Knowledge of Income Tax Rates Reduce IRA tax

In this post, we present a simple example showing how a rudimentary knowledge of income tax rates will help you to pay less IRA tax when you take money out of your IRA. The key concept here is that you are charged income tax in tiers or levels. The higher your income, the higher the tax rate. Therefore, it's important to know how close you are to the next level because often, you will want to take advantage of any room left in the lower level that you're currently in.

Let's take the example of Bill and Linda who are both retired, have large IRAs, and are age 60. Their taxable income will be $40,000 this year (2012).

Current income tax rates extend the 15% tax bracket up to $70,700 for couples filing jointly (see income tax rate tables below). Thus, Bill and Linda could convert $30,700 worth of their IRAs to Roth IRAs this year and fully use up their 15% tax bracket ($40,000 current taxable income plus $30,700 IRA withdrawal = $70,700, the maximum amount of income still taxed at 15%). In other words, they have room left in your 15% bracket which would make sense to use up. If they don't use it up they could quite possibly need to take distributions from their IRA in later years that are larger (because of the required minimum distribution rules) and thus be pushed into a higher tax bracket (25%).

Married Filing Jointly
If the taxable income is:		The tax is:
Over	But not over—		of the amount over—

$0	$17,400	———–10%	$0
17,400 (Bill and Linda's current bracket)	70,700	$1,740.00 + 15%	17,400
70,700	142,700	9,735.00 + 25%	70,700
142,700	217,450	27,735.00 + 28%	142,700
217,450	388,350	48,665.00 + 33%	217,450
388,350	———–	105,062.00 + 35%	388,350

The federal income tax rate on the $30,700 conversion will be 15% or $4,605. And after Bill and Linda hold the Roth IRAs for five years, they can withdraw all of the money tax-free, if they desire. Each year they will repeat the process and continually shift a portion of their IRA to a Roth IRA and do so at the low 15% income tax rate.

If Bill and Linda had waited until they were 70 ½ and subject to mandatory distributions, the withdrawals may well have pushed them into a higher marginal tax bracket, forcing them to pay more taxes because they did not do their tax planning.