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Making Sense of Money

A New Way to Save Tax Free

A New Way to Save Tax Free

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The Federal deficit is rising and Congress is trying to cut the budget, however it is inevitable that taxes will increase sometime in the future.  In a recent article in Fortune Magazine, it talks about a quirk in the tax code that allows high income earners an opportunity to build savings and shelter more of their income from future taxes.  Has Congress gone mad?

Rules

The Roth IRA, a tax-sheltered savings plan, has limitations to keep high income earners from participating in a Roth.  For 2011, single tax filers can make only the maximum Roth IRA contribution if their modified adjusted gross income is less than $107,000; once their income hits $122,000, they can’t contribute at all. For married couples filing jointly, allowable contributions begin to phase out when their combined income reaches $169,000.

High income earners were not eligible for a Roth IRA because of the income limitation; however anyone can open a traditional IRA.  A traditional IRA allows tax-deferred savings as long as you earned income equal or greater than your contribution, and you must be under the age of 70 1/2.  You may contribute up to$5,000 ($6,000, if over 50) per year (2011).  If you are not covered by an employer sponsored retirement plan, your contribution is fully tax deductible.  If you are covered by employer sponsored plan, your deductible amount depends on your income.

Explanation

The major difference between the traditional IRA and the Roth IRA is how it is taxed.  The traditional IRA distributions are taxed when it is withdrawn as ordinary income.  The Roth IRA distributions are federally tax free if you had your Roth for at least five years and you are over the age of 59 ½.  If you are under 59 ½ and had your Roth for at least five years and your distribution is due to death or disability or for a first time home purchase ($10,000 lifetime maximum).

Quirk

The rules are meant to keep the high income earners from taking advantage of the Roth IRA until now!  Prior to 2010, Roth conversions were allowed for single or married taxpayers with modified adjusted gross incomes below $100,000.  There is no dollar limit on the amount of traditional IRAs you can convert, but you will have to pay taxes on the amount converted.  Why would someone want to do this?  They believe they will be in a higher tax bracket when they receive the distributions.

Since most people use a traditional or Roth IRA for retirement savings, you expect to be in a lower tax bracket.  Are there exceptions?  Yes!  You are an executive of a public company with a very rich retirement package with stock, annuity and pension.  High earners who expect to be in a high tax bracket are good candidates for this conversion.  In addition, you may believe that the existing tax brackets will be increased due to the continuing federal deficit.  Whatever your reason, this may be your last chance to take advantage of this quirk.

Epilogue

Why is the government being so nice to rich people?  Do you think the government likes rich people more than the rest of us?  Do you think they did it on purpose to help out their rich friends who contribute to their political campaigns?  Maybe the answer is simpler!  They allowed this loophole so the people with money would convert and pay the taxes now in order to avoid taxes later.  The federal government reaps the increased taxes now and everyone is happy.  Sounds like a win/win!  What do you think?  Are you going to take advantage of this loophole?

Photo by:  woodleywonderworks

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Comments

  1. No way. I still have 20+ years until retirement. Converting to Roth IRA would cut my IRA down almost 30%. That is a huge set back.
    Let’s say I have 100k. If I convert, I would have 72k left.
    If I let the 100k compound at 5% a year, I would get about 265k after 20 years.
    With 72k, I will only have 191k after 20 years. That’s a huge decrease.

    When I withdraw, I can withdraw only a part of that 265k per year to minimize tax. I don’t see an advantage to converting at this point. Am I missing something? If tax bracket shot up, then I can see converting now would be advantageous.

    • I think this is for the few people who realistically will be in a higher tax bracket. For example, the Fortune 500 executive who has multi-million dollar retirement. The also have the funds to pay the taxes too.

  2. I’m not in a position to take advantage unfortunately. My income is within Roth limits, so my account is fully funded, with no traditional IRA to roll-over.

    Just as a side note. I had my photo taken beside the exact same plaque on the Treasury last weekend. I’ll send you a copy.

    • Very few people will be in a higher tax bracket in retirement! This is for them, the rest of us will be earning less.

  3.  We have one of the lowest personal savings rate in the world.  So any incentive to save is a good incentive!  Hey rich or poor, you need to plan for your retirement!

    I’m mad at our government for a lot of things, but this is not one of them!

    • Any incentive to save is good, however this change has limited application! How many average people will be in a higher tax bracket in retirement?