Q. We are in our early 60s and of modest means but are financially secure because we have modest wants and were good savers. Our kids and their families are doing very well. We will leave them our house but the rest of our assets will probably go to charity. We converted some traditional IRA money to Roth IRAs for the first time this year because we pay taxes at low rates but we are second guessing whether that was smart because the government seems to mismanage tax revenue. What do you think about our situation? — R.R.
A. I think your situation is enviable. Congratulations. As for the wisdom of the Roth conversions, I can see it both ways.
Generally, converting traditional IRA moneys to a Roth IRA is a good move if the tax rate paid at the time of the conversion is low relative to the rate that would need to be paid later. Paying tax at say, 15% now is better than paying at 25% or more later.
We can usually estimate the tax bill on a conversion with great accuracy. If you find that you converted too much and your tax bill is higher than estimated, you can unwind a conversion by "recharacterizing.” You have until Oct. 15, 2013 to recharacterize a conversion made in 2012.
It can be much harder to estimate a future tax rate with the precision we can apply to the current tax rates. To get a good idea of what the future rate may be, we look at the tax situation of the ultimate recipients. Even with the little I know about you I see several possibilities.
Even though you are in a low tax bracket now, you may not be paying at such low rates in the future. At age 70 1/2, required minimum distributions (RMD) from IRAs and other retirement accounts begin for you. If the projected RMDs will push you into a higher tax bracket, this condition favors a conversion. By converting, the RMD at age 70 1/2 will be lower because less will be in the traditional IRA than if no conversion occurred and Roth IRAs are not subject to RMDs under these circumstances.
Further, when one of you passes away, the survivor will no longer be filing a joint return in future years. It takes a taxable income of $72,501 for a married couple filing jointly to get out of the 15% bracket and into the 25% bracket but only $36,251 for a single to begin paying federal income taxes at that 25 % rate.
You indicated that all but your house could be going to charity ultimately. Qualifying charities are tax exempt. Naming a charity as beneficiary on your IRAs makes converting much less attractive. Converting means you will pay taxes now when no taxes would have been paid later by the charity. When the future tax rate payable is lower than the current rate, converting to a Roth is a poor strategy.
Conversely, if you do opt to leave some traditional IRA moneys to your children, it sounds like they could be in a higher income tax bracket than you. If keeping it in the family becomes important, their high incomes point in favor of conversions to a Roth IRA.
Q. With interest rates so low and our stocks doing so well, we are considering moving some of my bondholdings into dividend paying stocks. What do you think about that? — F.G.
A. I am not a fan of this rationale. Dividend paying stocks are just that — stocks and not bonds. Dividend payers are subject to getting hammered by market forces like any other segment of the stock market. Take a look at the behavior of exchange-traded funds and mutual funds that focused on dividend paying stocks during the 2008-2009 period. They were no safe haven. Good quality bond funds on the other hand did exactly what you would hope they would. They held their value.
Now, if you were contemplating increasing your stockholdings generally, I would say having a fair portion of the stock portion in dividend payers is a good idea. However, moving money into stocks because stocks have been performing well lately is asking for trouble. Chasing what is hot is a notoriously bad way to make money long term.
Q. We are being pitched a variable annuity on the premise that by lowering our taxable income, less of our social security will be taxable but I am skeptical. What is your take? — P.J.
A. It is true that the amount of your social security that is taxable is a function of your income. Take half your Social Security payments and add that to your income from all other sources, even tax-free municipal bonds. If the total exceeds $25,000 for a single or $32,000 for a married couple filing joint returns, some portion of your Social Security will likely be subject to federal income taxes. At the most 85% of Social Security payments will be taxable if the total exceeds $34,000 for a single person or $44,000 for joint filers. For more detailed information see IRS Pub 915 .
Earnings from an annuity contract are not included in your gross income until those earnings are withdrawn. So it is possible that putting your savings into an annuity could lower your taxable income enough to reduce or eliminate tax on your Social Security. However, annuities only defer taxable income.
As soon as you or your spouse or your heirs take a withdrawal, earnings will be taxed at ordinary income-tax rates. You may be trading short term relief for a longer term problem. Generally, if you can get your income low enough to decrease the taxable portion of your Social Security, you are in a low tax bracket already.
Heck, long-term capital gains, something you would hope would result from investing in any variable product, are taxed at 0% until the 15% bracket is used up, then capped at 15% until taxable income reaches $400,000 for a single $450,000 for married couples. All ordinary income-tax rates are higher than long term capital gains rates at corresponding income levels. See the above question on Roth conversions for a primer on strategy regarding relative tax rates.
The details of your situation are important. How much of your savings would need to go into the annuity to get you under the income thresholds for taxing Social Security mentioned above? All of it? Forget that. The thresholds listed are not adjusted annually for inflation. How long would you be able to stay under the thresholds and still pay your bills and enjoy retirement? If you couldn't stay below those amounts for long, the most likely person to profit from all this may be the salesperson.
Annuity contracts can be sold with various guarantees other types of investments do not possess but remember none of those features are free so don't be dazzled by such promises. Even if the strategy of using an annuity to get less Social Security taxed makes sense, buying a particularly costly contract can undermine the strategy and the effectiveness of the product severely. You may face restrictions and fees that complicate your situation a great deal.
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