One of the key issues facing many retirees today is income taxes. Those who have to pay substantial taxes after they stop working are left with a smaller amount of money to live on than they may have expected, while those who pay little or no taxes can often get by on fairly modest means. The advent of the Roth IRA in 1997 started a mass migration of retirement dollars into tax-free savings accounts that have grown into a major source of retirement funds for many Americans.
Traditional tax-deferred individual retirement accounts (IRAs) and qualified plans have been around since the ’70s, but their tax advantages have some limitations. All money that is withdrawn from these accounts must be taxed as ordinary income, even if any securities that were liquidated inside them were held for more than a year. But the issue of taxation during retirement goes beyond retirement plan required minimum distributions (RMDs) and encompasses many factors.
Your Taxes May Not Be as Bad as You Think
Many middle-class Americans may be surprised to learn that they could owe little to no income tax after they stop working. If their joint income is less than $50,000, then their standard deduction and personal exemptions will substantially reduce their taxable incomes, and what is left may fall into the lowest bracket. Following is an example of how this could work:
Frank and Mary Jennings are both retired and in their upper 60s. Frank receives $2,200 per month in Social Security income and Mary receives $785 per month. Frank also receives $1,100 per month from his company pension, and Mary earns $7,000 a year from a part-time job she works from home. Frank has a traditional IRA worth $150,000 that he rolled over from his company retirement plan. Mary has a contributory Roth IRA worth $40,000, and they have a joint savings account with $10,000 in cash.
Frank and Mary will most likely pay little to nothing in actual taxes when they file. Their pension and earned income is not enough to make their Social Security benefits subject to taxation, and their itemized deductions and personal exemptions will most likely exceed the amount of their reportable income. Of course, at some point, Frank will have to begin taking RMDs from his IRA, which will also count as taxable income, but this may still not be enough to make any of their income taxable. Even if their deductions and exemptions (including any withholdings from Mary's earnings) don't completely eliminate their taxable income, the actual amount of tax owed will likely be minuscule.
Beware of Roth Conversions
Although converting a traditional IRA or qualified plan to a Roth IRA is often a good idea, Frank and Mary would be wise to refrain from doing so in their current situation. If Frank were to convert his entire IRA in a single year, then he would have to pay tax on the entire balance at once at a rate higher than his current tax rate, because the conversion would land the couple in the 28% tax bracket. Then, not only would the couple face a 28% tax rate on their conversion balance, pension and earned income, but 85% of their Social Security income would become taxable as well.
Depending upon various factors, Frank and Mary could conceivably be looking at a taxable income of somewhere around $200,000 before deductions and exemptions. A 28% tax on the net amount could easily be in the neighborhood of $50,000, which would never have to be paid at all if the conversion was handled differently. If Frank wants to convert his IRA to a Roth, he needs to carefully estimate what his income will be for the year and whether he can convert any of it without generating actual taxable income. Of course, if it becomes necessary to take a large distribution from one of their IRAs for any reason, then Mary's Roth account would probably be the best choice for this. If the amount needed exceeds her Roth balance, this account should be depleted before accessing Frank's IRA in order to generate the lowest amount of taxable income possible.
Keeping Income Low
Mary may want to consider giving up her job when Frank starts taking distributions from his account, in order to keep their taxable income at approximately the same level. Or, if their taxes permit her to continue earning some income when Frank takes his distributions, then they may want to contribute Frank's distributions into Mary's Roth IRA. Also, if the couple pays their house off and becomes unable to itemize deductions, then their tax liability may increase.
The Bottom Line
The example in this article illustrates how various factors can come together in determining the amount of tax that you must pay when you retire. Tax problems usually arise when a large sum of money must be withdrawn at once; this is where Roth IRAs have a real advantage over other types of retirement accounts. For more information on how taxes can impact your retirement, consult with your financial advisor.