Year-End Retirement Tax Planning

November 23, 2016

Many people save money for retirement in a traditional IRA. The funds might have come from annual IRA contributions, or from rolling over an employer sponsored retirement account such as a 401(k). Either way, the dollars in your traditional IRA  are probably pretax, so they’ll be taxed on withdrawal.

You can leave the money in your traditional IRA for ongoing tax deferral. However, you might need cash now, especially if you’re retired or have had unexpected expenses. In another scenario, you may expect your traditional IRA to be extremely large by the time you reach age 70½ and RMDs begin. Those RMDs might be so large that they’ll be heavily taxed in a high bracket.

Therefore, you might want to take withdrawals from your traditional IRA before year-end 2016, so they’ll count in this year’s taxable income. With savvy planning, you can minimize the tax bite by staying within your current tax bracket.

Example 1: Greg and Heidi Jackson’s taxable income last year was $100,000. They expect their taxable income to be about the same this year. In 2016, the 25% bracket goes up to $151,900. Thus, the Jacksons can take as much as $50,000 from their traditional IRAs before December 31 this year, without moving into a higher tax rate. They might withdraw, say,
$20,000 from their IRAs, pay $5,000 in tax at a 25% rate, and have $15,000 left for other purposes.

The right spot

If you’re taking money from a traditional IRA, the best time may be between ages 59½ and 70½. After age 59½, the 10% early withdrawal penalty won’t apply; before 70½, you won’t be subject to RMDs, which will restrict your flexibility about IRA withdrawals.

If you’re younger than 59½, you still might avoid the 10% penalty by qualifying for an exception. Several exceptions are available, including one for higher education expenses.

Example 2: Suppose Greg and Heidi Jackson from example 1 are both younger than 59½. If they take $20,000 from their IRAs this year, as indicated in that example, a $2,000 (10% of $20,000) penalty will be added to their $5,000 (25%) tax bill. However, if the Jacksons pay at least $20,000 in 2016 for their daughter’s college bills, they can take that $20,000 from their IRAs and owe the 25% income tax but not the penalty.

Canny conversions

After withdrawing funds from a traditional IRA at a low tax, un-penalized rate, you can use the after-tax dollars to pay college bills or for living expenses in retirement. If there is no immediate need for cash, you can move the money into a Roth IRA. After five years and age 59½, all withdrawals from a Roth IRA will be tax-free.

Converting traditional IRA money to a Roth IRA will trigger income tax. That might not be a major issue if you’re staying in the 15%, 25%, or 28% tax brackets. However, if you convert too much, you could wind up moving into a higher bracket and paying more income tax than you’d like.

Fortunately, the tax code offers a solution to this potential problem. You can recharacterize (reverse) a Roth IRA conversion, in whole or in part, by October 15 of the following year, and owe tax only on the amount that stays in the Roth IRA.

Example 3: In the previous examples, Greg and Heidi Jackson expect to have around $100,000 in taxable income this year. Their 25% tax bracket goes up to $151,900 in 2016. The Jacksons, hoping to convert as many dollars as possible at the 25% tax rate, convert $50,000 of Greg’s IRA to a Roth IRA by year-end 2016.

When the Jacksons prepare their income tax return for 2017, they learn that their 2016 taxable income was higher than expected. Not including the Roth IRA conversion, their taxable income was $118,500. A full $50,000 Roth IRA conversion would put part of the conversion amount into the 28% bracket, generating more tax than the Jacksons want to pay.

In this situation, the Jacksons could recharacterize enough of Greg’s Roth IRA conversion to wind up with a $33,400 conversion, retroactively. They would use up the full 25% tax bracket while the recharacterized dollars would return to Greg’s traditional IRA, untaxed. If you are interested in this type of lookback fine tuning, our office can help you with a year-end Roth IRA conversion and a possible 2017 recharacterization.

Beyond IRAs

The 2016 contribution limit for 401(k) plans is $18,000 per participant plus $6,000 if you’re 50 or older by year-end. If you are not maximizing your 401(k) contributions and wish to put more into the plan this year for increased tax deferral, contact your plan administrator. Meanwhile, keep in mind that many retirement plans impose RMDs after age 70½. Make sure you’re withdrawing at least the minimum amount, if you’re required to do so, in order to avoid a 50% penalty on any shortfall.