Friday, January 18, 2008

A Retirement Tax Strategy - Minimizing the Tax Impact of Roth IRA Conversions

In 2008, I plan to convert some of our regular IRA funds to a Roth IRA to use up tax credits and itemized deduction that may otherwise go unused. As background, I retired in my forties in October, 2007. As a result, our income will be significantly lower, but our itemized deductions will remain relatively high due to mortgage interest and property taxes. In addition, we will now qualify for a child tax credit, which is nonrefundable. In order to take advantage of these deductions and credits, we will need to increase our taxable income. Otherwise, the deductions and credits may be partly unused, because the tax liability is already low.

Here are the ways I've been considering to increase our taxable income:

  1. Earn some income. I'll be doing some part time jobs in 2008. However, because the work is seasonal and part time, the earnings will be less than the amount necessary to completely offset the deductions and credits. Of course, this is to be expected since I am retired:-)

  2. Increase taxable interest. Part of our fixed income investments pay tax exempt interest. By changing to investments that pay taxable interest, we will increase our taxable income. Again this will provide some but not enough additional income to offset our expected deductions and credits.

  3. Take capital gains on stock investments. Selling stocks which have increased will create income. For 2008 to 2010, stock long term gains will create zero percent federal tax liability for those with in the 15% tax bracket ( $65,100 for Married Filing Jointly, $35,550 for Single in 2008). Unfortunately, if the market continues as it has for the beginning of 2008, I may not have may not have many stocks with gains later this year :-(

  4. Convert regular IRAs to Roth IRAs. Taxpayers (not including Married Filing Separate)with an AGI (before the Roth conversion) of less than $100,000 are eligible to make conversions from a regular IRA to a Roth IRA. The funds of the regular IRA that would have been a taxable distribution are considered taxable income when doing a conversion.
I will be using all four of the options to increase our taxable income for 2008. Option #4 provides the most flexibility since I fully control of the amount of income created. In addition, I can wait until the end of 2008 to make the conversion. Based on preliminary estimates, I may be able to make a sizable Roth conversion and pay no federal income tax due to itemized deductions and child tax credits. However, we would still have a state income tax liability since there are fewer state deductions and credits than in the federal return.

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This is not financial or tax advice. Please consult a professional advisor.

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