Jonathan Clark for the Lakewood Observer writes: Part 1 of 2: Layering Tax Efficient Investment Toolsmight be a valuable strategy for portions of your wealth as we look into the future. There are a variety of tools that can lead to some sort of tax efficiency such as: IRAs, Roth IRAs, Roth Conversions, Tax-Free Municipal Bonds, Annuities, and Life Insurance. There is not a tax crystal ball to tell advisors and CPAs what the income tax structure will look like 10 years, 5 years, or even two years from now. What we do know is that we are currently at historically low tax rates and government debt continues to increase. A case can be made that potential tax increases in the future are a strong possibility. With that thought in mind, here are some strategies that in some cases can create tax flexibility in the future.
IRA’s, Pro: During your working years you might be in a position to set some excess money away for retirement. IRA’s as well as other retirement plans offered through your employer allow you to set that excess money in a place where you won’t pay tax on the contribution until you take it out. Although the initial tax deferral is a nice benefit, the real power comes from the compounding effect on the growth of the IRA. By compounding effect I mean the interest on the principal plus interest on the tax deferred growth.
Con: Retirement accounts can grow to be quite substantial in size. At age 70 ½, the government requires that retirees start to take a minimum distribution from the total of their IRAs. At times that distribution may not be wanted because it could cause up to 85% of social security payments to be taxed. The other risk posed by IRA’s tax deferral is the possibility of tax rates increasing in the future.
Roth IRA’s, Pro: Like the IRA, Roth IRA’s are contributed to during your working years. The choice here is the decision to pay income taxes on the contribution during the year it was earned. In exchange for paying income taxes now the Roth IRA will grow income tax free as long as certain rules are followed. This means that most distributions after age 59 ½ will be income tax free. Roth IRA’s do not have a Required Minimum Distribution like the IRA. That is a crucial benefit during retirement. At your passing, heirs will have the option to keep the account as a Roth IRA.
Con: Finding a con for the Roth IRA is challenging. One difficulty is having the cash flow to contribute to the Roth and pay income taxes. Also, if you have a higher income you will be phased out or not be permitted to contribute. Another thought, if the investment choice for the Roth IRA decreases in value, it is possible that you could end up paying taxes on money that you never get to spend.
Roth Conversion, Pro: This was the hot topic a few years back. Roth Conversion is the ability to take all or a portion of an existing IRA, pay the taxes now and convert it to a Roth IRA. Example: In 2012, you had an IRA worth $100,000 you decide to wave the wand and covert it to a Roth IRA. When filing your income taxes for 2012 you will need to add $100,000 to your income taxes for the year. Wait 5 years before taking a distribution and you will have a tax-free Roth IRA. There are no Required Minimum Distributions once converted. If the $100,000 grows to $200,000 it is all tax-free.
Con: In the example above, you would add $100,000 to your 2012 income tax return…..ouch. There are ways to soften some of the tax burden, but that maybe the biggest mental roadblock when deciding to convert or not. Investment choice once converted is an important factor. Imagine paying taxes on $100k in 2012 and then having that 100k worth only 70k in 2014 because of a market downturn.
IRA’s, Roth IRA’s, and Roth Conversions are three tools if used correctly may add tax flexibility to your wealth. Age, current and future income, health, family, and account values collectively create a profile to guide you through the pros and cons of these tools. I do believe moving forward that some individuals and families that position parts of their wealth in tax efficient vehicles will find they will have more choices down the road when funds are needed for retirement. These strategies would likely work best with the help of a tax professional.
Part 2 of this article will address Municipal Bonds, Annuities, and Life Insurance as tax efficient alternatives.
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