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Year End Tax Planning for Retirement

For most workers, contributing to an employer sponsored retirement plan usually is a good idea. In 2013, since passage of ATRA, making full contributions to plans such as 401(k)s can be an especially valuable tactic for high-income workers who are close to retirement. These contributions reduce gross income and taxable income, thus, decreasing your exposure to all the taxes imposed on people in high brackets. Ideally, you’ll take distributions in a lower tax bracket once you stop working. In 2013, most people can contribute up to $17,500 to 401(k)s and similar plans. If you’ll be 50 or older by December 31, the ceiling is $23,000. Check to make sure you’re contributing as much as your budget permits, up to the annual ceiling. On the other hand, young workers with relatively low incomes might minimize deductible 401(k) contributions for the year, putting in enough to get a full employer match but saving money beyond that for a 2013 Roth IRA contribution by next April 15. All Roth IRA distributions will be taxfree after 5 years and after age 59½.

 Conversion factors

The tax code now contains many income-based tax provisions. For example, individuals with modified adjusted gross income (MAGI) over $200,000 ($250,000 on joint returns) may have to contend with a 3.8% surtax on net investment income. Other provisions take effect at various income levels. Therefore, it can be crucial to avoid going over these thresholds. One way to fine tune your MAGI, AGI, and taxable income amounts is to execute a full Roth IRA conversion at year-end 2013. Any time until October 15, 2014, you can recharacterize (reverse) all or part of that conversion to arrive at precise income levels.

Example 1: Ian Martin has $300,000 in his traditional IRA. In December 2013, he converts the entire amount to a Roth IRA. When Ian has his 2013 tax return prepared, he asks his CPA to determine the Roth IRA conversion with the ideal tax result. Ian’s CPA determines that a $75,000 conversion (25% of the original conversion) will keep Ian and his wife, Alicia, in the 28% tax bracket, which goes up to $223,050 of taxable income on a joint return in 2013. Thus, Ian recharacterizes 75% ($225,000/$300,000) of the amount then in his Roth IRA. That amount reverts to his traditional IRA. The Martins owe $21,000 in tax on the Roth IRA conversion: 28% times $75,000, which they can pay out of non-IRA funds. The Martins avoid moving into the 33% tax bracket; they also may avoid such extra taxes as the 3.8% Medicare surtax and the phaseout of itemized deductions. Meanwhile, Ian has moved onefourth of his traditional IRA to a

Roth IRA. After 5 years and after age 59½, he can take completely tax-free distributions from his Roth IRA, regardless of future income tax rates. Under the tax code, all Roth IRA conversions have a January 1 starting date for the 5-year test. Thus, Ian’s December 2013 conversion will meet that requirement in just over 4 years, in January 2018.

 Divide and conquer

Ian’s plan, as described, is good but could be better. Instead of one $300,000 Roth IRA conversion, he could convert his traditional IRA into multiple Roth IRAs, holding different investments. By converting the losers and letting the winners ride, Ian could improve his results from this socalled “look back” opportunity. Example 2: At year-end 2013, Ian converts his $300,000 traditional IRA into a $100,000 Roth IRA holding domestic stock funds, a $100,000 Roth IRA holding foreign stock funds, and a $100,000 Roth IRA holding bond funds. In early October 2014, his domestic stock Roth IRA is worth $120,000, his international stock Roth IRA is worth $95,000, and his bond Roth IRA is worth $97,000.

Ian’s CPA runs the numbers and says the ideal plan would be for Ian to recharacterize 75% of his original Roth IRA conversion. Thus, Ian recharacterizes the entire international Roth IRA, the entire bond Roth IRA, and $30,000 (25% of the amount originally converted plus 25% of the net income attributable to it) of his domestic stock Roth IRA. By following this plan, Ian avoids paying tax on a $100,000 Roth IRA conversion to hold $95,000 worth of foreign stocks and he avoids paying tax on a $100,000 Roth IRA conversion to hold $97,000 worth of bonds. He winds up paying tax on a $75,000 Roth IRA conversion (75% of his original $100,000 conversion) to hold $90,000 worth of domestic stocks. Eventually, Ian may be able to withdraw that $15,000 in gains, tax-free. That’s the result from this split conversion. If Ian had just one Roth IRA, which grew from $300,000 to $312,000 before a $234,000 recharacterization (75% of the original amount converted plus 75% of the net income attributable to it), he would have paid tax on a $75,000 conversion (25% of his original $300,000 conversion) for a Roth IRA worth $78,000. Ian would have $3,000 of potential tax-free gains, not $15,000. To execute this strategy, you can use any types of different investments in any number of Roth IRAs. Our office can help you calculate the most tax-efficient amount to recharacterize after one or more Roth IRA conversions.

Copyright AICPA

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