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Tax-Free vs. Tax-Deferred Growth

September 19, 2022

An IRA – it’s great retirement savings but remember how an IRA works: one receives a tax break now on the investment but must pay the taxes on the total amount invested plus all its earnings later when your money is redeemed – at least at age 72 (currently) when we are required to take a minimum distribution called an RMD.

To help receive the most benefit out of an IRA let’s consider how to best use IRA proceeds.

First let us remember there are two investment phases with your IRA.

  • Phase 1, it is the accumulation of wealth – the tax deferring phase.
  • Phase 2 is the withdrawal from the account – this is the tax paying phase to avoid.

Investors, unfortunately, only pay attention to the first phase of stashing away as much money as possible. But with retirement savings, it’s not how much you have; it’s how much you can keep after taxes!  With traditional IRAs you are really growing an account that will one day will be shared with the IRS. To prepare for the second half of retirement, one needs to have a plan on how that IRA money can best be redeemed out with the lowest possible tax consequences.

Solution – consider converting the IRA to a Roth IRA because this conversion now could lower your total tax bill on the future withdrawals.

The issue/strategy as to how to convert an IRA to an IRA Roth. Simply there are two ways.

  • Either in a lump sum if you think your tax rate will be higher in retirement or
  • Converted in lesser amounts over time. In this instance, year by year, you are whittling down the growing tax bill in your traditional IRA and building up a tax-free portfolio in a Roth using what’s called a rollover.

Notes on indirect vs. direct rollovers:  If you take money out of an IRA and the check is in your name you have 60 days to roll that money over into another retirement account before the IRA withdrawal becomes taxable income. The IRS considers this an indirect rollover. The direct rollover or transfer is from one IRA account to an IRA is the simplest tax wise and best method to use to use because no one touches the money and narrows IRS questions on such a transfer. You may make more than one transfer from one IRA to another in a year, but you can only make one indirect rollover per year.

If you do an indirect rollover and break the 60-day rule, you could have taxable disbursement, be hit with a 6% excise contribution penalty, and be slapped with a 10% penalty if you are under age 59 ½.

Notes on RMDs:  You must start taking required minimum distributions once you are 72 years old (IRS rule as of the writing of this article).  This could be a big problem area for some. For instance, people sometimes forget to, or not take enough to satisfy all their RMDs (those of us that have multiple IRAs), or they simply miscalculate the requirement.  Such mistakes can be costly – you could be struck with a 50% penalty for the amount not withdrawn. Note you can ask the IRS for a penalty waiver.

If Roth IRAs are preferred for their long-term tax-free income versus the traditional IRA for tax-deferred growth, why not simply contribute to the Roth in the first place?  You can but not everybody is eligible to invest directly into a Roth. Those earning over a certain income limit cannot contribute directly into a Roth. However, they can still make an IRA contribution then convert to a Roth.  For more information on this tax strategy talk to your tax accountant or financial planner.