Retirement Guys: A tax-free retirement strategyWritten by Nolan Baker Mark Clair | | firstname.lastname@example.org
One of the common ways for an investor to save for retirement is through a traditional IRA or a 401(k). These type of plans usually save money in taxes, both when contributions are made and as the money grows tax-deferred. The account owner pays ordinary income taxes when withdrawals are made after the age of 55 or 59 and a half, depending upon the type of tax-deferred savings account. The idea is to get the tax savings now while earned income is higher and pay a lower rate in retirement when income and tax rates are lower. The problem for many families is that this may not be the case, which is why a 2012 Roth IRA triple split conversion strategy may be a great idea early this year.
A Roth IRA is not a new type of retirement savings account. It was originally created under the Taxpayer Relief Act of 1997. Roth IRA contributions can be made on a yearly basis. Roth IRA conversions involve taking current traditional IRAs and moving them to Roth IRAs. The conversion rules changed in 2005 under the Tax Increase and Reconciliation Prevention Act to allow greater flexibility. The primary advantage to a Roth IRA is that deposits can be withdrawn tax-free after five years from the initial
investment and earning can be withdrawn tax-free after five years of initial investment and once the account owner is over the age 59 and a half. A second advantage for retirees who do not need the income from their retirement accounts is that there are no required minimum distributions on the funds in a Roth IRA. The potential disadvantage of a Roth IRA is the account owner pays the taxes now versus later.
A 2012 Roth IRA conversion may be a great strategy. The old practice of getting the tax break now while the investor’s income is higher during working years means that the investor expects to have less taxable income in retirement. In our experience of working with many retirees, during the first 10 years after someone retires, it is not uncommon for them to live off the same if not more income than they had when they were working. The beginning retirement years are a time to enjoy the fruits of their labor, and income needs can be higher. It is not normally until much later in life that people tend to slow down and spend less. Having potentially tax-free Roth IRA money to complement Social Security and other income can be a better solution than having only tax-deferred fully taxable accounts.
The second potential flaw in the old philosophy is that low current tax rates could rise substantially in the future, making Roth IRA conversion even more appealing this year. The current Bush-era tax extensions are set to expire at the end of 2012 and America has a massive debt problem the government has to deal with. Future tax rates can only be higher, lower, or the same. If an investor feels that tax rates will be higher for their family, they should consider a Roth IRA conversion before the tax rates change.
Doing Roth IRA conversion analysis early this year makes even more sense because of the current recharacterization rules. Using these rules, an investor can convert money from a traditional IRA to a Roth IRA this year and wait and see how the investments perform before deciding to pay the taxes next year. If the investments go up in value, the profits would be considered tax-free if the rules are followed. If the investor waited and left the money in the traditional retirement account and the investments go up in value, the entire value of the account, including the profits, would be taxable later when a conversion or a withdrawal is made. If the conversion is done and the investments go down in value, the recharacterization rules allow the investor to cancel the conversion and avoid paying taxes on a higher starting balance. The deadline for recharacterization this year is Oct. 15; so the sooner the conversion is done the more time an investor has to see if the strategy works out.
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