It’s a taxing time: Reducing income taxes in retirementWritten by Guest Author | | GuestAuthor@toledofreepress.com
With tax season a recent memory, many retirees are likely wondering why they pay so much of their hard-earned money in income taxes to the IRS. Perrysburg-based financial adviser Jeff Bucher believes Roth IRA conversions are one plausible solution for many to consider.
“Roth IRAs offer a number of benefits for pre-retirees and retirees who want to avoid a tax burden later in life,” said Bucher, president of Citizen Advisory Group. “By converting to a Roth IRA today, you could potentially help yourself tomorrow by reducing your tax liabilities in retirement.” But Bucher warns that, ”Roth IRAs are not for everyone, so it’s important to know all the rules and how they might impact your specific financial situation before making a decision.”
Benefits of a Roth IRA include tax-free withdrawals in retirement and no required minimum distributions (RMDs). If done correctly, a Roth IRA can help maximize savings and minimize taxes, although the rules can be complicated to understand. Bucher offers three tips to consider before converting your 401(k) or traditional IRA to a Roth IRA.
Determine if a Roth IRA conversion is right for you.
There can be a lot of expensive fees involved if a conversion is done incorrectly. Income taxes are due on the amount of money converted to a Roth IRA in the year converted, which means you will need to have to pay now in order to be able to take advantage of the benefits later. A Roth conversion may not be right for you under the following scenarios:
- You will be in a lower retirement tax bracket. Converting to a Roth may not make sense if your retirement tax bracket will be considerably lower than it is today. You could end up paying more now on the conversion than you’d pay later on the withdrawal of funds in retirement.
- You will need to dip into your retirement account to afford conversion taxes. Taking money out of your IRA or 401(k) account to pay for the conversion taxes can result in a 10 percent early withdrawal penalty. You would also end up having less money saved for retirement. Paying the taxes out of pocket can help you avoid this fee.
Know how to convert correctly.
Roth IRA conversions can be costly, incurring extra penalties and/or taxes if done incorrectly. Following are a few common mishaps that could affect the value of your account:
- Failing to do a direct transfer. A direct transfer is the best way to receive the funds from your traditional IRA or 401(k) to a new Roth account. To complete a direct transfer properly, your former IRA or 401(k) custodian needs to put the funds directly into your new account. In addition, if you do not complete a direct transfer and are younger than 59½, you could have to pay an early withdrawal penalty.
- Avoiding the 20 percent withholding trap. If you have the check issued in your own name and deposit it into the new Roth IRA account yourself, you will be subject to a 20 percent withholding tax.
- Rolling over your required minimum distribution to a Roth. Those who are required to take an RMD from a traditional IRA or 401(k) should not roll over the RMD in converting to a Roth. Doing so could push you past the amount you are allowed to contribute every year, resulting in a 6 percent excise tax for every year the excess amount remains in the account.
Understand which accounts are eligible for a Roth IRA conversion.
Not all funds are eligible to be converted to a Roth IRA. That means you need to be careful that you do not get penalized for trying to convert ineligible funds. Here are a couple situations to avoid, as they could result in costly penalties:
- Postponing conversion for 60 plus days. If you wait too long to put funds into a Roth IRA, they could become ineligible for conversion. This mistake can happen when a direct transfer is not completed because the account owner is then responsible for depositing the check. If the check is not deposited within 60 days, the funds are no longer eligible.
- Converting inherited IRAs or dividends from employer stocks. These accounts are ineligible for conversion and could cost you a 6 percent excise tax for each year they stay in the account.
Bucher adds, “The good news is if your account is worth less after the first year, you can convert back to a traditional IRA, penalty free. This is called a recharacterization and you have until October 15 of the following year to change your mind. A qualified financial adviser can assist you with ‘un-doing’ your IRA.”
Jeff Bucher is co-founder and president of Citizen Advisory Group, an independent financial advisory firm serving the greater Toledo area, specializing in retirement planning. He is an investment adviser representative under AlphaStar Capital Management LLC and is a licensed life and health insurance agent with the state of Ohio. For more information about Jeff M. Bucher and Citizen Advisory Group, please visit www.CitizenAdvisory.com.