Tax Planning, Avoid a bump to higher tax bracket

This is a cautionary tale of one retiree who suffered a loss of income in her later years. Although the story is fictional, its lessons are significant and could save you and your spouse money at a time when you may need it most.

A few years ago, John and Mary Rodgers were enjoying a comfortable retirement together. Their annual income of $80,000 from Social Security, pensions and withdrawals from John's IRA was enough to cover their living expenses and allow them to pursue leisure activities such as travel, golf outings, and fine dining.

That changed when John unexpectedly passed away. Mary continued to receive the same pension income. She also inherited John's IRA and continued to withdraw the same amount of money each year to maintain her standard of living and leisure activities.

However, as the years went by, she found that she actually had less money to spend, and had to scale back on some of her vacations, golf outings, nights out with friends, and other daily expenses.

She wonders, "What happened to the comfortable retirement I was living before John passed away? Why don't I have as much money now as I did when my husband was still alive?"

Unfortunately, Mary is now in a higher tax bracket, and more of her annual income is going to the government and not to her retirement.

Married Filing	Jointly	Single
Taxable Income	80,000	$80,000
Tax Bracket (2005)	25%	28%
Taxes Due	$13,330	$16,906

Among the many unfortunate circumstances that may occur upon the death of a husband or a wife is that the surviving spouse could be pushed into a higher income tax bracket, even though his or her income level hasn't changed. While a surviving spouse like Mary may have some options to lower her income tax burden, one of the best times to find a solution to this problem is while both spouses are still alive.

If your situation is similar to John & Mary's, one possible solution that might help is to convert an existing traditional IRA to a Roth account. Although there is an income tax up front at the time of conversion, qualified distributions from the Roth IRA are free of federal income taxes, even if they are made by the surviving spouse. A qualified distribution is one in which the age and holding-period requirement have been satisfied (which are discussed below).

Also, partial roll-overs can be used in some cases to help reduce the income taxes incurred on the conversion. For example, consider a situation where a taxpayer is holding $100,000 in a traditional IRA and wants to convert this money over to a Roth account. Assuming the taxpayer converts $20,000 each year for five years, the income tax will actually be spread out over a longer period. This strategy can also prevent the converted funds from being taxed at the higher 28-35% federal tax rates.

Unlike a traditional IRA, a Roth IRA has no minimum distribution requirements. Many retirees find this advantage useful in managing their income flow and, likewise, their tax burden. With a traditional IRA, you are required to take minimum withdrawals from the account by age 701/2, even if you have other sufficient sources of income and do not need to withdraw the money. These requirements may push you or your surviving spouse into a higher tax bracket, with fewer options for reducing your tax burden.

Before you do a consider a conversion, however, you should know that there is a five year holding period rule that applies to amounts rolled over to the Roth account. Also, early withdrawals from a Roth IRA prior to age 59 1/2 can be subject to federal income taxes as well as a 10% federal tax penalty. Therefore, a Roth may not be the best choice if you are already into your retirement and need to use your money now or in the near future. Although distributions are typically free of federal income taxes, state income taxes might apply in some states. I always advise people to consult with their own qualified legal, tax, and financial advisor prior to making any financial decisions.

Before you convert a traditional IRA to a Roth, it is wise to review the benefits of each type of account and determine if a conversion would be appropriate for your current financial situation.

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