Within the last several days, President Obama released his 2017 budget proposal to the public. Included in the proposal were many provisions that targeted retirement income. Between this proposal targeting retirement income and the Bipartisan Budget signed last year that eliminated Social Security claiming strategies, it sure seems retirement strategies are being picked on quite a bit lately. But let’s remember, the President’s proposal shouldn’t be seen as anything more than a “wish-list”. While the “wish-list” provides a good indication of where the administration may be heading, it could take years before any of the provisions gain traction. In the meantime, it’s important to take advantage of the retirement strategies available to us.
One strategy that the President’s proposal would eliminate but is still available this year is known as a “backdoor” Roth. A Roth IRA is funded with after-tax dollars which allows the funds to grow tax-free. In addition, Roth IRAs do not require a minimum distribution to be taken. The limitation with Roth IRAs is that higher earners are not allowed to contribute to these accounts. In the spirit of the law, this would only give these individuals access to a traditional IRA. Traditional IRAs are funded with pre-tax dollars which are then taxed upon withdrawal. These accounts also require a person to take a minimum distribution starting at age 70 ½. By using a “backdoor” approach, these higher earners can have the benefit of contributing money to a Roth IRA. The sequence of action would be for the person to contribute to a nondeductible IRA, then convert to a Roth immediately afterwards. If the taxpayer does not have any pre-tax funds in their IRA, the conversion can be made without tax.
Late in 2015, Congress made permanent a few tax provisions that were set to expire at year-end. One in particular allows individuals to make charitable donations directly from their traditional IRA without treating the distribution as taxable income. As mentioned above, distributions from a traditional IRA are generally taxable and are required when a person reaches age 70 1/2. This transaction, known as a Qualified Charitable Distribution (QCD), will count towards the required minimum distribution but will not be treated as taxable income. To be considered a QCD, the individual must be age 70 ½ or older, the distribution must be paid to a public charity, the full payment must qualify as a charitable contribution and the distributions must be a direct transfer from the IRA trustee to the charity.
Being that the QCD is excluded from taxable income, the charitable donation itself cannot be deducted on an individual’s tax return. At first glance, this may seem to provide no real tax benefit. Why not just include the distribution as income and take the deduction? For many people, this may be the right strategy. For those individuals that are subject to itemized deduction phaseouts and the 3.8% Medicare tax on investment income, a QCD can help minimize or avoid these consequences. In addition, excluding IRA distributions from income will lower adjusted gross income (AGI) and may make it easier to deduct medical expenses and miscellaneous expenses subject to 2% of AGI, reduce the taxability of social security benefits and minimize the Medicare Part B insurance premiums.
It’s typically best practice to make your Roth or Traditional IRA contributions early in the year, so they can grow tax-free or tax deferred all year. Most of you will be meeting with your CPA or financial advisor within the next several weeks. This will be a good time to discuss these two strategies and see if they will work for you. Here at DWM, we are always happy and available to have these discussions with our clients, during tax season or not. Please let us know how we can help.