The One-Two Punch of the Roth IRA

It helps retirees reduce pitfalls in the tax code and creates a tax-free legacy.

By Gregory B. Gagne, ChFC, Feb. 2005

The retirement-planning market is on the verge of one of the largest wealth transfers in history. Understanding the planning opportunities will make you a valued member of your senior client’s planning team.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 has created wonderful planning opportunities for the informed advisor. The tax code was enacted back in 1913 and with the tax package of 2003, we are enjoying the “luxury” of some of the lowest tax brackets in our country’s history.

Current tax brackets: (2005 projected)

• 10 percent. Married couples earning less than $14,600 and single people earning less than $7,300 in taxable earnings are taxed in the 10 percent tax bracket.
  
• 15 percent. Married couples who earn less than $59,400 and single people who earn less than $29,700 in taxable earnings are taxed in the 15 percent tax bracket.
  
• 25 percent. Married couples who earn less than $119,950 and single people who earn less than $71,950 in taxable earnings are taxed in the 25 percent bracket.

Here is some food for thought. The government is allocating a huge amount of resources to fight the war on terrorism and the war in Iraq. Our nation’s deficit and debt are reaching epic proportions while at the same time we are enjoying some of the lowest tax rates since the tax code was adopted. Sooner or later, we will have to change either our spending or tax structure. If you believe it is the tax structure, read on.

Retirees have been trained to avoid taking distributions from their IRA portfolios for two primary reasons. First, many are living comfortably on their Social Security benefits and pension incomes. Second, when retirees take money out of their retirement accounts, they must do something they have been trained to avoid—pay income tax on the distribution. Many seniors delay the distribution event until it becomes mandatory at age 70½. (See publication 590.)

This is often a major financial planning mistake. One of the biggest planning mistakes retirees make regarding their IRAs is waiting too long to begin the distribution process. Here’s why. The IRA is tax-deferred, not tax-free. When one spouse dies, the survivor is now forced to file a tax return as a single taxpayer.

Review the brackets for single people as opposed to married couples. Married couples enjoy much wider 10 percent and 15 percent tax brackets compared to single people. In fact, the brackets are cut in half! Many widows and widowers suddenly find themselves in higher tax brackets and pay more income taxes when they become single taxpayers. Unfortunately, this is not a rare occurrence. Finally, upon the survivor’s death, the IRA is often taxed to the heirs at even higher tax brackets.

SOONER OR LATER, SOMEONE IS GOING TO HAVE TO PAY THE TAXES ON THE IRA.

The Roth IRA
With some savvy planning and foresight, you can make the outcome much different. First, review your clients’ tax returns. Many retired clients are in the 0 percent, 10 percent or 15 percent tax brackets. The technique described next works best within categories. Sooner or later, someone is going to have to pay the taxes on the IRA. The question is: Should your clients prepay the tax now at the low bracket rates or delay? Here is one way to find out.

Step 1: If your client is already over age 70½, take the minimum required distribution (MRD) as required by law out of the IRA. If he is under age 70½, proceed directly to step 2.
Step 2: Using your client’s previous year’s tax return as a guide, determine what sources of income were reported and what the taxable income was.
Step 3: With this information, forecast what the taxable income will be for the current year.
Step 4: If your client is “enjoying the luxury” of being in the 0, 10 or 15 percent tax bracket, consider “converting” his IRA assets into the Roth IRA to the extent that the client will remain within these low brackets. You must review the client’s Social Security benefits for inclusion into this calculation. (See Publication 1040 Instruction Manual, page 25, “provisional income.”)

The benefits
The result is that your client will create a tax-free legacy. There will be no required distributions or additional taxes for the surviving spouse. When one spouse dies, a jump in rates is less likely because there is no required distribution to pass through the single person’s bracket. If there is not sufficient time to convert the entire IRA to the Roth IRA, you will still have reduced the IRA value for the MRD calculation.

The Roth IRA provides a one-two punch by allowing the retiree to reduce the pitfalls in the tax code for single taxpayers while creating a tax-free legacy for his family. Understand this technique and you will be a valuable resource for the families you serve.

Gregory B. Gagne, ChFC, is the owner of Affinity Investment Group, LLC, past president of NAIFA-New Hampshire and a member of MDRT. For additional information, contact him at 877-858-8156 or by email at greg@affinityinvestmentgroup.com.