I’m not a tax specialist. I have my taxes done by an expert IRS-enrolled agent. Keeping track of tax laws is a full time job and one I'm delighted to outsource.
I do have a tax idea to pass along that sometimes works for retirees. Please discuss this with a tax expert if you’re interested.
Retirees can find themselves in the position of not only owing no federal taxes (because they’re no longer working), but actually having more deductions than they can use. Health care and health insurance costs, for example, can generate far more tax deductions than you might have considered when you were budgeting for retirement.
Health care costs have been the second largest financial shock of my retirement (right after learning that kids don’t actually grow up, go to college and then support themselves, anymore).
This may especially be the case if you’re spending first from your taxable accounts, and thus not generating taxable income from IRA’s and 401(k)’s. You might just find that you have no taxable federal income and, in fact, you have more itemized deductions than you can use.
Here's an example. Joe retired at the beginning of 2013 and paid his living expenses from his taxable retirement savings. $10,000 interest and dividends from his taxable accounts makes up his only taxable income. He has no taxable income from Social Security (he hasn't claimed, yet) and no taxable withdrawals from IRA's or 401(k) accounts.
Joe has $30,000 in mortgage interest and deductible property taxes and paid another $30,000 for deductible medical costs and private health insurance, and of course, exemptions for himself and his spouse.
According to the TurboTax online tax estimator, Joe should expect to report $10,000 of taxable income, $59,250 deductions and $15,600 exemptions. He should expect to pay no federal taxes.
No federal taxes sounds good, but Joe could have had another $65,000 of taxable income and still paid no federal taxes because he has unused tax deductions.
Here's an example. Joe retired at the beginning of 2013 and paid his living expenses from his taxable retirement savings. $10,000 interest and dividends from his taxable accounts makes up his only taxable income. He has no taxable income from Social Security (he hasn't claimed, yet) and no taxable withdrawals from IRA's or 401(k) accounts.
Joe has $30,000 in mortgage interest and deductible property taxes and paid another $30,000 for deductible medical costs and private health insurance, and of course, exemptions for himself and his spouse.
According to the TurboTax online tax estimator, Joe should expect to report $10,000 of taxable income, $59,250 deductions and $15,600 exemptions. He should expect to pay no federal taxes.
No federal taxes sounds good, but Joe could have had another $65,000 of taxable income and still paid no federal taxes because he has unused tax deductions.
Now, you can carry forward capital gains losses and net operating losses to future years when you do owe taxes, but you can’t carry forward unused itemized deductions.
So, how can a retiree make use of all those deductions? By generating more income. And, how do you do that the last week of the year when you didn’t do it for the previous 51?
Convert a traditional IRA to a Roth. The conversion amount will be reported on IRS Form 8606 and claimed as an IRA withdrawal in the Income section near the top of IRS Form 1040. The amount will be taxed as regular income, so the trick is to convert the amount of your IRA account to a Roth account that will be offset by your excess deductions and leave your taxes at zero, or thereabouts.
The TurboTax estimator tells us that if Joe converts $75,000 from his traditional IRA to a Roth IRA, increasing his taxable income from $10,000 to $75,000, he will still pay no taxes. (The estimator says $4, but let's not quibble.)
You don't pay income tax on Roth IRA withdrawals, but traditional IRA withdrawals are taxed as ordinary income. Leave the money in an IRA and you will eventually be taxed when you take it out. The funds you convert to a Roth will no longer be subject to income tax when you spend them and you will have achieved this by paying the current taxes dues on the IRA withdrawal, which, if you do it right, will be zero.
The TurboTax estimator tells us that if Joe converts $75,000 from his traditional IRA to a Roth IRA, increasing his taxable income from $10,000 to $75,000, he will still pay no taxes. (The estimator says $4, but let's not quibble.)
You don't pay income tax on Roth IRA withdrawals, but traditional IRA withdrawals are taxed as ordinary income. Leave the money in an IRA and you will eventually be taxed when you take it out. The funds you convert to a Roth will no longer be subject to income tax when you spend them and you will have achieved this by paying the current taxes dues on the IRA withdrawal, which, if you do it right, will be zero.
The amount you convert doesn’t need to be exact because, should you convert too much, you can undo all or part of the conversion in 2014 with a Roth recharacterization. I suggest you estimate your taxes, guess the amount of excess deductions you will have, and convert that amount or a little more. (You can put money back into your IRA in 2014, but you can’t take out more.)
Let's say Joe converts $75,000 by the end of 2013 but his tax preparer points out another $10,000 in taxable income that Joe didn't realize would be treated as taxable income. Joe can simply put $10,000 back in his IRA through a recharacterization.
Let's say Joe converts $75,000 by the end of 2013 but his tax preparer points out another $10,000 in taxable income that Joe didn't realize would be treated as taxable income. Joe can simply put $10,000 back in his IRA through a recharacterization.
As I said, you can undo all of this in 2014, but the conversion has to be done by the end of 2013 to offset taxes this year.
There are deadlines for the recharacterization, the earliest of which is the day your 2013 taxes are due but this can be extended to October 15.
What happens if Joe only converts $30,000 and finds out after his taxes are prepared next April that he could have converted $75,000? Too bad. You can put converted dollars back after the end of the tax year, but you can't take out more.
Of course, there are many reason to do a Roth conversion, or not to, and retirees aren't the only potential beneficiaries. Maybe you were unemployed for part of 2013, but still had high medical bills and deductible mortgage interest. You still might find yourself with more deductions than you can use.
I can’t say this enough: I am not a tax expert. Roth conversions, like many tax maneuvers, have subtleties that need to be considered. I am not suggesting that you do this, I am suggesting that you might want to discuss this with a tax expert.
You'll have to act quickly to do it this year. You have until close of business Tuesday to convert. It 's pretty easy at websites like Fidelity's. It takes just a few minutes.
Of course, there's always next December.
What happens if Joe only converts $30,000 and finds out after his taxes are prepared next April that he could have converted $75,000? Too bad. You can put converted dollars back after the end of the tax year, but you can't take out more.
Of course, there are many reason to do a Roth conversion, or not to, and retirees aren't the only potential beneficiaries. Maybe you were unemployed for part of 2013, but still had high medical bills and deductible mortgage interest. You still might find yourself with more deductions than you can use.
I can’t say this enough: I am not a tax expert. Roth conversions, like many tax maneuvers, have subtleties that need to be considered. I am not suggesting that you do this, I am suggesting that you might want to discuss this with a tax expert.
You'll have to act quickly to do it this year. You have until close of business Tuesday to convert. It 's pretty easy at websites like Fidelity's. It takes just a few minutes.
Of course, there's always next December.
Happy New Year to all my fellow (and future) retiree readers.
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