Category Archives: Investments

Roth IRA Conversion – Even for High Tax Bracket People

Roth IRA conversions allow you to move pre-tax funds in a Traditional IRA into a Roth IRA. Once the funds are in a Roth IRA, you will no longer pay any income taxes on future earnings or withdrawals as long as at the time of withdrawal (1) you are at least age 59½ and (2) at least five years have passed since the conversion. The cost of a Roth IRA conversion is paying ordinary income taxes on the conversion amount in the year of conversion. Because of this tax cost, individuals in high income tax brackets are often reluctant to do a Roth IRA conversion. I believe that even those in high income tax brackets should consider Roth IRA conversions if they have excess cash outside of their retirement accounts to pay the income taxes due on conversion.

First, let’s discuss some math. Ignoring estate planning considerations, you are no better off or worse off doing a Roth IRA conversion if the following two statements are true: (1) the funds that you would use to pay the income taxes due on conversion earn the same rate of return outside of your Roth IRA as they would inside of your Roth IRA and (2) your marginal income tax rate stays the same throughout your life.

On the first point, the funds that you would use to pay the income taxes due on conversion are likely to earn a lower rate of return than your Roth IRA since the outside funds are subject to ongoing income taxes on interest, dividends, and capital gains even if you diligently invest the outside funds. Alternatively, perhaps the outside funds would just sit in a bank savings account earning minimal interest or, worse, you would simply spend the money. In any scenario, I believe the first point strongly favors a Roth IRA conversion.

The second point (marginal income tax rates) often causes high income tax bracket people to pass on the Roth IRA conversion. Lower marginal income tax rates during retirement would favor not converting to Roth today. Let’s think about this, however. The current top federal income tax rate is 35%, which is low by historical standards. Your marginal income tax rate during retirement could be higher simply because the government decides to raise income tax rates overall. Also, consider all the sources of taxable income that you might have during retirement: required minimum distributions from IRAs and 401(k)s, pension income, Social Security income, annuity payouts, interest income, and dividend income. If your mortgage is paid off by retirement and you no longer have dependents, then your deductions and exemptions could be lower too. Also, the differences in marginal income tax rates among the highest, second highest, and third highest federal tax brackets are not large.

If your estate is likely to be subject to estate taxes, then there are estate tax benefits to doing a Roth IRA conversion. By converting pre-tax funds to a Roth IRA, you remove the income taxes paid on conversion from your gross estate while creating an investment account that is free of income taxes, subject to certain rules, for your heirs.

If you have excess cash to pay the income taxes on a Roth IRA conversion, I believe the strongest argument for doing a conversion is a behavioral one. A Roth IRA conversion allows you to pay a one-time cost today (the income taxes on conversion) to save a significant amount of income taxes, most likely, during retirement. You do not have to do anything further to achieve the future payoff other than keep your Roth IRA invested and not withdraw from your Roth IRA until retirement. Think of it this way. Paying the income taxes on a Roth IRA conversion is like making a one-time contribution to your Roth IRA, except that you are not limited to $5,000 or $6,000 per year. For many people, the alternative to a Roth IRA conversion is not to diligently invest the funds outside of the Roth IRA but to simply spend the money. A Roth IRA conversion makes it less likely that you will do something unwise with the money that you would otherwise use to pay the income taxes that will be due on conversion.

Roth IRA – The Ultimate Retirement Account

You can think of retirement investments like a box of rocks. In this analogy, the rocks represent the types of investments in your account, such as stocks and bonds. The box represents the type of account, such as a taxable account vs. an IRA account. In this article, I am going to discuss the type of box without discussing the rocks. When it comes to retirement investing, I believe that the Roth IRA is the ultimate account type. It is the best “box” to hold your retirement investments.

Some people go to great lengths to defer income taxes on investments, such as by entering into a deferred compensation arrangement with their employer or by contributing to deferred variable annuities. Of course, many people defer income taxes in more ordinary ways by contributing to 401(k) plans and Traditional IRAs. Deferring income taxes can be okay if you plan for the income taxes that you will ultimately pay when you withdraw your tax-deferred funds. IRS rules require holders of 401(k) and Traditional IRA accounts to start withdrawing funds at age 70½. I think that many people who have amassed large amounts of tax-deferred funds will be shocked at their income tax bill when they start withdrawals.

The Roth IRA eliminates the issue of deferred income taxes. Once you put money into a Roth IRA account, it grows income tax-free, and no income tax is assessed on future withdrawals as long as the withdrawal occurs after age 59½ and you have held the account for at least five years. Unlike with contributions to 401(k)s and Traditional IRAs, you do not receive an income tax deduction for Roth IRA contributions. For most people, however, I believe that this is a small price to pay for not having to worry about future income taxes at withdrawal. Income tax rates are currently low by historical standards. With growing government deficits, income tax rates could easily rise in the future, even if your level of taxable income decreases during retirement.

For those of you who may not need the money in your Roth IRA account during your lifetime, the Roth IRA has even more benefits. Unlike 401(k)s and Traditional IRAs, there are no required minimum distributions for Roth IRAs during the life of the account owner, even past age 70½. So, you can have your Roth IRA account grow income tax-free for your entire life. If your spouse inherits your Roth IRA account, he or she can treat the Roth IRA account as his or her own account and allow it to continue growing income tax-free during the life of the surviving spouse.

So, how do you get money into a Roth IRA account? If you have taxable earned income and your Modified Adjusted Gross Income is under certain limits, you can contribute directly to a Roth IRA even if you participate in your employer’s retirement plan. If your employer’s 401(k) plan allows, you can designate 401(k) elective deferrals as designated Roth 401(k) contributions. After you change jobs or retire, you can roll over the designated Roth 401(k) portion of your account into a Roth IRA. You can convert a Traditional IRA into a Roth IRA and pay income tax on the conversion amount. If your employer’s 401(k) plan allows, you can do an in-plan Roth conversion. Finally, when you leave your employer, you can roll over any pre-tax qualified retirement plan amounts (e.g., a regular 401(k) account) into a Roth IRA; this will be treated like a Roth IRA conversion, and you will need to pay income tax on the converted amount.

Roth IRA/401(k) – Better Than Tax Deferral

One common piece of investment advice is to defer investment related income taxes whenever possible, especially through the use of 401(k) and Traditional IRA accounts. The underlying concepts are (1) your tax-deferred account will grow faster than otherwise because investment related income taxes are deferred until withdrawal and (2) you will receive current income tax deductions for your contributions, which you can invest in addition to your tax-deferred account. Some financial advisors take this concept even further and recommend that investors also use variable annuities after maximizing contributions to 401(k)s and IRAs to defer additional investment related income taxes.

I believe that maximizing “tax-deferred” investment accounts is not the best advice for many if not most people. It is true that 401(k) and Traditional IRA accounts grow tax-deferred, but your eventual income tax liability also grows. For example, let’s say that you contribute $1,000 into a Traditional IRA at age 35 and that it grows at 5% a year for the next 30 years. Then, by age 65, your $1,000 contribution will be worth $4,322. If you withdraw this entire amount at age 65, you will have to pay ordinary income taxes on $4,322 of income. This tax liability may not be too burdensome if you took your income tax savings from your $1,000 contribution and invested it consistently for 30 years. I wonder, however, how many of us really think, “I saved $300 in income taxes on my $1,000 IRA contribution so I had better invest that $300 carefully and consistently until retirement.” I believe that most of us do not bother to calculate our income tax savings on 401(k) or IRA contributions much less actually invest it.

The other issue with tax-deferred investment accounts is that it converts long-term capital gains into ordinary income for income tax purposes. Some of your investment return is from capital appreciation. If you have long-term (i.e., longer than one year) capital gains within a taxable account, it is taxed at favorable long-term capital gains tax rates under current law. If you have long-term capital gains within a tax-deferred account, it is taxed at less favorable (for most people) ordinary income tax rates at withdrawal.

I am not suggesting that 401(k)s and Traditional IRAs are all bad. If your employer’s 401(k) plan offers employer matching contributions, you should try to contribute at least enough to receive the maximum employer matching. This is what is called “free money.” Beyond that, however, I believe that most people should maximize contributions into a Roth IRA or Roth 401(k) account before making further contributions to a tax-deferred account. With a Roth account, you do not receive an income tax deduction at contribution, but the account grows tax-free (not just tax-deferred) as long as you wait until age 59½ before making withdrawals and meet certain other requirements (e.g., the five-year rule). So, if you were to contribute $1,000 to a Roth account at age 35 and it grows to $4,322 by age 65, you can withdraw the entire $4,322 at age 65 without paying any income taxes on the withdrawal.

There are several ways to get money into a Roth account:

  1. Roth IRA Contributions. You can contribute to a Roth IRA if you have taxable earned compensation (e.g., W-2 income or self-employment income) and your Modified Adjusted Gross Income is under certain limits. The maximum that you can contribute to a Roth IRA is $5,000 per year ($6,000 if you are age 50 or older). Being an active participant of an employer retirement plan does not affect your ability to contribute to a Roth IRA.
  2. Roth 401(k) Contributions. The IRS allows, but does not require, 401(k) plans to allow employees to designate their elective deferrals as Roth contributions. Many 401(k) plans now allow designated Roth contributions; so, check with your employer’s benefits department. Only employee elective deferrals (up to $17,000 a year or $22,500 if age 50 or older) can be designated as Roth. Employer matching contributions must be pre-tax (i.e., non-Roth).
  3. Roth IRA Conversion. If you have money in a Traditional IRA, you can convert some or all of the account into a Roth IRA. You will have to pay ordinary income taxes on the conversion amount in the year of conversion.
  4. 401(k) In-Plan Roth Conversion. The IRS allows, but does not require, 401(k) plans to allow employees to convert pre-tax amounts in their 401(k) account into a designated Roth 401(k) account in the same plan. The IRS has restrictions on the types of contributions that can be converted into Roth; so, check these rules carefully. As with a Roth IRA conversion, you will have to pay ordinary income taxes on the conversion amount in the year of conversion.

Year-End Financial Checklist

Can you believe that today starts the final month of 2011? Around this time of the year, many newspapers and magazines publish articles about year-end tax planning. While year-end is certainly a good time to do tax planning, it is also a good time to take stock of your financial situation and think about broader financial issues. The following are some things that you may want to consider. I will also throw in a couple of my favorite year-end tax tips as well.

  1. Evaluate your financial goals. Is buying a house one of your goals? If so, do you know how much income and savings you need to buy a home without jeopardizing your other financial goals? What if your goal is to get out of debt? Do you know how much debt you have right now? Do you have an action plan to accomplish your goal? Do you see the pattern? Get information. Make a plan. Execute the plan.
  2. Analyze your spending and saving patterns. Different people may have different goals, but many of these goals have one thing in common. You must save money to accomplish them. Do you know your average monthly spending? Can you estimate the recurring expenses that do not occur every month or every year, such as insurance premiums, home renovation costs, and automobile purchases? Do you know what percentage of your income is being saved? If you answered “no” to any of these questions, then now is a good time to get organized.
  3. Are you missing any necessary insurance policies? Do you rent an apartment but have no renters insurance? Do you have a sizeable net worth but no personal umbrella policy?
  4. Check every beneficiary designation. Life insurance policies and retirement accounts have beneficiary designations. You can also add beneficiary designations to regular bank and investment accounts through pay-on-death or transfer-on-death provisions. Check every beneficiary designation, especially if your family situation has changed recently (e.g., getting married, having children). These beneficiary designations override any provisions in your will.
  5. Contribute to a Roth IRA if you are eligible. Contributing to a Roth IRA is an excellent way to invest for retirement. Assets in a Roth IRA grow tax-free as long as you meet certain requirements when you withdraw the funds. You can contribute to a Roth IRA as long as you have earned compensation (e.g., wages or self-employment income) and your modified adjusted gross income (“MAGI”) is below certain limits. If you are single, you can contribute up to $5,000 to a Roth IRA if your MAGI is less than $107,000. If you are married, you and your spouse can each contribute up to $5,000 to Roth IRAs if your joint MAGI is less than $169,000. The $5,000 limit increases to $6,000 for those age 50 and older. You can contribute to a Roth IRA even if you participate in a 401(k) plan at work. You can make a Roth IRA contribution for tax year 2011 any time before April 15, 2012.
  6. Consider a Roth IRA conversion. If you are in an unusually low tax bracket this year (e.g., due to a break in your career or going back to school) and you have some extra cash to invest for retirement, then consider converting some of your Traditional IRA assets into a Roth IRA. You will have to pay regular income tax on the conversion amount, but that might be a good opportunistic investment if you are temporarily in a low tax bracket. Be careful, however, that the conversion does not push you into a higher tax bracket. Also, make sure that you have cash outside of your IRA to pay the income tax due on conversion. The deadline to make a Roth IRA conversion for tax year 2011 is December 31, 2011.

Are You Investing Tax Efficiently? Your 1040 May Have the Answer

If you have invested in the stock market during the past few years, it may feel like the day-to-day movements of the stock market are out of your control. The stock market goes up one day or down another day based on various news and data that is released each day. No one can consistently predict the short-term movements of the stock market. There is one very real aspect of investing, however, where the investor wields a substantial degree of control: income taxes. Let’s take a short guided tour through your federal income tax return (IRS Form 1040) to see if you are investing tax efficiently.

Form 1040 Schedule B. Schedule B is used to report interest income and ordinary dividends. Does your Schedule B Line 1 include any interest income from taxable bonds? Does your Schedule B Line 5 include any ordinary dividends from bond or REIT mutual funds, where such dividends are not included in Form 1040 Line 9b as qualified dividends? If you answered yes to either question, consider placing these bond or REIT investments in your Traditional IRA or 401(k). If you currently own stock funds in your Traditional IRA or 401(k), sell the stock funds in these tax-deferred accounts and buy them in a taxable account. This will make space for the bond or REIT funds in your tax-deferred accounts. For most investors, it is preferable to hold bond or REIT funds in a tax-deferred account because these funds are generally less tax efficient than stock funds and benefit more from the tax deferral feature. If you must hold bonds in a taxable account and are in a high income tax bracket, consider tax-exempt bonds.

Form 1040 Schedule D Lines 1 or 8. Schedule D is used to report realized capital gains and losses. Are you reporting any capital gains on Schedule D Line 1 or Line 8? If so, investigate the source of such capital gains. A taxable capital gain is triggered by selling an investment at a price that is greater than the cost basis of the investment. This may sound like a good thing from an investment perspective, but from a tax perspective, it is better to defer realizing gains as long as possible. Sometimes, there are legitimate reasons for incurring capital gains, such as diversifying a concentrated stock position or replacing high-cost mutual funds with low-cost index funds. If you are trading frequently, however, in search of the next hot stock or mutual fund, consider investing in index funds instead. Not only is there a good chance that the index fund strategy will beat your previous strategy, but you will end up with a lower tax bill.

Form 1040 Schedule D Line 13. This line is entitled “capital gain distributions.” Is there a number greater than zero on Schedule D Line 13? If so, is the capital gain distribution coming from an actively managed mutual fund? If you own shares of a mutual fund that generates a capital gain within the fund, it is required to pass along that gain to you so that the IRS can tax you. The distributed gain shows up on Line 13 – not a good thing from a tax perspective. As you may have guessed by now, it is better to defer gains as long as possible within the fund. In general, actively managed mutual funds generate capital gain distributions far more frequently than index funds because actively managed funds trade more frequently. Some exchange traded equity index funds have never distributed taxable capital gains in the history of their existence (this is good!). Consider replacing your actively managed mutual funds with index funds.

Form 1040 Schedule D Lines 6 or 14. Do you show a number other than zero on Schedule D Line 6 or Line 14 (capital loss carryover)? If not, you are probably not using a strategy called tax loss harvesting. Here is how it works. Say you own a large-cap equity fund that tracks the S&P 500 index. You purchased it many years ago for $50,000. Now it is worth $30,000. You sell the S&P 500 fund at a long-term capital loss of $20,000. In order to maintain your exposure to large-cap equity, you use the $30,000 in sale proceeds to purchase immediately a large-cap equity fund that tracks another large-cap index, such as the Russell 1000. If you repurchase the same S&P 500 fund within 30 days of selling it, the IRS will not allow you to claim the capital loss, but you are allowed to purchase a similar but not “substantially identical” fund and still claim the capital loss. What is the net result? You have $20,000 in capital losses that can be used to offset any other capital gains that year. If you do not have any capital gains that year, you can use up to $3,000 of the capital loss to offset any other taxable income, such as wages, interest, and dividends. The remainder of the loss can be carried forward to future years indefinitely. In this example, if you have no other realized gains or losses that year, $17,000 ($20,000 minus $3,000) of the capital losses would be carried forward to the subsequent tax year and be reported on the subsequent tax year’s Form 1040 Schedule D Line 14. There is one caveat. You may incur transaction expenses in buying and selling funds. So, it is not a good idea to conduct tax loss harvesting trades too frequently.

As you can see, there are many strategies for managing your investment related income taxes. Use the tax law to your advantage to enhance your after-tax investment returns.