The profusion of new taxes, higher brackets, phase-outs, and multiple 'threshold' levels makes income planning a high-stakes chess game.
With the American Taxpayer Relief Act's new higher tax rates, managing income is more important than ever. Here are some ideas for how to keep taxes low.
Question: "Rick" is a self-employed consultant, age 66, who earns about $250,000 a year of Schedule C income. He has no employees. He stopped contributing to retirement plans a few years ago because he already had enough in his retirement plans to finance his expected retirement needs. His and his wife's income from interest and dividends is about $40,000. He's wondering if he should start contributing to a retirement plan again, and whether he should go with a "Roth 401(k)."
Answer: Right now, Rick and his wife have about $290,000 of taxable income, of which $40,000 is "investment income" subject to the 3.8% surtax of $1,520. Plus, he has to pay self-employment tax on his Schedule C income. Rick has a lot to gain by contributing the maximum ($50,000) to a traditional self-employed retirement plan, such as a money purchase pension plan or a profit-sharing plan. That money would bring the spouses' joint income down to $240,000, too low to be subject to the 3.8% surtax. That would also reduce their adjusted gross income for all kinds of purposes, such as determining deductible medical expenses. Plus the contribution to the retirement plan would not be subject to the self-employment tax, saving another $1,339.
Someday he will have to take the money out of the plan, but he may be in a lower bracket then. And the self-employment tax will definitely not apply to the plan distributions (at least not under current rules). There can be a definite tax advantage for the self-employed person to continue contributing to these plans even after his retirement needs are fully funded, and even after the point at which he must start taking annual minimum required distributions (if he's still working after age 70½).
A "401(k)" style plan will not work as well, however. The worker's "salary reduction" (or "cash-or-deferred") contributions to a 401(k) plan are subject to the self-employment (or FICA) tax, even if they go into the plan on a deductible basis for income tax purposes, thus taking away one of the advantages.
Question: "Patty" is single and newly retired at age 68. Her income consists of distributions from a qualified pension ($72,000), nonqualified annuity ($36,000), Social Security pension ($22,000), and interest and dividends ($30,000), totaling about $160,000. She has $3.5 million in a traditional IRA and $500,000 in a Roth IRA. She wants to spend a one-time lump sum this year (or maybe spread over a couple of years) of about $400,000 for home improvements, travel, paying off her mortgage, etc., to "launch" her planned retirement lifestyle. What's the best source for her to take that cash from?
Answer: Patty would profit by working closely with a financial planner to figure out how to get the spending cash she needs without increasing her tax bracket. If she can keep her adjusted gross income at $200,000 or less, she will not be subject to the 3.8% surtax on her investment income and nonqualified annuity payments. If she goes over that number, the surtax hits.
If Patty were to take $400,000 of cash out of her big traditional IRA in 2013, not only would she incur the surtax of 3.8% on her nonqualified annuity, interest, and dividends ($2,508), she would become subject to the phase-out of itemized deductions and personal exemptions (which kicks in for a single individual at $250,000 of adjusted gross income), and she would even get into the top income tax bracket of 39.6% on all her taxable income over $400,000. Obviously it would be desirable to avoid that scenario, unless she believes that as one of the "1 percent" she should pay income taxes that she could easily avoid. (I have never yet met anyone who believes this.)
On the other hand, looking ahead, she is going to begin taking minimum required distributions from that huge traditional IRA in just a few years, so her ability to manipulate her taxable income will be less then than it is now.
To get cash without getting up to one of those dreaded levels of income ($200,000, $250,000 and $400,000 for a single person), she has two potential sources. Her Roth IRA can always be tapped for income-tax-free cash, and her non-IRA investment accounts can also be tapped, though selling securities may generate some capital gains taxes. By tapping her non-IRA investment funds first, and raiding the Roth IRA only to the extent she still needs cash but is over the $200,000 income level, she can avoid the 3.8% surtax while minimizing the hit on the precious tax-free Roth IRA.
If in any year her income is going to come in below the $200,000 threshold level, she should consider doing Roth conversions of pieces of her traditional IRA, enough to bring her income up to the $200,000 level. That helps relieve the pressure on her income that will be created in future years by minimum required distributions from the traditional IRA.
The profusion of new taxes, higher brackets, phase-outs, and multiple "threshold" levels makes income planning a high-stakes chess game. A few hours with a spreadsheet and a tax manual could save a retiree quite a bit of money.
Resources: For discussion of the new tax rates effective in 2013, see the Special Report: Recent Developments 2013 downloadable free at www.ataxplan.com.
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