRA has many potential benefits, but most important is the role that taxes will play over years in retirement. When you have the potential of 50 percent or more of your Social Security benefits or 100 percent of your pension income is subject to ordinary income tax, you should consider a Roth IRA. If all distributions for retirement income are going to be taken from traditional IRA or 401(k) accounts, again subject to ordinary income tax, you should consider a Roth IRA. If you've had the benefit of a large percentage of your portfolio riding a stock market that posted a 32 percent increase in 2013, you should consider a Roth IRA.
There are few things that are guaranteed in life, but when the government consistently runs a budget deficit each year, it's hard to see how taxes can stay at historically low levels. Be proactive when you have the choice rather than reactive when the important decisions have already been made. Your retirement longevity and legacy could benefit significantly.
Kelly Campbell, certified financial planner and accredited investment fiduciary, is the founder of Campbell Wealth Management and a registered investment adviser in Alexandria, Va. Campbell is also the author of "Fire Your Broker," a controversial look at the broker industry written as an empathetic response to the trials and tribulations that many investors have faced as the stock market cratered and their advisers abandoned their responsibilities to help them weather the storm.
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