Unconventional Roth IRA Strategy to Lower Tax Bill

Posted by Madison on August 7, 2008

I’ve been utilizing a tax strategy the last few years to take advantage of low tax rates. Huge deferrals and unpaid maternity leaves gave us some room in the 15% tax bracket to convert traditional IRAs to Roth IRAs, and even 401ks to Roth IRAs. Although we had to recharacterize some of it, we were able to convert quite a bit over the last 10 years.

Planning for High Taxes

I was working on our tax situation during our mid-year review and found that this year we’re going to find ourselves in the opposite situation.

I substantially reduced our retirement savings due to our decreasing contribution plan. In addition, since we’re adding some successful business income we’re going to be hit heavy with taxes. In addition to paying a higher incremental tax, we’ll lose out on our child tax credits and student loan deductions.

Tax Strategy by Income Level

Wouldn’t it be great if some tax strategies existed to smooth out the discrepancy between years? It would look like this:

  • Low tax year: Move tax deferred accounts to after tax/tax free accounts.
  • High tax year: Move after tax/tax free accounts to tax deferred accounts.

The great news is that a tool exists to accomplish the first one: Roth IRA conversions.

Move Tax Free Money to a Tax Deferred Account

I searched all over but couldn’t find a tool to do this for you. So I came up with a new process that I think might work:

  1. Make a tax free Roth IRA withdrawal from contributions and conversions.
  2. Defer the same amount of money plus savings on taxes to a tax deferred account (401k, 457, or 403b). You could also use a traditional IRA if you qualify, but the higher limits may give you more room to play with on an employer sponsored plan.
  3. Use the Roth IRA withdrawal money to replace the reduced amount from your paycheck.

Example

  • Year 1: You contribute $5,000 to a traditional IRA. You also roll over $5,000 from an old 401k plan.
  • Year 2: You contribute $5,000 to your Roth IRA.

Your balances (without earnings or losses) now look like this:
Traditional IRA: $10,000
Roth IRA: $5,000
Total: $15,000

  • Year 3: Your tax bracket is low. You convert $5,000 from the traditional IRA to the Roth IRA at 15%. Tax bill: $750.
  • Year 4: Your tax bill is higher. You withdraw $5,000 from your Roth IRA and contribute $6,666 to your 401k ($5,000 plus the 25% that would have been paid on taxes). Your tax savings: $1666

Notice in year 4 you can only withdraw the $5,000. To withdraw the $10,000 conversion, you must wait 5 years.

Your balances (without earnings or losses) now look like this:
Traditional IRA: $5,000
401k: $6666
Roth IRA: $5,000
less taxes paid: $750
Total: $15916

Net gain: $916

Importance of Tracking Roth IRA contributions and conversions

This process reinforces the importance of tracking Roth IRA money. Once I satisfied the 5 year time period, I unfortunately didn’t keep stellar records of my contributions and conversions. My mom is busy digging out all my old tax returns for the last 10 years to piece it back together.

Action Plan

Because of the need to use a payroll deduction, it’s a good thing I uncovered this one mid-year instead of at the end of the year. I’ll be submitting our changes shortly after I figure out how much I have to work with this year.

Also, see the 2010 Roth 401k and Roth IRA Limits to see how much you can defer in the future.

So what do you think of the plan? The math looks too easy on this one. Tell me what I’m missing!!



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Comments to Unconventional Roth IRA Strategy to Lower Tax Bill

  1. Wow, now that is thinking outside the box. Very interesting Madison – unfortunately for me, all my income is 1099’d. But for those of you having money taken out of your paycheck for your 401K, this looks very interesting!

    David

  2. @ David: I just thought of something… For 1099 income, if you are an LLC, you could use a SEP-IRA to do the same thing as the 401k. It actually might be easier since you wouldn’t have to sign up for payroll deductions. I’m going to think about this one a little more…

    Madison

  3. Okay, I’d love to be able to take advantage of strategies like this, but I’m afraid, I’m not the best of record keepers.

    What I’d love to hear about is how you’re able to organize and track your records so meticulously. If you’ve written about this already Madison, I’d appreciate links to those posts! I really need to figure out a better way to stay more organized. I have actually kept our finances very simple and straightforward and I don’t do much rejiggering of my accounts for fear I’d just confuse myself 😉 .

    But as it is, I really don’t enjoy trying to remember if $X amount of dollars is converted, or if I need to contribute $Y amount of dollars to make up for the $X amount I just moved…. stuff like that makes my head spin! 🙂

    As mentioned, if you have coverage on how you’re able to track your accounts (credit card and financial) so well, I’d so love to hear more about it! What tool do you use? Just excel? Did you customize your formulas? etc….

    The Digerati Life

  4. My mind is boggling at this strategy. I like it, but it does suppose that your Roth money is not tied up in stocks, mutual funds, etc. I wonder if that is the case? Or are you willing to trade possible future investment growth for a tax break today?

    M

  5. Sounds interesting but I like to contribute the max to our Roths each year and leave it to mature tax-free. Aren’t you sacrificing your future tax benefits, which in our case we expect to be greater for short term sheltering?

    Erin a

  6. What if I earn too much to contribute to a Roth?

    Mike

  7. @ M: I switch the same funds, so the investment growth would not be changed.

    @ Erin: I am sacrificing the future tax benefit, however, I will reverse it in the next year that the income is lower. So it’s really just moving it back and forth depending on the tax year.

    @ Mike: I answered your question here: Roth IRA Q & A.

    Madison

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