I have a new client who engaged me on a hourly basis. He wanted some help to determine the best way to handle a forthcoming distribution from a profit sharing plan and a low 6-figure gain on the sale of his personal residence. He was concerned about taxes and IRAs.
He is 52 years old, divorced with grown kids, moving to a different state, starting a new job and is excited by his prospects.
This current year, he will earn somewhere in the low $30,000s. Next year, he will earn much more, in the mid-to-upper $50,000s.
He wanted to take his $30,000+/- profit sharing distribution as a taxable event and then contribute it to a Roth IRA.
He didn’t have any real plan for the $120,000+/- expected proceed from the sale of his home.
Want to know what I suggested?
Let’s start with 3 Roth IRA basics:
- Roth IRAs are after tax, but the earnings grow tax-free forever. They are not subject to required minimum distributions, which can simplify retirement income planning.
- Roth IRAs are best when you are young, in a low income tax bracket or at times such as 2008-2010 when markets are significantly depressed.
- Anyone can convert traditional IRA money to a Roth IRA by including the conversion amount in taxable income and paying the tax. Contributions to a Roth, like a traditional IRA, are limited to $5,500 (or $6,500 if 50 or older) this year and are subject to higher income phase-outs. Conversions are subject to a 5-year timetable where they are not available for distribution, whereas contributions are always available for distribution.
The following is a bit dense, but stay with me…
If my client takes a $30,000 distribution from a profit sharing plan as a taxable event, he will not only pay ordinary income tax on it but also be subject to an early distribution penalty of 10% because he is under 59½ years old.
Further, the addition of $30,000 of income pushes him well into the 25% federal income tax bracket, up from 15%.
So, the vast majority of his newly enjoyed $30,000 windfall will be eaten up by 35% to the feds and 6% to the state of Georgia. Some $12,300 gets to be enjoyed and spent by government instead of him, leaving him with less than $18,000 to spend and invest as he chooses.
I suggested that he roll the distribution over to a rollover IRA, deferring the tax. Then, convert a small portion to a Roth IRA penalty free and within his remaining 15% tax bracket.
Next, take $6,500 of the proceeds from the sale of the home and contribute it to his new Roth IRA this year, he is over 50. There is no tax liability, $250,000 of gain from personal residences is excluded from taxable income. And though contributions to an IRA have to come from earned income, he has plenty, so nothing other than switching accounts is going on here.
Next year, I want him to participate in his new company’s 401k plan, which has a 3% match, electing to defer 10% of his income, roughly $5,700, and contribute it to the plan. And, take another $6,500 from the home sale proceeds to contribute to his rollover IRA.
Since he is under the income earning limitations of around $62,000 adjusted gross income, he can do both. Because he will in 2018 be squarely within the 25% federal income tax bracket at some $57,000 of income, he will enjoy a 25% federal and 5.75% state income tax deduction (he is moving to Virginia) on both the contribution and his elective 401k contributions.
Keep the rest of the home sale proceeds in a taxable brokerage account, investing most of it very conservatively, avoiding any loss on his money. For now, he is renting, but may want to purchase another home as he gets settled and acclimated in Virginia.
Let’s add it up:
- He is saving some $12,300 in taxes by using a rollover IRA instead of a Roth IRA.
- He will be paying roughly $750 in tax on some $5,000 converted to a new Roth IRA.
- He will save roughly $3,752 in federal and state income tax next year with the 401k and IRA contributions.
- A net savings of $15,300.
Like it? Does this make sense? Other ideas?
If you have a question or would like to learn more, give me a ring…