At the end of the day, all of your retirement money is treated in one of three ways: taxable, tax-deferred or tax-free. Taxable income is taxed during the year in which it is received, e.g., pension or investment income. Taxable income may also be tax-favored if from capital gains, dividends or certain other activities. Earnings from tax-free municipal bonds are lower than their taxable counterparts; thus, taxes are implicit, so put these bonds in the taxable classification. For many retirees, Social Security benefits are taxable also; as I mentioned before in my Retirement Blog. Tax-deferred earnings are not taxed as income now but will be in the future when withdrawn and used, e.g., IRA, 401(k) and annuity earnings. If passed to the next generation, the deferred taxes will be paid by the beneficiary or the estate of the deceased. Tax-free income may have been taxed earlier but is not again taxed when withdrawn and used, for example money take from a Roth IRA.
Which of these three tax strategies is best? The correct answer is “it depends” because the best strategy depends on factors that cannot be predicted: changing tax rates, life expectancy, future income, allowable deductions and more. Since the future is uncertain, diversification would appear to be prudent. The exact composition of the diversification will be a matter of personal preference, but it seems logical tax diversification might be better than the risk of guessing wrong. Unfortunately, most retirees have little tax diversification.
The tax deferred bucket can be accomplished by using qualified retirement accounts such as IRAs, 401(k), 403(b), etc. or tax-deferred annuities. The taxable bucket is generally filled with investment/business income, rents and salary/wages, plus Social Security benefits are generally taxable. The difficult bucket to fill, especially for the affluent, is the tax-free one. While income from municipal bonds is tax-free, the lower returns offset this feature. The logical choice for tax-free income is the Roth IRA. Most employers have not yet added the Roth option to their 401(k) and most high-income families cannot qualify for Roth contributions or conversions. In 2010 the Roth conversion income limit will be suspended, allowing higher income families to take advantage of tax diversification.
With tax diversification you can hedge the uncertainties of future tax changes. This is why the window of opportunity for a Roth conversion in 2010 should not be ignored. If your current adjusted gross income exceeds $100,000, you do not now qualify for Roth conversion but you will in 2010. As icing on the cake, the taxes from a 2010 Roth conversion can be spread equally over 2011 and 2012. Unfortunately, many will miss the opportunity because their retirement money is unnecessarily locked in 401(k) and other employer-sponsored plans which prevent withdrawal unless an easy, but relatively unknown, provision is added to the plan. Once converted to a Roth it will not be subject to income taxes nor required annual distribution, plus all money and future earnings will be tax-free to the beneficiaries. If you need tax diversification, ask your financial advisor about converting your qualified retirement money to a Roth IRA.
Shelby J. Smith, Ph.D.