Can Early Retirement Reduce the Cost of Taxes?

I've got 30 years on the job, my 457 plan is funded with pre-tax dollars, and I'm worried. How will the coming payroll tax hikes affect my payouts? I'm considering retiring early, rolling over the balance into a Roth IRA, and [paying taxes today at a lower rate], rather than being at the mercy of the government [if I were to retire later]. Any comments? – D.D., Grand Prairie

July 6, 2012 - Answered by Al

Al's Answer:

It’s smart for you to be thinking about the impact of taxes on your retirement assets. Taxes can make up a significant cost of investing.
 
And at least for wealthier Americans, income and investment-related taxes which are at historic lows are scheduled to increase. Here’s what we know so far.
 
Beginning 2011, if the Budget plan recently proposed by the Obama administration is enacted, taxes would increase for individual filers with more than $200,000 in taxable income and married filing jointly filers with more than $250,000 in taxable income. This includes:
 
  • a change in the income tax brackets so that taxable income above those amounts is taxed at higher rates. (Fairmark.com has a helpful primer on tax brackets.)
  • higher long-term capital gains and qualified dividend tax rates.
  • a reduction in the extent to which personal exemptions and itemized deductions offset taxable income.
 
But given mounting budget deficit concerns, it’s reasonable that the $200,000 and $250,000 thresholds could be lowered in the near future.

(The Urban Institute and Brookings Institution Tax Policy Center has a detailed explanation of the proposed changes.)
 
What if no changes are enacted? Then, beginning 2011, earned and investment income taxes will rise for even more individuals — including 27 million households with income under $30,000 according to the Tax Policy Center — because of the various tax changes enacted in 2001 that are set to expire. (Another possibility is that Congress extends all current rates but only temporarily.)
 
Meanwhile, beginning 2013, as a result of the health-care reform act, additional payroll taxes are already scheduled to apply to earnings above $200,000 for individual filers ($250,000 for married joint filers), as are additional investment income taxes on non-retirement accounts (such as interest, dividends, and capital gains) to the extent they push one’s modified adjusted gross income (MAGI) over those same thresholds. (Kiplinger has a useful overview of the complete health bill tax rules.) While retirement plan distributions are not directly subject to either of those taxes, they could still indirectly affect you by, for example, increasing your MAGI so that you become exposed to the investment income tax.
 
Finally, you should consider whether state taxes might increase (income, as well as sales, property, estate, etc.) and whether the Alternative Minimum Tax, or AMT, might apply to you. (The IRS has a handy fact sheet on its Web site to help explain AMT.)
 
So what to do?
 
Look beyond the tax factor. First, take a step back — you don’t want to make decisions based solely on taxes without considering your overall situation. As an example, many financial professionals have stories of investors who held onto an individual stock for fear of paying taxes on their profits only to see it plummet in value, or who lost money buying tax-sheltered products of dubious value. While very important, taxes are only one of many considerations.
 
Consider your current and future finances. If you've thoroughly considered your overall financial situation and the quality of life you want to live, retiring early may be a justifiable and wise move. But it is not likely to benefit you economically. The earlier you retire, the less you can potentially save, the less your pension and/or Social Security benefits might increase, and the earlier and the more you'll potentially spend because you’re not working.
 
To Roth or not to Roth? Converting your 457 plan to a Roth IRA, in which you pay taxes now in return for tax-free earnings going forward, generally makes sense if you think your tax rate when you withdraw will be higher than the tax rate you pay to convert, and you have separate money available to pay the tax. But if you retire and are no longer earning a salary, are you sure you will be in a higher bracket down the road?
 
With that being said, converting to a Roth still may make sense in order to diversify how your different investments are taxed, providing a unique source of tax-free income you can draw from. Plus, down the road, converting may reduce taxation of Social Security benefits and Medicare Part B Premiums during retirement, as well as help you avoid any possibly unneeded but otherwise mandatory and taxable IRS-required distributions from your 457 plan upon turning age 70½.
 
Remember, a Roth conversion is not an all or none proposition. You can convert any amount. Weigh the pros and cons of converting a significant amount against a strategy of converting smaller amounts over time. For example, one strategy is to convert an amount each year that pushes you to the top of your current bracket. 2010 conversions are unique in that this year only you can spread the tax bill equally across your 2011 and 2012 return. Paying taxes later is often better, but not if you end up paying them at a higher rate.
 
Also, keep in mind that in the future Congress could change the rules so the tax-free benefits of the Roth are somehow lessened either directly or indirectly, say, through an increased consumption tax. While this is not likely, it’s something to consider if you are planning on converting a large amount.
 
The bottom line? It's wise to explore strategies, such as a Roth conversion, that might help you minimize the effect of higher future taxes. Just remember that the economic disadvantages of retiring early in order to expedite the conversion might be problematic. Be sure to work with a qualified financial or tax professional who understands your complete financial solution and who can recommend a strategy that is right for you!

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