Skip to main content

Tag: Retirement

Understanding IRAs

Understanding IRAs

An individual retirement arrangement (IRA) is a personal savings plan that offers specific tax benefits. IRAs are one of the most powerful retirement savings tools available to you. Even if you’re contributing to a 401(k) or other plan at work, you might also consider investing in an IRA.

What types of IRAs are available?

The two major types of IRAs are traditional IRAs and Roth IRAs. Both allow you to contribute as much as $6,000 in 2022 (unchanged from 2021). You must have at least as much taxable compensation as the amount of your IRA contribution. But if you are married filing jointly, your spouse can also contribute to an IRA, even if he or she has little or no taxable compensation, as long as your combined compensation is at least equal to your total contributions. The law also allows taxpayers age 50 and older to make additional “catch-up” contributions. These folks can contribute up to $7,000 in 2022.

Both traditional and Roth IRAs feature tax-sheltered growth of earnings. And both give you a wide range of investment choices. However, there are important differences between these two types of IRAs. You must understand these differences before you can choose the type of IRA that’s best for you.

Note: Special rules apply to certain reservists and national guardsmen called to active duty after September 11, 2001.

Learn the rules for traditional IRAs

Practically anyone can open and contribute to a traditional IRA. You can contribute the maximum allowed each year as long as your taxable compensation for the year is at least that amount. If your taxable compensation for the year is below the maximum contribution allowed, you can contribute only up to the amount that you earned.

Your contributions to a traditional IRA may be tax deductible on your federal income tax return. This is important because tax-deductible (pre-tax) contributions lower your taxable income for the year, saving you money in taxes. If neither you nor your spouse is covered by a 401(k) or other employer-sponsored plan, you can generally deduct the full amount of your annual contribution. If one of you is covered by such a plan, your ability to deduct your contributions depends on your annual income (modified adjusted gross income, or MAGI) and your income tax filing status:

For 2022, if you are covered by a retirement plan at work, and:

  • Your filing status is single or head of household, and your MAGI is $68,000 or less, your traditional IRA contribution is fully deductible. Your deduction is reduced if your MAGI is more than $68,000 and less than $78,000, and you can’t deduct your contribution at all if your MAGI is $78,000 or more.
  • Your filing status is married filing jointly or qualifying widow(er), and your MAGI is $109,000 or less, your traditional IRA contribution is fully deductible. Your deduction is reduced if your MAGI is more than $109,000 and less than $129,000, and you can’t deduct your contribution at all if your MAGI is $129,000 or more.
  • Your filing status is married filing separately, your traditional IRA deduction is reduced if your MAGI is less than $10,000, and you can’t deduct your contribution at all if your MAGI is $10,000 or more.

For 2022, if you are not covered by a retirement plan at work, but your spouse is, and you file a joint tax return, your traditional IRA contribution is fully deductible if your MAGI is $204,000 or less. Your deduction is reduced if your MAGI is more than $204,000 and less than $214,000, and you can’t deduct your contribution at all if your MAGI is $214,000 or more.

What happens when you start taking money from your traditional IRA? Any portion of a distribution that represents deductible contributions is subject to income tax because those contributions were not taxed when you made them. Any portion that represents investment earnings is also subject to income tax because those earnings were not previously taxed either. Only the portion that represents nondeductible, after-tax contributions (if any) is not subject to income tax. In addition to income tax, you may have to pay a 10% early withdrawal penalty if you’re under age 59½, unless you meet one of the exceptions. You must aggregate all of your traditional IRAs — other than inherited IRAs — when calculating the tax consequences of a distribution.

If you wish to defer taxes, you can leave your funds in the traditional IRA, but only until April 1 of the year following the year you reach age 72. That’s when you have to take your first required minimum distribution (RMD) from the IRA.1 After that, you must take an RMD by the end of every calendar year until you die or your funds are exhausted. The annual distribution amounts are based on a standard life expectancy table. You can always withdraw more than you’re required to in any year. However, if you withdraw less, you’ll be hit with a 50% penalty on the difference between the required minimum and the amount you actually withdraw.

Learn the rules for Roth IRAs

Not everyone can set up a Roth IRA. Even if you can, you may not qualify to take full advantage of it. The first requirement is that you must have taxable compensation. If your taxable compensation in 2022 is at least $6,000, you may be able to contribute the full amount. But it gets more complicated. Your ability to contribute to a Roth IRA in any year depends on your MAGI and your income tax filing status:

  • If your filing status is single or head of household, and your MAGI for 2022 is $129,000 or less, you can make a full contribution to your Roth IRA. Your Roth IRA contribution is reduced if your MAGI is more than $129,000 and less than $144,000, and you can’t contribute to a Roth IRA at all if your MAGI is $144,000 or more.
  • If your filing status is married filing jointly or qualifying widow(er), and your MAGI for 2022 is $204,000 or less, you can make a full contribution to your Roth IRA. Your Roth IRA contribution is reduced if your MAGI is more than $204,000 and less than $214,000, and you can’t contribute to a Roth IRA at all if your MAGI is $214,000 or more.
  • If your filing status is married filing separately, your Roth IRA contribution is reduced if your MAGI is less than $10,000, and you can’t contribute to a Roth IRA at all if your MAGI is $10,000 or more.

Your contributions to a Roth IRA are not tax deductible. You can invest only after-tax dollars in a Roth IRA. The good news is that if you meet certain conditions, your withdrawals from a Roth IRA will be completely income tax free, including both contributions and investment earnings. To be eligible for these qualifying distributions, you must meet a five-year holding period requirement. In addition, one of the following must apply:

  • You have reached age 59½ by the time of the withdrawal
  • The withdrawal is made because of disability
  • The withdrawal is made to pay first-time home-buyer expenses ($10,000 lifetime limit)
  • The withdrawal is made by your beneficiary or estate after your death

Qualified distributions will also avoid the 10% early withdrawal penalty. This ability to withdraw your funds with no taxes or penalties is a key strength of the Roth IRA. And remember, even nonqualified distributions will be taxed (and possibly penalized) only on the investment earnings portion of the distribution, and then only to the extent that your distribution exceeds the total amount of all contributions that you have made. You must aggregate all of your Roth IRAs — other than inherited Roth IRAs — when calculating the tax consequences of a distribution.

Another advantage of the Roth IRA is that there are no required distributions. You can put off taking distributions until you really need the income. Or, you can leave the entire balance to your beneficiary without ever taking a single distribution.

Choose the right IRA for you

Assuming you qualify to use both, which type of IRA is best for you? Sometimes the choice is easy. The Roth IRA will probably be a more effective tool if you don’t qualify for tax-deductible contributions to a traditional IRA. However, if you can deduct your traditional IRA contributions, the choice is more difficult. The Roth IRA may very well make more sense if you want to minimize taxes during retirement and preserve assets for your beneficiaries. But a traditional deductible IRA may be a better tool if you want to lower your yearly tax bill while you’re still working (and probably in a higher tax bracket than you’ll be in after you retire). A financial professional or tax advisor can help you pick the right type of IRA for you.

Note: You can have both a traditional IRA and a Roth IRA, but your total annual contribution to all of the IRAs that you own cannot be more than $6,000 for 2022 ($7,000 if you’re age 50 or older).

Know your options for transferring your funds

You can move funds from an IRA to the same type of IRA with a different institution (e.g., traditional to traditional, Roth to Roth). No taxes or penalty will be imposed if you arrange for the old IRA trustee to transfer your funds directly to the new IRA trustee. The other option is to have your funds distributed to you first and then roll them over to the new IRA trustee yourself. You’ll still avoid taxes and the penalty as long as you complete the rollover within 60 days from the date you receive the funds.

You may also be able to convert funds from a traditional IRA to a Roth IRA. This decision is complicated, however, so be sure to consult a tax advisor. He or she can help you weigh the benefits of shifting funds against the tax consequences and other drawbacks.

Note: The IRS has the authority to waive the 60-day rule for rollovers under certain limited circumstances, such as proven hardship.

1If you reached age 72 before July 1, 2021, you will need to take an RMD by December 31, 2021.

To discuss this article further or to learn more about CapSouth Wealth Management, visit our website at www.capsouthwm.com or call 800.929.1001 to schedule an appointment to speak with an advisor.

Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice. Any performance data quoted represents past performance; past performance is no guarantee of future results.

Reverse Budgeting

How Much Do I Spend in Retirement?  Does it Really Matter?  What if I could budget without…budgeting?

At CapSouth, it is our mission to help clients define and live their One Best Financial Life™.  We challenge clients to consider their values and what is important to them, and then to develop actionable goals that we endeavor to help them achieve.  This leads to the need to have a sound financial plan in place that considers a client’s assets and resources, and projects their probability of meeting those stated goals.  We want clients to live with confidence in peace of mind, knowing that they are on track to live the life they want to live.  Sometimes the focus of planning needs to be encouraging a client to scale back and pace their spending to allow for a more secure retirement.  Other times that planning focus should be to urge a client to spend more, to travel, to take the family with them on vacations and make memories…to live their life more fully.  In all cases, we are looking for the client’s confidence zone in their plan to serve as guard rails, so that they are not worried about running out of money, and on the other end, they are not leaving significant assets behind that are unplanned for.

More often than not, it seems, we meet with clients who do not have a clear idea of how much they spend.  Particularly when a couple nearing retirement comes to us as a new prospect, a common answer is that they have just always lived within their means, or spent less than they made.  How much you spend in retirement is very important in planning.  Depending on your age at retirement and your assets, a seemingly small change in your annual spending can make a significant difference in the success of your plan.  Many people plan for thirty years or more in retirement – a long time for inflation and market fluctuations to catch up with you and to affect your probability of meeting all your goals and objectives.  We have invested in sophisticated software to factor in these variables for you, to allow you to simply think of how much you will need for retirement in today’s dollars.  That does require us, though, to have an accurate number for that element.  Whether we are planning for annual living expenses of $50,000 or $500,000, we need some assurance that this number is reliable.

But who wants to budget?  You should see some of the facial expressions we get when we mention that “B word”!  And if you are newly in, or approaching, retirement, how do you really know what your retirement lifestyle will be and what it will cost you?  Further, trying to look at past or future spending can be even more difficult when you have varying sources of income throughout the year.  Fear not, we have a solution.  Reverse Budgeting.  I believe in giving credit where it is due, so I will tell you this is not my concept; I learned it from CapSouth’s founder, Donald Bolden, years ago, and I have been recommending it to clients in retirement ever since. 

Here’s how it works:

  1. As best you can, come up with an idea of what you expect your basic living expenses to be in retirement.  This should not include other specified goals in your plan such as travel, new cars, etc., but your basic living expenses of utilities, groceries, fuel, clothing, dining out, and the like.  For illustration purposes, let’s say that number comes out to $5,000 per month.
  2. Now, figure up what regular income sources you have such as Social Security, pensions, rental income, etc.  For this number, let’s assume $3,000 per month.
  3. Set up an “operating account” for your household and start it with a cushion balance of your comfort level.  Let’s use $25,000. (Note:  You and your spouse may decide to have two operating accounts; the concept still works.)
  4. We would then work with you to establish a conservative Cash Management Account (CMA) among your accounts at Schwab, from which we would establish a recurring monthly transfer of the $2,000 per month to supplement your income and meet your expected expenses of $5,000 per month.  We typically recommend this transfer being set up to occur on the 5th of each month rather than the 1st, to help track which deposit was for which month and to not allow weekends or holidays to confuse things.
  5. What about those random sources of income throughout the year?  Still employed and have a varying income?  Receive additional bonuses?  It is so easy to allow yourself to quickly spend that seemingly “extra” income without realizing it, giving yourself (and us) an inaccurate picture of the cost of your lifestyle.  Under the Reverse Budgeting model, all variable income is deposited into the cash management account at Schwab, adding to the funds available to provide for your monthly transfers to your operating account.
  6. It is likely no surprise to you that some months will cost more than others.  You may have family visiting and spend more on groceries.  You might have an anniversary and treat yourself to a nice dinner and some gifts to celebrate.  Your refrigerator might need to be repaired or replaced.  However, if we look back at this operating account in six months, a year, or more, we can get an idea of what you were really spending. 

If that $25,000 cushion is down to $5,000, then we have a problem and need to make adjustments.  We would review to see if there were a number of non-recurring, unexpected expenses during that period, or if life just cost more than you thought.  We could increase the goal for living expenses in the plan to see if the new amount is still successful or what trade-offs need to be considered.  If your regular monthly expenses are $6,000 or $7,000, then maybe you need to consider reducing those big trips each year from three down to two. 

If that cushion is up to $50,000, we also have an inaccurate plan and need to make adjustments.  We might encourage you to consider what goals you had for retirement spending that you haven’t been doing and challenge you to do what you said that you valued.  It could also open the door for more travel, giving to charity or your family, upgrading your vehicle, buying a second home…whatever that looks like for you.  If you are doing everything you want to, then we need to acknowledge that you are going to likely leave more behind than you might have thought, and we may need to review your estate plan to make sure it aligns with your wishes.

This is a simplified example, and we recognize that yours may be more complex.  Life certainly will happen, and circumstances will change.  Planning is never complete, and we continue to monitor, review, and update assumptions over time.  Reverse Budgeting is a tool that can help to provide more confidence and reliability to your financial planning process, without having to focus on the “B word” of budgeting.  We may not be able to tell where the money is going, but we (and you) can tell how much is needed to maintain your lifestyle.

To discuss this article further or to learn more about CapSouth Wealth Management, visit our website at www.capsouthwm.com or call 800.929.1001 to schedule an appointment to speak with an advisor.

By: Scott McDowall, CFP®

Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice. Any performance data quoted represents past performance; past performance is no guarantee of future results.

IRA Strategy

IRA Strategy #1

The 50/50 Minimum Strategy:  Maintain 50% of your 401(k) and IRA money in Roth accounts

Why pay taxes today when you can postpone them until years later? The obvious answer is to delay paying taxes as long as possible.  But sometimes the obvious answer is not the best answer.  Let’s consider several assumptions that support the 50/50 Minimum Strategy.

First, if one invests the money that would have gone to taxes, it should compound over time and the total investments, less the eventual taxes to be paid, would potentially be greater than the amount of the Roth conversion, plus earnings.  The problem with this is most people will not diligently invest the money that would have gone to pay the tax.  It is more easily spent in the normal household budget.  And even if it were invested, the potential to keep it invested over a long period of time is dependent on many variables. 

Second is the assumption that a person’s income will be lower in retirement. This is true for many taxpayers.  However, many of our clients remain in a high tax bracket after retirement.  This is especially true if one has large IRA balances that require minimum distributions combined with large investment accounts that create capital gains. 

Third is the assumption that tax rates will remain relatively stable over time.  This is the most dangerous assumption.  Congress has the power to change the tax rates at any time and with the skyrocketing budget and related government debt, it appears likely that tax rates will be higher in the future. So, even if one’s income is lower, the tax rate could be higher. 

How high could tax rates go?  The following chart provides a history of the highest marginal tax rate for 1944 through 2022 for married couples filing jointly:

Years                                                 Highest Marginal Rate#                 Taxable Income Over#

1944 through 1951                           91%                                                 $200,000 (1950)

1952 through 1953                           92%                                                  $300,000 (1953)

1954 through 1963                           91%                                                   $300,000 (1958)

1964                                                  77%                                                   $200,000 (1964)

1965 through 1981                           70%                                                   $180,000 (1974)

1982 through 1986                           50%                                                   $108,300 (1984)

1987                                                  38.5%                                                $80,000 (1987)

1988 through 1990                          28%        (Bubble Rate 33%)           $78,400 (1988)

1991 through 1992                           31%                                                    $70,450 (1991)

1993 through 2000                          39.6%                                                  $288,350 (2000)

2001                                                  39.1%                                                  $297,350 (2001)

2002                                                 38.6%$                                                 $307,050(2002)                           

2003 through 2012                           35%                                                     $388,350 (2012)

2013 through 2017                           39.6%                                                  $444,550 (2017)

2018 through 2022                           37.0%                                                  $647,850 (2022)

#  Rate for Married Couples Filing Jointly

 Information provided by The Tax Foundation, Washington, DC. 20005

The strategy that we have continued to recommend to most of our clients is to approach retirement with a minimum of 50% of their IRA and 401(k) assets held in Roth accounts.  With this approach, an investor takes a balanced approach to the payment of taxes.  Pay taxes at the rates in effect now on the Roth contributions and conversion amounts while delaying the taxes on the non-Roth portion of their deferrals or contributions.  If we err on one side or the other, we prefer to convert more of the retirement assets and pay the taxes at today’s rates as opposed to leaving these assets subject to whatever future rate Congress enacts. 

If a client is charitably minded, we do not recommend converting ALL your IRA assets.  The preferred use of a portion of your IRA assets is to process Qualified Charitable Distributions (QCD) with the pre-tax IRA assets.  After age 70.5, taxpayers may donate money directly from their IRA to qualified charities utilizing the QCD provisions.  The annual limit on QCD donations is currently $100,000. 

ACTION:  Consider adopting the strategy of working towards a minimum Roth balance of 50% of your total retirement assets by your retirement date.  Work with your financial advisor to determine if you should convert a higher percentage. 

To discuss this article further or to learn more about CapSouth Wealth Management, visit our website at www.capsouthwm.com or call 800.929.1001 to schedule an appointment to speak with an advisor.

By: Donald P. Bolden, CFP®, CLU & Lewis Robinson, CPA

Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice. Any performance data quoted represents past performance; past performance is no guarantee of future results.

Help us keep you informed!

Let us do the work and keep you updated! Sign up for the CapSouth financial updates.

You have Successfully Subscribed!