Year-End Retirement Tax Planning

One reliable way to reduce the impact of higher tax rates, surtaxes, phaseouts and so on is to make tax deductible contributions to retirement plans. In 2014, the maximum salary (and tax) deferral for 401(k) and similar plans is $17,500, or $23,000 if you are 50 or older. If you are not maximizing such contributions already, consider increasing the amount by year-end.

Business owners, professionals, and self-employed individuals may be able to make even larger deductible contributions to retirement plans. Often, the deadline to create such a plan for the year is December 31, even though the actual contributions may be deferred for several months. Our office can help you determine which type of plan would be best for you and your employees.

Refining Roth IRAs
The end of the year is often a good time to convert a traditional IRA to a Roth IRA. All Roth IRA distributions are tax-free after five years, if you are at least age 59½. What’s more, the five year clock starts on January 1 of the conversion year. Thus, a December 2014 conversion will have a January 1, 2014, start date for this purpose and reach the five-year mark on January 1, 2019, just over four years from now.

The downside of a Roth IRA conversion is that you must pay income tax on all pretax dollars you move from your traditional IRA to a Roth IRA. Converting can be extremely taxing.

Example 1: Diane Carson is a single taxpayer with $150,000 of taxable income in 2014, before any Roth IRA conversion. If Diane converts her traditional IRA, which contains $250,000 in pretax dollars, to a Roth IRA, she will report $400,000 of taxable income on her tax return. The added income will be taxed mostly at a 33% rate so Diane will owe more than $80,000 in tax on the conversion.

In this example, Diane has an excellent idea of what her taxable income will be for 2014. Her $150,000 of taxable income puts her in the 28% tax bracket, which goes up to $186,350 for single filers this year. Thus, Diane decides to convert $35,000 of her Roth IRA in 2014. She’ll owe $9,800 in tax on the conversion (28% of $35,000), which she can pay with non-IRA funds. Over time, a series of such partial conversions can build up Diane’s Roth IRA so that it can become a valuable source of tax-free retirement income.

Suppose, though, that Diane’s taxable income varies from year to year. In that case, she might do a much larger Roth IRA conversion. A conversion in 2014 can be recharacterized (reversed) back to a traditional IRA, in whole or in part, until October 15, 2015.

Example 2: Diane converts $100,000 of her traditional IRA to a Roth IRA in 2014. When she has her tax return prepared in April 2015, Diane learns that her taxable income would be $166,350, without any income from the Roth IRA conversion.

As mentioned, the 28% tax bracket for a single filer goes up to $186,350 in 2014. Therefore, Diane can add $20,000 to her taxable income for the year, still taxed at 28%. Diane recharacterizes enough of her Roth IRA conversion to leave her with a $20,000 Roth IRA conversion, in the 28% bracket. She can repeat this process every year, building up her Roth IRA at a relatively low tax cost.

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