How to Build a Tax-Free Retirement Plan with a Roth IRA.mp3: Audio automatically transcribed by Sonix
How to Build a Tax-Free Retirement Plan with a Roth IRA.mp3: this mp3 audio file was automatically transcribed by Sonix with the best speech-to-text algorithms. This transcript may contain errors.
Speaker1:
Well, welcome back to the Federal Retirement Show. I'm your host, Val Majewski, vice president of sales and marketing here at American Benefits Exchange. I appreciate you taking the time out to join us for another episode. Today, we're going to be talking about tax free retirement strategy using Roth IRAs. Now, why do we do this? It's important because we've been getting asked questions about these things. That's why we know it's important. And recently with with everything going on in the world and why why things are going on or the questions we're getting asked is how are we going to mitigate these things or where do we see taxes going and how do I properly prepare for retirement? The big question has been revolving around taxes, and federal employees in general have been asking me or talking to me about the mitigation of their future tax liability and how do we do so? How do we prepare properly for retirement? And how do we reduce our tax liability and try to kick Uncle Sam out of our pocket as much as we can in retirement? Because if you weren't aware, Uncle Sam is a big partner of yours in retirement. And so really the question I've been asking federal employees in response to that is, well, which direction? It all depends on which direction you think taxes are going to go in. You think taxes in the future are going to go up, we're going to go down.
Speaker1:
And the consensus, the majority not it's not unanimous, but the consensus is that taxes are going to go up. And again, I'm not making this up. I'm just reporting the news here and sharing with you the data that I've gotten from other federal employees that I've talked to across the country. The consensus, the majority, you're saying that they believe taxes are going to go up in the future. Now, if you've watched our previous episode about calculating the future of retirement, most federal employees that I talked to want to get to about 100% of their net take home pay in retirement. So they want to have relatively the same take home pay retirement that they had when they were working. Now, if taxes go up in the future, how is that going to affect your net take home pay? You're going to take home less because more are we going to taxes? So how do we mitigate our future tax liability? Well, there are several different tax free retirement sources or ways in which you can reduce tax liability in retirement. We're going to talk about one of them today called a Roth IRA. Now, you may have heard of Roth IRAs before. I'm going to go into some detail about what they are and how they can benefit you. If you're a federal employee and you contribute to TSP. You can also save money in your Roth portion of your TSP.
Speaker1:
Now, this is not a Roth IRA because you can have a Roth TSP, which is a41k and a Roth IRA at the same time as long as you qualify for one. Now what our Roth IRAs? Well, this is a type of retirement savings account where you put in after tax dollars. That money goes into the account. It grows over time with interest depending upon the type of vehicle you have in it. And then when you withdraw the money in the future, every dollar your contributions plus the earnings are tax free. So you have essentially prepaid the taxes. You've paid the taxes now and every dollar you take out in the future will be tax free. Unlike, say, the traditional portion of your TSP, where you get a tax deduction on your contributions today so you do not pay tax on the money that you're putting in to your traditional TSP. It will then grow with interest and all of the money. Your contributions plus interest in the end will be taxable as ordinary income when you take withdrawals. So it's the big question when do you want to pay tax now or later? Well, let's say that you wanted to save additional money for retirement on a tax free basis, and you were thinking about starting a Roth IRA. What does that look like? Well, a Roth IRA is great again for tax free retirement, but it's a little restrictive.
Speaker1:
And I'm going to explain. It's not to say it's a bad deal or anything like that. I just want to tell you it's a little restrictive and I'll give you the reasons why. Looking at the bullet points here, it's restricted in how much you can contribute per year. So you're only limited to $6,000 per year per person. Now, this is not per account. So if you had the thought, hey, I might as well just open ten Roth IRAs, it's still $6,000 total to a Roth IRA or multiple Roth IRAs per person per year. Now, if you're 50 or older, you can increase that to 7000. So you get a little bit of a catch up, right, 7000 per year for those that are 50 or older contributions because we're prepaying the tax are not tax deductible. This is money you've already paid tax on. So after tax dollars go into the Roth IRA to have tax free dollars come out. On the back end. Now you can contribute for a non-working spouse. Why is this important? Because you have to have a job in order to contribute to a Roth IRA. So once retired, if you're not working, you can no longer contribute to a Roth IRA. But if you're a working person, you have a non working spouse, you can also contribute for them. Now, your principal money that you put in in a Roth IRA is available on day one.
Speaker1:
Now, why would I say that? Because it's going to come to our next slide where we talk about the five year rule and why you got to keep the money in there for a certain period of time. So this is another restriction when it comes to Roth IRAs. So I'm going to skip to my third bullet point here on this next slide, because the other restriction that Roth IRAs have is the money needs to stay in there for at least five years. At least you cannot start withdrawing money that you've earned the earnings on a Roth IRA for at least five years. So that's where the five year rule comes into play. Earnings cannot be withdrawn until five years down the road. Now, as I mentioned before, growth in the account is tax free distributions in the end are tax free, but it's restrictive a little bit on the front end of how much you can put in, even if you want to put in a lot more and when you can start taking out the earnings. I said your principle they want is liquid. So you can access that at any point, but you cannot take out the earnings for at least five years now. Distributions income that you get from a Roth IRA do not count towards the Social Security income tax or when it comes income test, sorry, when it comes to Social Security taxation, that's a totally different subject.
Speaker1:
If you have questions about that, please reach out to us. This is about what portion of your Social Security benefits that you collect in retirement will be subject to tax? There's an earnings test for that to see how much of your what portion of your Social Security will be taxable distributions from your Roth IRA will not count towards that. There are no required minimum distributions with a Roth IRA. So if you have money that is in your traditional TSP, let's say, and you retire and you leave it in TSP, you leave it where it's at, it's still in the traditional account. You are required to start taking withdrawals known as RMDs required minimum distributions. Once you turn age 72, that restriction goes away in a Roth IRA. Now, here's the other funny thing. If you have your money in a Roth TSP, so even though it's in the Roth in TSP. You are required to take RMDs from that account. Generally speaking. Rmds Have you start taking withdrawals so you can start paying taxes on things? But with Roth TSP, the money is not taxable. They just want you to start taking the money out. But if you move your money when you're eligible to do so from your Roth TSP into a Roth IRA, now you avoid that RMD requirement. Pretty awesome stuff. Now when it comes to paying the taxes and prepaying these that way, there's no taxable implications down the road.
Speaker1:
This is the way that you can now set up your your heirs, your loved ones, when it comes to their beneficiaries with a tax free. Legacy gift, tax free. Whatever's left in your account goes to them tax free so you can prepay the taxes for your beneficiaries. Now, the other thing, too, is you can decide when you want to take distributions because you're not required to do so. I just talked about the RMDs. You can take that money out at any point. You can leave it in there. You don't have to or you're not required to not force to take money out of your IRA at any point. Pretty awesome stuff. Now, I said earlier that Roth IRAs are restrictive and we talked about how much you can contribute to a Roth IRA. We talk about the five year rule with a Roth IRA. Another way in which they restrict a Roth IRA access or who can contribute to a Roth IRA is based upon your income. So if your modified adjusted gross income is above a certain amount, I'm sorry, but you cannot contribute to a Roth IRA for that calendar year. Now, what are those limits and who is restricted on this? Well, if you're married, filing jointly and you make 214,000 or above, as far as your modified adjusted gross income, you are not eligible to contribute to a Roth IRA for that calendar year.
Speaker1:
There's actually a phase out which begins at 205,000. So your your contributions to your Roth are restricted once you start getting at 205,000 or above, and then they're eliminated, meaning you cannot put anything in to a Roth IRA. If you made more than 214,000. These are the new numbers for 2022. If you're a single tax filer, if you make more than $144,000, you cannot contribute to a Roth IRA for that given year, your phaseout actually starts at $130,500, meaning they'll start limiting the amount you can put into a Roth IRA above 130,500. But once you hit 144, nope, not contributing for that year. So if you've put in money into your Roth IRA and you've made more than the limit for that year, you have to then take that money out of your Roth IRA. Technically, for that year, you can't have it in there. You can get penalized for it. So it's important to know what the limits are as far as contributions to a Roth IRA are, what the maximum income you can earn is in order to contribute to a Roth IRA and also when that phase out starts. So that brings us to another point where you may say, Wolf, all this is a moot point for me because I make too much money or I want to put in more than 6000 a year. So I'm not even going to contribute to a Roth IRA.
Speaker1:
I find it too restrictive. It's not for me. But how can I still turn my retirement income, my retirement money into tax free money? Because this is a question we get asked. Right? This is a part of the the biggest question we get asked. Not not necessarily. How can I contribute more to a supplemental retirement plan that's tax free? Most of these questions are coming from people nearing retirement saying, how can I eliminate my tax liability or reduce my tax liability? I don't have time to contribute to a Roth IRA. What are my options? And that's where we get to a Roth conversion. Typically, this is going to be more for the people that have put money into a traditional type account, a traditional IRA or a41k or some other kind of pre-tax vehicle. Right. Money that you've put in pre-tax. It has not been taxed and in a typical fashion, if to let it ride and have to take money out down the road, all of the money, your contributions plus interest would be subject to tax as ordinary income. So that's where, again, a Roth conversion comes into play. This is where you can take traditional funds, pre-tax funds, and instantly turn them into Roth funds. How do you do that? Well, you'd have to think about prepaying the tax, right. Taxes are going to be paid up front. I'm going to get more into this in just a second.
Speaker1:
But in order to do a Roth conversion, there are no earnings limits or contribution limits. So it's not like you can only convert 6000 a year or 7000 a year if you're 50. Right. There's no earnings limits either on how much you can earn in a given year in order to do a Roth conversion. So the reason people do this is simply because. They can write, you have the ability to do it. And that's why this is also known as a back door Roth. It's a way for people who are generally not eligible to contribute to a Roth IRA to convert traditional funds into tax free or Roth funds. Now, we'll say the only restriction is the five year rules still apply. So if you convert money, it needs to stay in there for at least five years before you start withdrawing it. It's not converted to tax free dollars and start immediately taking it out because otherwise you will be penalized because you haven't satisfied the five year rule yet. I mentioned taxes are paid up front. So if you have a pretty big balance and let's say your TSP and you want it to convert that to Roth money, well, unfortunately, in order to convert it all, you'd have a pretty big tax liability in order to do so. Let's say you had 500,000 in your TSP and you said, Well, I want to turn this all into tax free dollars.
Speaker1:
How can I do that? Well, we can take 500,001 day and the next day it's now tax free. Voila. But you're going to get a big tax bill because it's going to be as if you earned an extra 500,000 for that tax year, which can not only bump you into a higher tax bracket and you have to pay more on the converted amount, but you have to pay more tax on all the money you earned as income that year, too, because you're in a total, totally new tax bracket. So that's where we can talk about partial Roth conversions. And that's a way that federal employees and others can take portions at a time and convert them gradually. So you're not stuck with a large tax bill. Let's go back to that 500,000 example. And let's say and this is a question I normally ask federal employees to ask their CPA or their accountant or tax professional. So what you're worried about going into higher tax brackets, ask them how much more can you earn this year before going into a higher tax bracket or without bumping up a couple tax brackets? Right. Let's say that the number was well, I found out that I'd be safe to convert only $100,000 a year. So we can take 500,000 and we can convert 100,000 per year each year until all 500,000 is fully converted five years from now.
Speaker1:
Now, instead of paying a tax bill on all 500,000 up front, you'd pay an incremental tax bill. You'd pay taxes on 100,000 each year for five years, and that would really limit your total tax liability. Over time, you'd end up paying less taxes. And then at the end of five years, the entire amount would be considered growth and tax free dollars. So really, you decided to prepay Uncle Sam here. Uncle Sam, you're no longer going to be my partner in retirement. I'm prepaying you what I owe you. And now my money is free and clear. All the earnings that I'm going to have in my account are going to grow and grow tax free, and you can't touch any more of it. And that's a big, big, big concern that we get with federal employees. As I mentioned earlier, the reason we started talking about this and tax free retirement strategies in our federal presentations and seminars is because it's feedback we're getting from you all. You're concerned about taxes going up in the future and what kind of a problem or issue that's going to have on your retirement, what kind of effect it's going to have on your bottom line, your net income. So you can take care of that now. And if you believe that you're going to be in a lower tax bracket today, then you will be in the future. Why not prepay the tax, or at least some of it, or gradually over time, so that when you get to that point, if taxes do go up, you don't owe a penny on those withdrawals from the Roth accounts.
Speaker1:
You'll still owe taxes on your pension and your Social Security benefits and some of your TSP. But you can eliminate a good amount of your taxes by prepaying them, either through incremental contributions in a Roth IRA or taking big lump sums of money from previous four one K's or IRAs and converting them either in a lump sum one time or truly over time. I use the five year example, but it can be more than that. It can be five, six, ten years. It can take you to convert everything, whatever is best for you in your situation. So I hope you enjoyed our talk today about tax free retirement strategies using Roth IRAs. If you have any questions for us, please reach out to us. Visit our website, think abc.com, ask questions, get a full review of your situation and see if starting a Roth IRA or doing a Roth conversion is right for you, your situation, your family, your future, your retirement. Again, my name is Val Majewski. I'm the host of the Federal Retirement Show. I appreciate you taking the time to join me today to learn about this important topic. And we look forward to seeing you on a future episode. And.
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