The IRA tax bomb and why Roth conversions are now more important than ever
You’ve been an excellent saver, funding as much as you can into your 401(k) every year. And now you’ve got a big 401(k) or IRA rollover (or both). Your retirement looks secure and you’re starting to think about what retirement is going to look like. It’s a nice problem to have. But what about taxes on distributions?
We spend our working careers shoveling money into 401(k)s, 403(b)s or IRAs hoping that its going to be enough. And, then, when we finally realize that we are close to having saved enough, we have a new problem: We’ve saved so much on a pre-tax basis that the big IRA is a big problem.
If you’ve been putting money into your retirement account on a pre-tax basis (e.g., Traditional 401(k) / 403(b) or a Traditional IRA), you have put off the tax bill until retirement. It was great paying less in taxes during your high income years but now you’ve essentially back-loaded your tax bill—distributions from these pre-tax accounts are 100% taxable and treated as Ordinary Income for tax purposes. This could mean you’ll be taking distributions at one of the higher income tax rates.
Big IRA example
Let’s say that you are really awesome at saving for retirement over a career (age 32-72) and that you put away the current maximum contribution limit into a 401(k) / 403(b) of $19,500 per year. Yes, we know that saving the max. early in your career can be challenging (that’s why this example starts at age 32) and that later, once you turn 50, you can put in more. In addition, the max. limit is increased with inflation. We also know that most people have breaks in employment when they are not contributing towards retirement so we’ve taken 5 years out of this 40-year savings period. Even so, here’s how it plays out:
Yearly contribution: $19,500
Years of contributions: 35
Growth rate less inflation: 6%
Projected balance at age 72: $2,173,000
Now, at age 72, you’ll need to start taking Required Minimum Distributions (RMDs) based on IRS tables. That first year, you’ll need to take out $82,882 which, combined with Social Security and other potential income sources means you may cross over into a higher tax bracket.
If you plan to leave your IRA to your adult children, this could be creating a big problem for them: They are likely still working which means they are not in a low tax bracket either. And, with the new tax law, inherited IRAs must be distributed to the beneficiaries within 10 years.
IRA tax bomb for IRA beneficiaries
Let’s say you die at age 72 (sorry), your beneficiaries will need to take out an average of $295,000 per year in order to exhaust the account by the 10th year as required.
If you have two adult children, adding $147,500 of income to their tax bill each year is a nice problem to have but it could still mean a significantly higher tax bill.
Renewed interest in Roth conversions
That’s why Roth conversions are taking on a renewed interest by both planners and retirement savers. Qualified Roth distributions are tax-free which can be beneficial to recipients that are in high tax brackets.
While Roth conversions do not make sense for everyone, they may be worthwhile to those with big 401(k)s or IRAs. Managing the conversions carefully over time could result in more manageable tax bills for some in retirement.
Please keep in mind that retirement plan distributions and Roth conversions have special tax rules and penalties if you are not careful. As always, please consult a tax professional for specific advice concerning your particular tax situation.
Have more retirement planning questions? Give us a call. We’re here to help.
Lyman H. Jackson
617-653-3303
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. FPS provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client after entering into an advisory relationship. Information herein includes opinions and forward-looking statements that may not come to pass. Information is derived from sources believed to be reliable. Information is at a point in time and subject to change without notice. Such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.