In retirement, taxes change a lot. A source of many of these changes comes from the fact that most retirees are now drawing from their IRAs for income.
Roth IRAs are going to give retirees a triple crown of tax benefits with a proper plan in place for how to use this money!
What are the 2 different types of IRAs?
There are 2 basic types of IRAs. Most people have a traditional IRA.
Traditional IRAs are tax-deferred, meaning you do not have to pay taxes on the money when you put it into the account.
Any withdrawals from a traditional IRA, which cannot start until age 59 ½ without penalty, are counted as current income and taxed accordingly.
Traditional IRAs also have Required Minimum Distributions (RMDs). With recent changes, RMDs are now required to start at age 72. That means when you turn 72, the government is going to make you start taking a certain amount of money out of your IRA. If you don’t, you face a huge penalty.
The government wants their tax money, and RMDs make it so you cannot just use your IRA as a savings account. Even if your plan is to leave the money in a traditional IRA to your heirs, they are going to have to pay the taxes when they inherit it. There is no way to “get out” of paying the taxes owed on the money.
The second type of IRA is a Roth IRA.
Roth IRA’s are different in that they are funded by after-tax money. That means that you pay the taxes before you put money into the account.
Since you pay the taxes up front, the government has less rules around Roths. You do not have RMDs with Roths. You also do not have to count the money that comes out of Roth IRAs as taxable income, since you already paid that tax.
If you leave a Roth to your children, they do not have to pay taxes on that money either. Once you’ve paid the taxes on the money once, you won’t have to do it again.
Having a Roth in retirement comes with many benefits, specifically 3 tax benefits:
Tax-free income in retirement
Like mentioned above, distributions from Roth IRAs do not have to be counted as taxable income since you already paid the taxes on the money in the account.
This means if you are taking a large portion of your retirement income from a Roth, you are likely going to have very little if no taxes to pay in retirement.
Not only is it nice to just not have to pay taxes, but having a low taxable income in retirement means your Social Security and Medicare is not taxed either.
2. Avoid Taxes on Social Security
While up to 85% of your Social Security can be taxed, it is not fun to lose a chunk of your benefit that you’ve worked your whole life for to taxes.
Tax on your Social Security benefit is calculated based on your combined income.
(Combined income = adjusted gross income + nontaxable interest + ½ your social security benefits)
Based on that formula, you can see that what you pay in taxes is really going to depend on how much you are bringing in “other income”. Other income is anything that counts as taxable income on your tax return.
Traditional IRAs count as taxable income, but Roth IRAs do not. Therefore, having the large portion of your savings in a Roth IRA instead of a traditional IRA could save you from having to pay additional taxes on your Social Security benefit.
3.Avoid the Medicare Tax (IRMAA)
Medicare, like Social Security, also has a tax on it for people who earn above a certain level. IRMAA, or the Income Related Monthly Adjustment Amount, puts a surcharge on your Medicare Part B and Medicare Part D premiums.
IRMAA is based on your income from 2 years prior. If you are a single filer in 2020 and make over $87,000 or if you are a married filing jointly filer and make over $174,000 you will have to pay IRMAA.
IRMAA is tiered, so the amount you will pay will depend on what tier you fall into. On the lower end, you could pay about $70 extra per month. On the higher end, you could pay about $500 extra per month.
The best way to avoid IRMAA is to lower your taxable income. Once again, since distributions from a Roth IRA do not count as taxable income, having your money in a Roth instead of a traditional IRA could help you avoid having to pay IRMAA.
Why should I do a Roth Conversion in or near retirement?
When we suggest converting a traditional IRA to a Roth IRA, many people reject the idea right away. It is going to increase their current tax bill and most people just want to push off taxes.
The government is going to get their tax money though, if it’s from you now, you later, or your heirs after you pass. The taxes could also be significantly larger the later you wait. Currently, we are in a time of pretty low taxes.
For most people, we are not going to suggest you move all your money from a traditional IRA to a Roth. We usually leave money in the traditional side, as a small amount of money taken out of this account over many years is not going to significantly increase your tax bill.
We are also not going to suggest that you do this is one large withdrawal. We want to make sure you break up the taxes and pay them slowly over time and in smaller amounts.
For example, if someone has $300,000 in an IRA, we could move over $50,000 a year for 6 years, or even $25,000 a year for 12 years. This does require pre-planning and paying taxes now, but will significantly reduce the taxes you will pay in retirement.
Roth conversions are also a great strategy if you want to leave this money to their heirs, as they will inherit tax free income.
Cardinal can look at your IRAs and see what strategy will work best for your income and your goals. Give us a call today or send us a message!