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In changing tax times, Roth IRAs provide alternative strategies

Most people never think about reducing taxes until it's time to file their tax returns. Unfortunately, by then it is too late to implement tactics to minimize the tax bill.

The issue of tax planning should be considered in conjunction with retirement planning. Your tax strategies for next year could include some of the strategies that can maximize your income in retirement.

One of the biggest tax benefits available to most investors is the ability to defer taxes offered by retirement savings accounts, such as 401(k)s, 403(b)s and IRAs. By deferring taxes through these means, investors can more quickly grow their wealth.

Through tax deferrals, investors may grow their wealth faster and can achieve a potential double dose of tax advantages. Contributions may reduce current taxable income and any investment growth is tax-deferred. Roth IRAs work differently and are emerging as a viable option for many investors with an eye on future retirement.

A Roth IRA contribution won't reduce your taxable income the year you make it, however, there are no taxes on your future earnings and the contributions can be withdrawn penalty free. Be aware that while your earnings may be subject to taxes and penalties if withdrawn before certain conditions are met, your contributions can be withdrawn at any time without tax or penalty. Roth IRAs have no required minimum distributions (RMDs) during the lifetime of the original owner, so they can also be useful vehicles for estate planning.

Anyone can now convert to a Roth IRA, as long as they pay the appropriate tax on the conversion. If you convert to a Roth IRA, you will have to pay taxes on the amount of IRA that is converted.

Tax-savvy investors want to pay as little income tax as possible. Converting to a Roth IRA may allow you to make a tax move that will save you or your beneficiaries money in the long run. For example, if you anticipate your income dropping significantly in a certain year (and increasing in following years), you could plan a conversion (or partial conversion) for the low-income year. Since your income is lower, you may be in a lower tax bracket when you convert. Similarly, if the government announces a tax-rate increase to go into effect in a future year, a conversion in the current year could save income tax.

You also can make partial Roth IRA conversions - the switch does not have to be an all or nothing decision. Although the rules surrounding partial conversions can be complex, a competent financial professional can help you understand the tax impact and rules that govern converting some, all, or none of your existing IRA to a Roth IRA. Like any other decision, all variables of your situation should be considered.

You should consider running the numbers for your situation to best determine the impact of making a full or partial conversion to a Roth IRA. For example, suppose you are a married taxpayer filing jointly with $50,000 of taxable income and you have $300,000 in a traditional Roth IRA. Your marginal tax bracket is 12 percent. However, if your income increases above $77,400 you move into the 22 percent bracket. You might wish to convert up to $27,400 of your traditional IRA to a Roth IRA. From a taxwise perspective, this could be more attractive than a full conversion, because if you converted the entire IRA this year, you could pay tax on some of the conversion at rates as high as 32 percent. Saving for retirement has and always will be a priority for most investors.

Whether to convert to a Roth IRA and how much to invest are good questions that require an examination of your personal situation and goals. This is an area where a highly informed financial advisor can help you make an educated and calculated decision. The decision to convert some or all of your retirement account to a Roth IRA is complex, but it can be a very good planning tool for your retirement.

• Dean Hedeker is owner and principal of Hedeker Wealth in Lincolnshire. He is also an attorney at law and certified public accountant, and he can be reached at info@hedekerwealth.com.

Dean Hedeker
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