Both earnings within and withdrawals from a Roth IRA are tax free therefore providing maximum tax relief. This remains correct for your Roth beneficiary even though he'll need to make annual minimum required distributions. If that beneficiary is extremely young, the tax-free account growth provides a considerable benefit of a Roth IRA and massive tax savings of his life time. But changing your traditional IRA to a Roth forces you to pay income tax and a big conversion can drive up the tax rates you would normally pay. Here's a tax strategy of how you can keep that conversion tax low.
Most early retirees who're living off taxable accounts and not working produce little income tax if you take into account their exemptions and standard deduction. Making an Individual retirement account to Roth conversion in this illustration below subjects the converted funds to the lower tax brackets. In case you have a really big amount to convert, split it up and convert it over two or 3 years to pay lower taxes.
Let us take an example of a couple that converted a part of their IRA in 2010. As an example, presume a retired couple's income consists only of $14,500 in taxable interest revenue in 2010 -below the level where any taxes are due. They'll incur no taxable income until their AGI exceeds their individual exemptions and standard deduction. For 2010 the standard deduction for a husband and wife filing jointly is $11,400 and their individual exemptions are $3,650 each. So until their revenue exceeds $18,700 (= 11,400+3,650+3,650), they've no 'taxable' income. The couple can absorb another $4,000 in income and pay no tax within their current tax bracket. Now that is significant tax relief! So it would be wise for this couple to convert $4,000 annually of IRA funds to a Roth IRA as they could do so tax free.
The table shows that for 'married filing jointly' (for 2010), the minimum two tax brackets, 10% and 15%, cover the first $68,000 of taxable income and require $9,362.50 of tax for a couple earning that amount. So assuming no other income, $9362.50 would be the least taxation for converting $68,000 from an IRA to a Roth.
For our couple above, they already have $4,000 leftover for tax free income before they're subject to the greater tax brackets and forfeit tax relief from their moderate income. So they may convert $72,000 (= $4,000 + $68,000) of their IRA to a Roth IRA at a tax expense of only $9,362.50. That's a 13% effective tax on their $72,000 conversion.
Over just three years they could convert more than $210,000 of an IRAs to Roth IRAs for just over $28,000 in taxes if they can preserve their tax position. With out this kind of tax planning, they would most likely pay more and lose the considerable tax relief from pre-planning. If you're able to lower your other taxable income for a period of time (e.g. 2-3 years), you may make these conversions inexpensively.
Do not overlook that if you have made non-deductible contributions to a traditional IRA, then these contributions - not the earnings they generated - can be converted to a Roth IRA without taxation. That's simply because without the deduction, you already paid income tax on them in the year you contributed.
The point is this. Many of your financial transactions possess a tax impact. If you understand them, or find some good professional assistance, there is likely some tax relief opportunities available.
|Total Tax for Taxable Income Over the 10% and 15% Tax Rates for Married Filing Jointly (MFJ) Filing Status (2010)|
|Tax rate MFJ||Bracket Range||Range Income||Tax on Range income|
|15%||$16,750 to $68,000||$51,250||$7,687.50|
|Total 10% and 15% taxable income and tax:||$68,000||$9,362.50|
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