Roth IRA's and the hidden federal tax

[Ravensthorpe]

Some people are weighing the pros and cons of a Roth versus a regular IRA, and believing that they will be in a lower tax bracket after they retire, they might avoid investing in a Roth IRA.
However, consider this: even people on a modest income during retirement will have to pay taxes on an increasingly larger portion of their social security benefit for every dollar withrawn from taxable accounts (up to 85% of the SS benefit).
This may result in their "effective" federal income rate being 85% higher than what they might expect. In other words, that 15% rate might effectively be more like 27.75%!!!

 

[Nords]

This may result in their "effective" federal income rate being 85% higher than what they might expect. In other words, that 15% rate might effectively be more like 27.75%!!!

Welcome to the board, Raven, but I think that tax-bracket percentage might be a lot easier to understand if it had some real dollar numbers attached to it... and it might be a good bit lower than 27.75%, too, since those are marginal rates...

 

[LOL!]

This affect of income on social security benefits is often cited as a good reason to have a Roth 401(k). Here are my thoughts with respect to high income folks.

1. High income folks (HIFs) cannot have a Roth IRA anyways because their income is too high.

2. If HIFs choose to contribute to a Roth 401(k) instead of a traditional 401(k), they get hit with a large marginal income tax rate and lose other deductions as well.

3. In retirement, HIFs will get their social security taxed bigtime anyways, so it does not really matter.

4. Folks who retire early will not be drawing SS benefits for many years, so the taxes on SS bennies is moot during that time. They can convert traditional IRA to Roth IRA at a tax rate lower than the marginal tax rate they would've paid on a Roth IRA.

 

[Moemg]

Sorry if this is off the subject .Should I convert my traditional IRA to a Roth IRA .I have half my retirement money in taxable accounts that I would tap first so I probably would not even touch the IRA until the required distributions What would be the benefit of conversion to a Roth ?
Thanks !

 

[firewhen]

Like most people on this board (those who don't have pensions anyway), I will rely on my investments during the period from when I RE until I am eligible for SS. That could be a good 15 years. In that timeframe I will likely sell some investments and pay minimum capital gains, convert IRAs to Roths or make outright withdrawals using 72t and/or at 59 1/2. Having no earned income will give me flexibility to manage my finances and taxes in a way that is difficult now, with relatively high federal rates including the dreaded AMT.

By the time I actually collect SS, and who know what the age cutoff will be then, taxes may be less of an issue. But OP is right that even in retirement taxes are an issue and rates have only one direction to move from where they are now.

 

[Nords]

Sorry if this is off the subject .Should I convert my traditional IRA to a Roth IRA .I have half my retirement money in taxable accounts that I would tap first so I probably would not even touch the IRA until the required distributions What would be the benefit of conversion to a Roth ?
Thanks !

Do a little background reading first and see if any of these situations apply to you.

http://early-retirement.org/forums/index.php?action=search2
(Searches for Nords posts containing the words "IRA" and "conversion")

There's more unbiased info at Fairmark.com.

 

[NinjaPigeon]

However, consider this: even people on a modest income during retirement will have to pay taxes on an increasingly larger portion of their social security benefit for every dollar withrawn from taxable accounts (up to 85% of the SS benefit).

What does this mean?

And LOL hit the nail on the head. I am not eligible to contribute to a Roth. But I can't imagine I'd actually need to replace my current income in retirement anyway, so I'd expect to be in a lower tax bracket than I am now.

As for reasons not to do a Roth conversion, I am planning on marrying a Canadian, and we will probably move there at some point. As I understand it from my research, Canada does not recognize the Roth as a valid retirement vehicle, so they would tax me on it just as if it was a normal, after-tax investment account.

 

[firewhen]

But I can't imagine I'd actually need to replace my current income in retirement anyway, so I'd expect to be in a lower tax bracket than I am now.

You may not need the income, but if I did not RE, I could see paying much higher taxes in retirement. By continuing to work, my portfolio would grow that much faster, and at 65 or whatever, between SS, eventual RMDs and dividends, taxable income could be very great.

 

[LOL!]

Another thing to add: folks with a qualified plan at their job are not eligible for deductible traditional IRA anyways if they make any kind of salary (i.e. "modest income") at all. Thus, they have to go the Roth IRA route. If their salary is low enough that they can have a deductible traditional IRA, they are probably not paying taxes anyways and a Roth is the way to go.

In other words, I think it would be rare thing for someone to have to choose between a traditional IRA and a Roth IRA.

 

[cute fuzzy bunny]

By the time we retire, we'll have half in a roth and half in a traditional. However it works out taxwise we'll split the fence.

Now onto argue discuss whether it should be a 60/40, 70/30 or 80/20 split instead

 

[FinanceDude]

By the time we retire, we'll have half in a roth and half in a traditional. However it works out taxwise we'll split the fence.

That should work.

Now onto argue discuss whether it should be a 60/40, 70/30 or 80/20 split instead

I have my own theories. but they can wait for another day..........

 

[cute fuzzy bunny]

No they cant.

 

[FinanceDude]

No they cant.

Well, I guess it depnds on what percentage is coming from a COLA pension and/or Social Security is it's still around.........

If I take SS out of the equation and figure no pension ( ), then I'm going for 50% of my total liquid assets in ROTH, and 50% in taxable accounts, meaning all my qualified monies would be converted to ROTH before I retire.........

Sounds extreme, but oh well it's my plan...............

 

[CCdaCE]

Well, I guess it depnds on what percentage is coming from a COLA pension and/or Social Security is it's still around.........

If I take SS out of the equation and figure no pension ( ), then I'm going for 50% of my total liquid assets in ROTH, and 50% in taxable accounts, meaning all my qualified monies would be converted to ROTH before I retire.........

Sounds extreme, but oh well it's my plan...............

Based on "The Coming Generational Storm" .pdf , everyones 401k in retirement is gonna get hammered as far as taxes...

Starting on page 232 of the electronic document (page 203 of the book), they go on a tirade about taxes and how all the debt and deficit spending we're in the midst of now, will cause the tax rate for a retiree to be WAY higher.

This is all just one set of assumptions.

I have a better feeling about having assets in a Roth, but we've already argued feverishly over this issue been down this path. I broke my crystal ball.

And what/who's to say "the gov't" can't increase the tax on my Roth directly or indirectly (sales tax) in the future.

-CC

 

[audreyh1]

You may not need the income, but if I did not RE, I could see paying much higher taxes in retirement. By continuing to work, my portfolio would grow that much faster, and at 65 or whatever, between SS, eventual RMDs and dividends, taxable income could be very great.

OK - there are lots of great reasons to RE, but are you seriously REing so you can avoid paying more taxes in the future?

More taxes implies you have much more disposable income after retirement. This is not a bad thing.

Audrey

 

[firewhen]

Audrey,

My problem is just the opposite. Most folks have been trying to convince me to RE, or at least that I can. I was just saying that RE could help with my tax situation. It could help with many other things, like my mental well being. I am just saying that another added benefit of RE is more tax flexibility, although admittedly less total lifetime income. It is that last part that still has me shackled to the paycheck.

 

[FinanceDude]

OK - there are lots of great reasons to RE, but are you seriously REing so you can avoid paying more taxes in the future?

More taxes implies you have much more disposable income after retirement. This is not a bad thing.

Audrey

Best quote I ever heard: "Capital Gains are the Tax you Pay for DOING WELL".......