Many investors in their 50s, 60s, and beyond have managed to accumulate a lot of money in tax-deferred retirement accounts such as 401(k)s, 403(b)s, and individual retirement accounts (IRAs). All that tax-deferred money will be fully taxable as ordinary income when it is withdrawn by the account owner. If any funds are withdrawn before age 59 ½, in addition to any applicable federal and state income taxes due, a 10% penalty tax will also be applied, unless the withdrawal meets a small list of exempt transactions.
An investor might reasonably ask, “Why would ALL of my IRA, 401(k), or 403(b) money be taxed as ordinary income, as if I am still working, when I have held this stock or mutual fund for years and should receive more favorable long-term capital gains treatment?”
Well, the deal we all made with the government when we contributed dollars to an IRA or qualified retirement plan was that we received a tax break at that point, and the money grew tax-deferred for what could be, in many cases, decades.
So, when any and all dollars come out of these tax-deferred accounts, that tax deferral ends, and every single dollar is taxed as ordinary earned income. If someone in their 60s or early 70s does not need to tap these accounts for income or expenses, they can let all that money continue to grow tax-deferred, but upon reaching age 73, they’ll be forced to start withdrawing at least a small amount from these accounts and start paying taxes—regardless of whether they even need or want to make a withdrawal. These are called Required Minimum Distributions, and if the person has a large amount of money in these accounts, even the small percentage withdrawal forced by IRS rules could incur a large tax bill—perhaps a lot larger than expected.
A powerful retirement planning strategy is to shift some of this tax-deferred money over to an account that is tax-free every year and forever. This account is called a ROTH IRA, and the process of shifting or moving funds to these tax-free-forever accounts is called a ROTH Conversion.
If someone moves a large amount of accumulated money in these tax-deferred accounts to tax-free ROTH IRA accounts, through a series of ROTH conversions over the years, the end results can be stunning—lots of tax-free income, tax-free growth, and a tax-free legacy for loved ones!
However, there are some costs and steps to be aware of before you pursue this very powerful tax planning strategy. In the video below, we walk you through this process in plain English. Please contact us at New Century Planning Associates with any questions.