Required Minimum Distributions: The Government Wants Their Money!

Required Minimum Distributions, The Government Wants Their Money, James Lange - The Roth Revolution BlogOver the years, I’ve met with many clients who have managed to accumulate small fortunes over the course of their working careers – even though their incomes were never even high enough to put them in the top two or three tax brackets. I call these clients my “savers.” These individuals seem to share one trait – mainly that they simply don’t feel the need to spend money if they don’t have to. Instead, they set the money aside for the times when they absolutely must spend and, more often than not, they spend far less than what they could.

It’s these clients who seem to suffer the greatest shock when they turn 70 ½ and are required to start withdrawing money from their qualified retirement plans. They object, “But I don’t need the money! I just want to leave it sit there in case I need it some day!” And I have to tell them that it doesn’t matter if they need the money or not. The money that they squirreled away in their retirement plans for a rainy day has grown all these years without being taxed, and now the government wants their tax money!

There’s no avoiding the Required Minimum Distribution rules on traditional retirement plans. Failure to take a distribution when required, in fact, will cost you a penaly tax of 50% on the amount not withdrawn. Individuals who hate the RMD rules and have a spiteful streak might enjoy an interesting (and legal) tip presented in Chapter 5 that allows them to take advantage of the withholdings on the distribution to wait until the very last minute to pay the IRS their due, while also avoiding a late payment penalty. They can also learn of a possible way to completely avoid tax on their Required Minimum Distributions – and also a general increase in their tax bracket – by sending their RMD direct to a charity. I encourage everyone, though, to read Chapter 5 so that you have a good understanding of the RMD rules. Later chapters address proposed legislative changes to the rules that may not strike you as being significant, and unless you have a good understanding of how they currently work.

My next post will talk about rolling your old retirement plan to an IRA. There have been a lot of changes in the laws about this, so I hope you will stop back to get a summary of what you can expect.

Happy Reading!

Jim

Jim Lange A nationally recognized IRA, Roth IRA conversion, and 401(k) expert, he is a regular speaker to both consumers and professional organizations. Jim is the creator of the Lange Cascading Beneficiary Plan™, a benchmark in retirement planning with the flexibility and control it offers the surviving spouse, and the founder of The Roth IRA Institute, created to train and educate financial advisors.

Jim’s strategies have been endorsed by The Wall Street Journal (33 times), Newsweek, Money Magazine, Smart Money, Reader’s Digest, Bottom Line, and Kiplinger’s. His articles have appeared in Bottom Line, Trusts and Estates Magazine, Financial Planning, The Tax Adviser, Journal of Retirement Planning, and The Pennsylvania Lawyer magazine.

Jim is the best-selling author of Retire Secure! (Wiley, 2006 and 2009), endorsed by Charles Schwab, Larry King, Ed Slott, Jane Bryant Quinn, Roger Ibbotson and The Roth Revolution, Pay Taxes Once and Never Again endorsed by Ed Slott, Natalie Choate and Bob Keebler.

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Benefits of a Roth IRA

Back Door IRA, James Lange, Pittsburgh, Retirement Planning

There are numerous benefits to converting to a Roth IRA. Please remember, it is important to review all of your retirement accounts before converting to a Roth IRA. Some benefits of a Roth IRA include;

• Required minimum distributions are not obligatory until the participant’s death.

• Withdrawals are tax free.

• They pass onto your heirs income tax-free.

• You can compound your investments in a tax-free fashion.

 

Am I a Candidate for a Backdoor Roth IRA?

Backdoor Roth IRAs can be appropriate for investors who:

  • Only have retirement account through their jobs (i.e. 401k’s) and want to increase their retirement savings in tax-advantaged accounts, but whose income is too high to qualify for standard Roth IRA contributions; and
  • Have the time and ability to wait for five years or until they are 59 ½ to avoid the 10% penalty on early withdrawals. (If you open and make contributions to a Roth IRA in the standard manner, i.e. not through conversion, you are not subject to this rule).

A Backdoor Roth IRA is probably not recommended if you:

  • Are over the age of 70½ and can no longer contribute to a traditional IRA.
  • Don’t want to contribute more than the maximum retirement limit through your workplace retirement account.
  • Already have money in a traditional IRA and because of the Pro Rata rule may end up in a non-tax advantageous position when converting to a Backdoor Roth IRA.
  • Plan or expect to withdraw the funds in the Roth IRA within the first five years of opening it. A Backdoor Roth is considered a conversion and not a contribution. Therefore, the funds will incur a 10% penalty if withdrawn within five years unless you are age 59 ½ or older.
  • Are in a high tax bracket now and expect to be in a lower tax bracket in the future.
  • Plan to relocate to a lower- or no- income tax state.

 

Stay tuned for my next blog post, Recharacterizations and the Conclusion!

Disclaimer: Please note that the Tax Cuts and Jobs Act of 2017 removed the ability for taxpayers to do any “recharacterizations” of Roth IRA conversions after 12/31/2017. The material below was created and published prior the passage of the Tax Cuts and Jobs Act of 2017. 

Want to learn more? Give us a call at 412-521-2732.

– James Lange

 

Beware of the Pro Rata Rule for Roth Conversions

What is the Pro Rata rule for Roth conversions?

The Pro Rata rule for Roth conversions states that if you have any other deductible IRAs (i.e. a previous 401k that you’ve rolled over), the conversion of any contributions becomes a taxable event that you’ll need to pay taxes on upfront.

The Pro Rata rule for Roth conversions determines whether or not your conversion will be taxable! For taxation purposes, the IRS will look at your entire IRA holdings (even if they are in different accounts), not just the traditional IRA you are converting to a Roth IRA, and will determine what your tax bill will be based upon a ratio of IRA assets that have already been taxed to those IRA assets in total.

The IRS determines the tax on this conversion based on the value of all of your IRA assets. For example Jane, a high income earner, already has $94,500 in an IRA account, all of which has never been taxed.  She decides on January 2nd to put $5,500 into a new traditional IRA. The next day she converts the new traditional non-deductible IRA to a Roth IRA.  Jane’s income is too high for her to make a direct contribution into a Roth IRA, but there’s no income limit on conversions.  Unlike Bill she has $94,500 in other IRAs (previously non-taxed), so her total IRA assets are now $100,000. When she converts $5,500 to a Roth IRA, the IRS pro-rates her tax basis on the previous taxation of her total IRA assets, therefore making this conversion 94.5% taxable ($94,500/100,000 = 94.5%).

So if you plan on using this backdoor IRA strategy, you want to be clear as to whether or not you have any other IRAs. As you can see, this can be a confusing area and this is where we can help.  If you are a high income earner we would be happy to review your situation to determine if this strategy is in your best interest.

Also, please remember that your spouse’s IRA is separate from yours.

Stay tuned for my next blog post, Benefits of a Roth IRA!

Want to learn more? Give us a call at 412-521-2732.

– James Lange

Example of a Backdoor Roth IRA

As promised from our last blog post, here is an example of a Backdoor Roth IRA

Bill, a high income earner decides on January 2nd to put $5,500 into a traditional IRA for himself and another $5,500 into a traditional IRA for his wife Mary.  Bill’s income is too high to be able to deduct these contributions from his taxes.

So the next day, he converts the traditional IRAs to Roth IRAs completely tax-free.  His income is too high for him to make a direct contribution into a Roth IRA, but there’s no income limit on conversions!

Since Bill and Mary couldn’t deduct the contribution anyway, they might as well get the advantage of never paying taxes on that money again available through the Roth IRA.

Stay tuned for my next blog post, Beware of the Pro Rata Rule for Roth Conversions!

Want to learn more? Give us a call at 412-521-2732.

– James Lange

 

Backdoor Roth IRAs: How Does the Backdoor Roth IRA Conversion Work?

The backdoor Roth conversion consists of two simple steps:

1)      You make a nondeductible contribution to your traditional IRA.

2)      Within a couple of days you convert this IRA into a Roth IRA (potentially paying little to no taxes on the conversion).

There’s one big caveat: This strategy works best tax-wise for people who don’t already have money in traditional IRAs. That’s because in conversions, earnings and previously untaxed contributions in traditional IRAs are taxed—and that tax is figured based on all your traditional IRAs, even ones you aren’t converting.

For an investor who doesn’t already hold any traditional IRAs, creating one and then quickly converting it into a Roth IRA will incur little or no tax, because after a short holding period there’s likely to be little or no appreciation or interest earned in the account.  However, if you already have money in traditional deductible IRAs, you could face a far higher tax bill on the conversion.

If you choose to, you can contribute to a non-deductible IRA for 2014 (the maximum is $5,500 or $6,500 for those age 50 or older). Remember, you must contribute to your IRAs prior to the April 15 2015 tax deadline. This non-deductible IRA can then be used for your backdoor Roth IRA conversion (please call us prior to doing so because the rules for Roth conversions can be complicated).

Want to learn more? Give us a call at 412-521-2732.

Examples of a Backdoor Roth IRA coming soon.

– James Lange

Backdoor Roth IRAs: A Potential Way for High Income Earners to Participate

The traditional contribution (“front door”) for Roth IRAs is currently not available for higher income earners. Married couples earning $191,000 or more and singles earning $129,000 or more in 2014 are still barred from contributing directly to Roth IRAs.

In 2010, Congress changed the rules and since then anyone can convert a traditional IRA to a Roth IRA. However, higher income earners are still ineligible to contribute to a Roth IRA.

A Backdoor Roth IRA is a strategy for some higher income earners to participate in Roth IRAs.  It is a way for higher income earners to put money into a traditional IRA and then roll that into a Roth IRA, getting all the benefits.  While this strategy sounds simple, there are several rules that you must know and follow to make sure you do not incur unintended tax consequences.  This is where working with a knowledgeable financial or tax professional can provide some great guidance and value.

One of the primary benefits of a Roth IRA is that any money contributed grows tax-free and is withdrawn without any further income taxation. In addition, unlike a traditional IRA, Roth IRAs have no required lifetime minimum distributions. Another benefit of a Roth IRA is it can be passed on to your heirs income tax free. This allows your funds to grow and compound tax free over many years.

Want to learn more? Give us a call at 412-521-2732.

More on this subject in the coming weeks.

– James Lange