trapped in an IRA

[jdw_fire]

I would add 3) The ROTH IRA. If I had it to do over, I would have placed much less in tIRAs and 401(k) and put more in taxable accounts instead. I would have maxed out my ROTH contributions as well. Now, in my dotage, I must carefully figure out which pot of money to pull funds from to keep my current AND future taxable income within manageable limits. I'm sure a case can be made for the benefits of tIRAs/401(k) but it isn't as simple as "put all you can into these vehicles". It ain't that simple for most of us. I look at these vehicles as overeating a favorite food. It sure tastes good going down, but...

sure its that simple, here is an outline. step 1) while you are making the big buck you "put all you can into these vehicles" (specifically 401ks and deductable IRAs) to get the tax benefits of these while you are earning at your peak. you also need to save in after tax accounts to prepare for step 2). step 2) retire early and live off the after tax accounts. while you are doing this you will be in very low tax brackets so now you also convert the money in pre tax accounts (eg. 401k) onto a roth IRA (via a TIRA) in a way that provides tax advantage (eg. convert enough to fill your lower tax brackets). you delay taking SS until you are age 70. 1 important rule: you dont convert any at a tax rate higher than you expect to be in at age 70 (after you have started to collect SS and RMDS). your goal here is to convert all pre tax money into a roth before you reach age 70 step 3) when you reach age 70 you start your SS and RMDs (if there is any pre tax money left).

these steps maybe more complicated or vary a bit depending on ur situation but like i said this is an outline.

 

[Coolius]

As this is my first partial year of ER, I calculated that my income was well within the 15% tax category, so I arranged to convert some shares from my Traditional IRA into my ROTH.

The conversion executed flawlessly, but now I have some questions.....

1. In future years, I hope to do this again. But from 2012 on, I have to send in Estimated Federal & States taxes. Must I allow for conversion income in calculating Estimated taxes, or can I wait and pay with my return without penalty?

2. Would such conversions affect ( increase ) Social Security tax by pushing the income beyond earnings limits? This is for future years when I start drawing Soc Sec.

 

[Nords]

1. In future years, I hope to do this again. But from 2012 on, I have to send in Estimated Federal & States taxes. Must I allow for conversion income in calculating Estimated taxes, or can I wait and pay with my return without penalty?

You only have to pay the estimated tax after you incur the liability. So this quarter you go through the IRS flowchart and 1040ES form to determine your estimated taxes as though you are NOT doing a Roth IRA conversion, and make your first payment in April on that low-income assumption.

Then later on in 2012 you surprise yourself by deciding to do a Roth IRA conversion after all. You'd take that change (and that higher income) into account before the next estimated taxes are due. For most taxpayers that's with the Jan 2013 estimated payment.

2. Would such conversions affect ( increase ) Social Security tax by pushing the income beyond earnings limits? This is for future years when I start drawing Soc Sec.

If you did a Roth IRA conversion while also receiving Social Security benefits then yes, your income would probably exceed the threshold of SS taxation. However if you're old enough to be receiving SS benefits then you're possibly also old enough to just take an IRA withdrawal and able to delay SS benefits for a few more years.

 

[FUEGO]

It might be interesting to have a poll to figure out how common non-deductible traditional IRA contributions are for folks on this forum.

Just based on a quick back of envelope calculation, I would say the great majority of people at large qualify for fully deductible IRA contributions, and even though active posters on this forum are probably higher earners than the average, I bet the majority of posters here are still eligible to fully deduct IRA contribs (of the traditional variety).

Our US average household income for a married couple is something like $70,000 per year. Taking the current IRS limits for full IRA deductibility for a married couple at around $91,000, and assuming this couple maxed out their 401ks as well, they could earn a total of $124,000 ($91000+$16,500+$16,500) and still deduct the trad IRA contribution in full.

We have only had 1 year during our working careers during which we were not eligible to fully deduct the IRA contrib, and we were still able to deduct about half of the limit IIRC (and contribute remainder to Roth).

 

[GrayHare]

Of course it's not just income level that can limit IRA contrib deductibility, but also participation (or spousal participation) in a retirement plan at w*rk.

 

[pb4uski]

I'm late to this party, but I don't see IRAs as a tax trap at all. All of my IRA money will be taxable so I avoided taxes on that income and investment earnings during my working years at 28% to 32.5% marginal tax rates and will be converting from now until age 70 (before I start to draw SS) at 0% (or 15%). I wish there were more tax traps like this available to me when I was working.

BTW, I never saw the merit to non-deductible IRAs - that already taxed money goes into my taxable investment accounts which are mostly equities.

 

[GrayHare]

Per kaneohe's suggestion, below I've recalculated the same scenarios altered only to allow payment of taxes from another source so that the $100k of contribs are not reduced by tax. The other source has $30k of outside-tIRA funds. The outside funds are invested so as to be subject to capital gains tax only.

1) If all IRA contribs are pre-tax, then all $100k goes into IRA, and full $30k remains outside. In 40 years
the IRA grows 4x to $400k, and the outside to $120k. The $400k less 30% tax of $120k leaves $280k, and the outside fund gain of $90k is subject to 15% CG tax of $13.5k, leaving $106.5k This total after tax is $386.5k.

2) If half of IRA contribs are after-tax dollars, IRA is funded with $50k pre-tax and $50k after-tax, $100k total, but the outside fund is tapped to pay the $15k tax on the $50k of after-tax IRA contribs, reducing that fund to $15k. In 40 years the IRA grows 4x to $400K and the outside fund to $60k. In the IRA, only $350k is subject to 30% tax of $105k, leaving $295k. The outside fund gain of $45k is subject to 15% CG tax of $6.75k, leaving $53.25k. This total after tax is $348.25k.

3) Instead, keep same $100k outside IRA, pay the 30% tax from the $30k outside fund, reducing it to $0. Invest in a buy-and-hold growth stock investment. In 40 years it grows 4x to $400k. Of that, $300k is subject to CG tax, so pay 15% CG tax of $45k, leaving $355k after tax.

With this approach, the outside buy-and-hold growth stock investment of scenario #3 does better than the IRA of #2. Updated Conclusion: tIRAs are a trap if 1) funded with after-tax dollars, and 2) one's ordinary tax rate will not go down post-FIRE. Many people made after-tax contribs before Roth was invented, and some may still be doing so due to lack of eligibility. tIRAs holding after-tax dollars are candidates for Roth conversion.

 

[FUEGO]

Of course it's not just income level that can limit IRA contrib deductibility, but also participation (or spousal participation) in a retirement plan at w*rk.

The income thresholds I quoted where deductibility of IRA contributions are limited assume both spouses are eligible to contribute to a 401k. I think you will find that a large slice of people are eligible to fully deduct IRA contributions and that only a relatively small proportion of high income earners are not eligible to deduct. For that small proportion, they are probably better off with a roth than a non-deductible traditional.

But to characterize deductible traditional IRAs as a trap somehow is certainly misleading for the large majority who are eligible to contribute to them.

 

[RetireBy90]

I think one important point is that you need to feed the beast, that is your retirement funds. The level of contributions can be more important than the vehicle. I agree you need to look at where you put cap gains and bonds, but first is feed your plan.

2nd, I find it much easier to leave the IRA and 401K funds alone than outside investments. Couple times I have snatched some cash from my cash stock account but never touched any of the funds from retirement accounts. Maybe this is just my problem. I'm not as disciplined as I should/could be.

3rd, I really wonder how many folks will really be in a higher income bracket after retirement than while W*rking. I am at my earnings peak now (at 55 with 4 left) so I should be making pretax investments, and with drawls at a lower rate later. Once SS kicks in (12 years) and tax rates go up to fix our problems, then I may rethink. But I'm making both trad 401k and roth 401k contributions so I'll have some options.

 

[REWahoo]

I think one important point is that you need to feed the beast, that is your retirement funds. The level of contributions can be more important than the vehicle.

+1

Just showing up is more than half the battle.