Taxes take their toll on IRAs. There are strong incentives to pack money into IRAs and other qualified retirement plans during the accumulation years. Yet, there’s a downside. In the distribution years the taxes can be high. Think of the taxes as the mortgage on your IRA. The government lent you money during the accumulation years by deferring taxes on your contributions and earnings. You pay the loan back, with interest, by paying taxes at ordinary income rates on the distributions.
The taxes are especially irritating to people after age 70½ when they are required to take minimum distributions, especially when RMDs exceed a person’s spending needs. Taxes also are a problem when IRAs are inherited and beneficiaries receive less than an IRA’s value because of income taxes.
Yet, IRA owners can reduce the lifetime taxes on IRA distributions by planning and acting early.
One point to consider is that sometimes it makes sense to pay taxes now instead of later. For some people, perhaps many people now, tax bills will be higher in the future. This is especially true with IRAs, because by paying taxes now you shelter future gains and income from being later subjected to ordinary income taxes and a forced distribution schedule. Consider these strategies to reduce future taxes on IRAs or defer the taxes as long as possible.
? Convert a traditional IRA to a Roth IRA. Paying taxes now can result in a lifetime, or more, of tax-free income for you and your heirs. Conversion isn’t for everyone. We covered the factors to consider in detail in past visits, and these area available in the IRA Watch section of the Archive on the members’ web site. The latest discussion was in the November 2010 issue.
Succinctly, a conversion can make sense when you can pay the taxes from assets held outside the IRA, won’t need to take significant withdrawals for about 10 years, and don’t expect that when distributions are made you’ll be in a lower tax bracket than now. You also need to consider the effect of the conversion on your Medicare premiums, Social Security benefits, and other tax factors. Including the converted amount in gross income could increase taxes by pushing you into a higher tax bracket, triggering income limits on tax benefits, and increasing Medicare premiums.
For the right taxpayers, an IRA conversion pays well over the long term. The most likely candidates are younger IRA owners and those who won’t need their IRAs as the primary source of retirement income.
? Empty the IRA. The analysis is similar to that for converting an IRA to a Roth IRA, but some people find this strategy more flexible than the conversion. You take a distribution of all or most of the IRA and include the amount in gross income, paying income taxes on it.
There are a range of actions you can take with the after-tax balance that might provide additional after-tax wealth for you and your heirs. For example:
? You can invest the balance in tax-wise strategies that generate long-term capital gains and qualified dividends taxed at the maximum 15% rate under today’s law. Over time, this generates more after-tax wealth than leaving the money in the IRA and paying ordinary income taxes when it is distributed.
? Purchase life insurance with the proceeds. The insurance benefit is tax-free to your heirs and likely will be more than the IRA was worth or would have accumulated to after taxes. Remember, when your heirs inherit an IRA they pay income taxes on all the distributions they take. They receive only the after-tax amount, not the face value. Life insurance benefits, on the other hand, are tax free. They’ll escape income taxes when the policy is owned by an irrevocable life insurance trust or you use some other strategy that keeps the policy out of your estate.
? Establish a charitable gift annuity. Give the IRA proceeds to a charity in return for lifetime payments to you and your spouse. The payments will be less than those from a commercial annuity, but you’ll receive a tax deduction for the difference, and that deduction will reduce the taxes on the distribution from the IRA. We discussed charitable gift annuities in detail in last month’s Tax Watch.
? Make charitable gifts from the IRA. We discussed in the past how it can be better to give from the IRA instead of other assets. You take the required distribution from the IRA and include it in income. Then, you make gifts to charity equaling the distribution. You can take more than the RMD to make the gifts. If you want to wait to make gifts through your estate, designate charity as the beneficiary of the IRA instead of family members. Let your family members inherit your non-IRA assets.
If you’re charitably inclined anyway, these are better ways to give, because they should lower your overall tax bill and increase after-tax cash.
RW June 2012.
Log In
Forgot Password
Search