As I mentioned in a previous retirement blog post, at the end of the day, all 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, but can also be tax-favored if from capital gains, dividends, Social Security, etc. Interest rates on tax-free municipal bonds are lower than their taxable counterparts; thus, taxes are implicit and municipals are in reality the same as taxable. Tax-deferred earnings are not taxed as income now but will be in the future when withdrawn. 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 Tax-free income may have been taxed earlier but is not again taxed when withdrawn. The best example of tax-free income is the Roth IRA.
How much of your retirement money should be in each of these categories? The correct answer is ‘it depends’ because the best strategy hinges on factors that cannot be predicted: changing tax rates, life expectancy, future income, allowable deductions and more. Since the future taxes and circumstances is uncertain, tax-liability diversification would appear to be prudent. The exact composition of the diversification will be a matter of personal preference, but it seems logical that tax diversification might be better than the risk of guessing wrong. Unfortunately, most retirees, probably including you, have little tax diversification. It is conspicuously absent among those with substantial assets and this is interesting given that future taxes are expected to be higher to address federal deficits, refinancing entitlement programs and the wealth redistribution trend. In fact, most retirees and near-retirees – regardless of income or net worth – have no tax-free holdings and this is not wise, especially for affluent families.
Tax-deferred annuities are a great supplement to qualified retirement money, and many of the retirement minded have utilized them along with their tax-deferred pension accounts like IRAs and 401(k)s. Likewise for the taxable bucket since investment/business income, rents and salary/wages, plus Social Security benefits are common. The empty bucket, even for the affluent, is the tax-free one. Municipal bonds do not fill this niche because of the implicit taxes. Also, tax-free municipal bond interest counts in the tax calculation for Social Security benefits.
The logical choice for tax-free income is the Roth IRA. Most employers have not added the Roth option to their 401(k); thus, working families have not had this access. Also, many high-income families cannot qualify for Roth IRA contributions or conversions. In 2010 the Roth conversion income limit will be suspended, allowing higher income families to take advantage of tax diversification. You need to start preparing now so you can convert your qualified money to Roth IRAs in 2009 and during 2010 when the income limit is suspended. Since partial conversions are permitted, you’ll want to carefully select the amount your convert to keep your total income in the lowest marginal tax bracket as possible. Also, keep in mind that you can change your mind and undo the conversion up to the date your file your taxes, including extension, for the conversion year.
The window of opportunity for Roth conversions in 2010 cannot be ignored. If your adjusted gross income exceeds $100,000 you do not now qualify for a Roth conversion but will in 2010. As icing on the cake, the taxes from a 2010 Rot conversion can be spread equally over 2011 and 2012. Unfortunately, many who can benefit will miss the Roth opportunity because their retirement money is unnecessarily locked in a 401(k) and other employer-sponsored plan which prevent withdrawals prior to retirement. This impediment can easy be removed by asking your employer to add an in-service, non-hardship withdrawal provision to your Plan (See the report I co-authored: “Tapping Into Your 401(k) Before Retirement”). Once retirement money is converted to a Roth, it will not be subject to income taxes nor required minimum distributions. Additionally, all money in the Roth IRA and future earnings will be tax-free to you, your spouse and eventual to your beneficiaries. If you need help understanding Roth IRA conversions, you’ll want to talk to your financial advisor or do some independent research (see IRS Publication 590). You may also want to look at the guaranteed lifetime income riders on fixed annuities because, when combined with a Roth IRA, this is your pathway to a lifetime of tax-free income that will overcome your biggest retirement fear: longevity risk. If you want to take advantage of the Roth IRA conversion, you need to start planning today – especially if your money is locked in a 401(k), 403(B), 457, etc. plan sponsored by your employer.
Shelby J. Smith, Ph.D.
April 2009
TheRetirementPros.com
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