Roth IRA: A Tax-Smart Retirement Strategy
Courtesy of: Jared O’Roak Portfolio Manager, Financial Advisor
Morgan Stanley Wealth Management
The retirement savings that you are working hard to build now will one day become your retirement income. But have you considered the impact that taxes may have on your retirement goals?
Roth IRA: Tax-Free Retirement Income
One approach to minimizing taxes in retirement is to include a tax-free account, such as a Roth IRA, in your portfolio. With a Roth IRA, contributions are made with after-tax dollars—but qualified withdrawals in retirement can be tax-free.¹ While income limits may preclude some investors from contributing to a Roth IRA, anyone can convert funds from a Traditional IRA or employer-sponsored retirement plan to a Roth IRA.
When you convert to a Roth IRA, you pay taxes on the amount converted as ordinary income for that year, rather than when you withdraw the funds in retirement. If you think tax rates will be higher during your later years—or that you may be in a higher tax bracket—you may be better off paying taxes on your retirement savings now so you can benefit from tax-free income in retirement. Additionally, a Roth IRA can serve as a source of tax-free income for your heirs.
Roth Conversions: Short- and Long-Term Tax Benefits
A Roth conversion can provide compelling benefits; the funds will benefit from tax-deferred growth potential and you will create tax-free income for your retirement. Below are some of the advantages a Roth conversion offers.
Create a Source of tax-free Retirement Income
Short-Tern Benefit – If you are concerned about future tax increases or you think that your tax liabilities may be higher in retirement, now may be a good time to convert some of your retirement savings—under today’s potentially lower income tax rates—into a Roth IRA, where they may never be taxed again. (Note that you should have funds available outside your retirement account to pay the income tax liability upon conversion, thereby retaining the greatest future benefit of the Roth IRA.)
Long-Term Benefit – Going forward, you can continue to build your tax-free retirement income each year by making nondeductible contributions to a Traditional IRA annually and immediately converting those contributions to a Roth IRA. Because you will have already paid taxes on contributions prior to conversion and growth would be minimal in such a short timeframe, your tax liability should be minimal.
Minimize Exposure to the new Medicare Taxes …
Short-Term Benefit – Starting in 2013, restored and new Medicare taxes on wages and investment income apply to high income households ($200,000 singles, $250,000 married filing jointly). While converting funds to a Roth IRA will increase your income this year, if you believe you might be in a higher tax bracket next year, converting now may help you manage your income threshold and minimize exposure to these taxes.
Long-Term Benefit – Qualified withdrawals¹ from Roth IRAs are not subject to the new Medicare surtaxes on investment income and wages, making Roth assets attractive to retirees whose other sources of income, such as pensions, Traditional IRAs and proceeds from company-sponsored plans, may push them over that income threshold, exposing them to the surtaxes.
Reduce Estate Tax Exposure and Create a Tax-Free legacy…
Short-Term Benefit – Roth IRAs carry the ancillary benefit of reducing your estate tax exposure, since the funds you use to pay the taxes on the Roth conversion are removed from your estate. This is especially important now, because the estate and gift taxes have risen to 40% in 2013 (from 35% in 2012).
Long-Term Benefits – A Roth IRA can help you create a tax-free legacy for your heirs. There are no restrictions stating when you must stop contributing and start taking withdrawals, so you can leave as much of your money in the account to benefit your heirs as you wish. If tax rates rise in the future, a tax-free inheritance is even more valuable because your beneficiaries will receive the income without raising their individual tax brackets.
By using the “stretch IRA” concept with a Roth IRA, your heirs can extend the tax-deferred growth potential and tax-free income benefits of your Roth IRA over each beneficiary’s own lifetime, again, without raising their individual tax brackets.
A Roth conversion isn’t an all-or-nothing proposition. You don’t have to convert all of the funds in your Traditional IRA or employer-sponsored plan. And conversions in 2013 may be reversed with a “Roth recharacterization” as late as October 15, 2014.
¹Restrictions, penalties and taxes may apply. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted.
If you’d like to learn more, please contact Jared O’Roak at 207.561.2006.
Article by Morgan Stanley Smith Barney LLC. Courtesy of Morgan Stanley Financial Advisor.
Articles are published for general information purposes and are not an offer or a solicitation to sell or buy any securities or commodities. This material does not provide individually tailored investment advice. Any particular investment should be analyzed based on its terms and risks as they relate to your specific circumstances and objectives.
Morgan Stanley Financial Advisor(s) engaged Courier Publications, LLC to feature this article.
Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice and are not “fiduciaries” (under the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise provided in a written agreement with Morgan Stanley. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are encouraged to consult their tax and legal advisors regarding any potential tax and related consequences of any investments made under an IRA.
The appropriateness of a particular strategy will depend on an investor's individual circumstances and objectives.
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