By Howard Hook, CPA, CFP

Howard Hook is a fee-only Certified Financial Planner and CPA with the wealth management firm of EKS Associates in Princeton, NJ. He has been named to Medical Economics’ list of top financial planners for physicians for nearly a decade and is a member of the Forbes Finance Council and contributor to that publication.

Everyone wants to figure out how to make their money last longer once they retire. Earn more and spend less are two ways people think this can be done.

A third way is to minimize the amount of income taxes you will pay each year in retirement. The Holy Grail would be to pay zero income taxes once retired. Unfortunately, this is not possible for most retirees. But, you still can come close.

We already know that for most retirees’ social security income (and pension income for some) will not be enough to cover their expenses in retirement. To make up for the shortfall, distributions will need to be taken from your investments. Different types of investments contain different tax characteristics. For example, a distribution from an IRA is fully taxed at ordinary income tax rates. The more you take, the greater the tax rate may be.

Consider the following:

Tom needs $50,000 to supplement his social security income and can choose from taking it from his IRA plan or from a savings account. Taking it from the IRA will increase his income taxes because the entire distribution is subject to ordinary income tax rates. Assuming Tom is in the 25% tax bracket (federal/ state), he would owe tax of $12,500. If Tom had nowhere else to get the money from to pay the tax, he would have to take it from his IRA. Distributing $12,500 from the IRA would also be taxable. In essence, Tom would need to take a gross distribution of $66,667 so that after 25% income tax he would net out to the $50,000 he needs.

Conversely, taking it from his savings account will not create any additional income taxes at all.

All things being equal, if you had a similar situation you would take it from your savings account. However, there are two problems with the savings account approach:

• The first problem is that most people do not have enough money in their savings account to last for 30 years.
• The second problem is even if you identified when you were much younger that you wanted to accumulate money you would need for retirement in a savings account, you would have to save so much money due to the low growth rate of that type of account that it would not be practical to do so.

All hope is not lost, however.

There is a type of an account which can provide the growth needed to get through a long retirement. but also keep your taxes low: it’s a Roth IRA.

Distributions from a Roth IRA, if the owner of the account meets certain qualifications, are tax free. The qualifications for tax free distributions are the Roth IRA account has to be open for five years and the owner has to have reached age 59 ½.

This can be an incredibly large advantage compared to taking distributions from an IRA, whereby 100% of the distributions are taxable.

A Roth IRA can be invested with a mix of different types of investments, including those better positioned for growth such as a stock mutual fund. There are several ways to contribute funds to a Roth IRA. The first is to make contributions each year you are eligible to do so. You are eligible if you have taxable compensation and your modified adjusted gross income (MAGI) for 2020 is less than $137,000 for single filers (or $203,000 for married filing jointly).

MAGI is calculated by starting with your Adjusted Gross Income (AGI) and then adding back certain items. For 2020, for those eligible, you can contribute the lesser of $6,000 ($7,000 if age 50 or older) or your taxable compensation. Another way to get money into a Roth IRA would be to convert funds in an existing Traditional IRA to a Roth IRA. When you do this, you will have to pay income taxes on the amount you converted since you received an income tax deduction when you made the original contribution to the Traditional IRA and the earnings are growing tax deferred.

A slight variation on the above two methods and one that may be attractive for taxpayers who do not meet the MAGI limits mentioned above would be to first contribute to a nondeductible IRA and then “convert” that amount to a Roth IRA. This strategy, sometimes referred to as a “backdoor Roth IRA,” works because there is no MAGI limitation for making a nondeductible IRA contribution.

You may still have to pay income taxes on a portion of the amount converted to the Roth even though no tax deduction was taken for the amount contributed. If you have other IRA accounts for which you have made deductible contributions to in the past, then you must use the “pro rata rule” to determine how much of the amount converted is taxable.

The rule requires you to calculate the percentage of pretax funds you have in all of your IRA accounts and apply that percentage to the amount converted.

The final way to get money into a Roth IRA without running into any MAGI limits or pro-rata rules would be to make a contribution to a Roth 401k or Roth 403b plan if offered by your employer. The tax treatment of Roth 401ks and 403bs are similar to Roth IRAs.

In addition to no MAGI limits or prorata rules, contributions to a Roth 401k and Roth 403b can be much greater than $6,000 or $7,000 for people age 50 or older. The limits for a Roth 401k or 403b are $19,500 ($26,000 for those aged 50 or older).

If you think the benefits of a Roth IRA are too good to be true you are not alone. Congress may agree with you as numerous times over the past several years there has been talk to eliminate or severely limit the use of a Roth IRA or 401k. Like many good things the Roth IRA may not last forever all the more reason why now is as good a time as ever to explore whether it makes sense for you to do this.