Do You Have Too Much Money in Your IRAs?

"A Roth IRA is worth more than a conventional IRA because withdrawals from it are forever tax-free..."
-- by Laura Saunders, a senior editor at Forbes Magazine (Quote from Forbes,9/6/99 edition)


A Roth IRA May Take a Smaller Tax Bite

If you expect to be in a higher income tax bracket when you retire (or after age 59½ when you'll have to take required minimum distributions from your traditional IRA), or if you think the future holds higher income tax rates for the country as a whole, it may benefit you to pay the income tax bill now while the bite is smaller. Unlike a traditional IRA which defers the tax until you take withdrawals, a Roth IRA is funded with after-tax dollars. Depending on your situation, your tax rate today could be as low as 10 percent.
In 2006-2007, you can contribute up to $4,000 annually, to a Roth IRA or a traditional IRA ($5,000 for those age 50 and over). In 2008 the contribution limit rises to $5,000 ($6,000 for age 50 and over). Unless further legislation is passed, however, in 2011 those limits will slip back to $2,000 per year.

Deferring taxes to the max is generally a good idea when your personal rates are going down, as they probably have done in recent years. Unfortunately, it's possible that federal income tax rates have bottomed out and will head higher in the future. This means the notion that you'll pay significantly lower income tax rates on withdrawals taken from traditional IRAs during your retirement years could turn out to be misguided.

Another thing to remember is that traditional IRAs impose restrictions on your ability to withdraw money before age 59½ without being hit with a 10 percent premature withdrawal penalty tax. This can prevent you from taking advantage of investment opportunities that cannot be funded with IRA money (such as certain real estate deals).

Perversely enough, you could also be charged a 50 percent penalty tax for failing to take so-called required minimum distributions (RMDs) each year from your traditional IRAs after reaching age 70½. On the other hand, Roth IRAs set up in your name are not subject to the RMD rules for as long as you are alive.

Last but not least, profits earned in your traditional IRAs can never qualify for the reduced federal income tax rates on long-term capital gains and qualified dividends. Instead, all income accumulated in traditional IRAs(including income from capital gains and dividends) will eventually be taxed at higher ordinary rates when you -- or your heirs -- take account withdrawals. Based on the current maximum federal tax rate for ordinary income rate, you could be paying 35 percent.

Bottom Line: For the reasons cited above, some people may be at the point where additional tax deferral is counter-productive. These individuals may be better off using taxable accounts (as opposed to tax-deferred accounts, such as traditional IRAs) to accumulate at least some of their retirement savings dollars from now on. Some individuals who are over age 59½ (and therefore exempt from the 10 percent premature withdrawal penalty tax) might even benefit from taking some voluntary IRA withdrawals now rather than in future years when tax rates might be higher.

One Size Does Not Fit All

Assessing whether you might have too much tax deferral, not enough, or just about the right amount depends on a number of variables such as your current marginal income tax rate, your expectations about future tax rates, the type of income or gains earned in your retirement savings accounts, and so forth.

Each person's situation is different, and there's not always a clear right or wrong answer. However, if you conclude you have too much tax deferral (meaning you're over-exposed to the possibility of higher future tax rates), you may want to consider some or all of the following strategies.

Start making at least some of your annual retirement savings contributions to taxable accounts rather than traditional IRAs. If you're a senior, withdraw money from your traditional IRAs sooner and faster than is necessary to comply with the RMD rules. That way, you pay taxes now at rates that may look quite low a few years later. You can reinvest the after-tax proceeds from IRA withdrawals in taxable accounts with the objective of earning lots of low-taxed long-term gains and qualified dividends. This strategy is most attractive if you would pay only a 10 percent or 15 percent marginal federal tax rate on IRA withdrawals.

Take advantage of opportunities to contribute to Roth IRAs, Coverdell Education Savings Accounts, Section 529 college savings accounts, and health savings account (HSAs). All these accounts can be used to accumulate federal-income-tax-free income. While you might have too much tax-deferral, you can almost never have too much tax-free income. If you qualify, convert some or all of your traditional IRA balances into federal-income-tax-free Roth IRA balances.

Conclusion

Contact your accounting professionals for more information on retirement savings and other wealth accumulation strategies. They can help you determine if you have too much tax-deferral in the form of traditional IRA balances (or balances in other types of tax-deferred vehicles) or not enough. Then they can help you decide on the best tax-smart course of action from now on.

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