We have discussed 3 tax strategies related to investment so far (I, II, III), now we will discuss the fourth one.
Roth Conversion
Roth IRAs and 401(k)s can be critical elements of your portfolios. A common myth is that the Roth wrapper is better than the traditional account if the assets are held for a certain number of years. This is not true. The only things that matter are the marginal tax brackets in the year of the conversion and the year of withdrawal. If the marginal tax bracket ends up higher upon withdrawal, the conversion will have been beneficial.
Tax Diversification
Since no one can be certain what lawmakers will eventually do, having three pots of money - taxable, tax-deferred and in a tax-free Roth - is an important way to diversify against unpredictable politicians.
You can contribute first to a traditional retirement account, and then do multiple partial Roth conversions from existing IRAs to take advantage of potential recharacterizations later on.
The Best Recharacterization Strategy
You can view traditional IRAs as a partnership between you and the government. For example: A $100,000 IRA owned by you in the 30% tax bracket would be 70% owned by you; converting it to a Roth costs you $30,000 to buy out the government's share.
In the above case, if you do three $10,000 Roth conversions, you will owe $9,000 in taxes - $3,000 per conversion to buy out the government's share. If you put each $10,000 conversion in different asset classes early in the year, you'll have up to 15 months to see how each performs. If, for example, the assets in one conversion tank and lose half of their value, you can hit the undo button and recharacterize - thus having the government buy back its share at the full $3,000 original price.
Recharacterization also gives you a chance to undo an unexpected impact from the dreaded alternative minimum tax. Tax accountants often underutilize the strategy of multiple Roth conversions - which can often be a vital part of tax planning.
It's important to note not everyone can have tax benefits through traditional IRA contributions, see IRS eligibility requirements on who can have traditional IRA tax benefits.
We'll wrap up with the last strategy - the best withdrawal strategies.
Roth Conversion
Roth IRAs and 401(k)s can be critical elements of your portfolios. A common myth is that the Roth wrapper is better than the traditional account if the assets are held for a certain number of years. This is not true. The only things that matter are the marginal tax brackets in the year of the conversion and the year of withdrawal. If the marginal tax bracket ends up higher upon withdrawal, the conversion will have been beneficial.
Tax Diversification
Since no one can be certain what lawmakers will eventually do, having three pots of money - taxable, tax-deferred and in a tax-free Roth - is an important way to diversify against unpredictable politicians.
You can contribute first to a traditional retirement account, and then do multiple partial Roth conversions from existing IRAs to take advantage of potential recharacterizations later on.
The Best Recharacterization Strategy
You can view traditional IRAs as a partnership between you and the government. For example: A $100,000 IRA owned by you in the 30% tax bracket would be 70% owned by you; converting it to a Roth costs you $30,000 to buy out the government's share.
In the above case, if you do three $10,000 Roth conversions, you will owe $9,000 in taxes - $3,000 per conversion to buy out the government's share. If you put each $10,000 conversion in different asset classes early in the year, you'll have up to 15 months to see how each performs. If, for example, the assets in one conversion tank and lose half of their value, you can hit the undo button and recharacterize - thus having the government buy back its share at the full $3,000 original price.
Recharacterization also gives you a chance to undo an unexpected impact from the dreaded alternative minimum tax. Tax accountants often underutilize the strategy of multiple Roth conversions - which can often be a vital part of tax planning.
It's important to note not everyone can have tax benefits through traditional IRA contributions, see IRS eligibility requirements on who can have traditional IRA tax benefits.
We'll wrap up with the last strategy - the best withdrawal strategies.
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