(PUB) Investing 2015

March 2015

Morningstar FundInvestor

17

Situation: You want to convert traditional IRA assets to Roth. Tactic: Favor lower-tax distributions from Roth or taxable accounts. Converting traditional IRA assets to Roth can jack up a tax bill, as you’ll owe ordinary income tax on the converted amounts that consist of deductible contri- butions and investment earnings. Thus, one of the best times to consider converting all or a portion of a traditional IRA or 401 (k) kitty to Roth is after retire- ment (and, thus, there’s no salary income coming in the door) and before that traditional IRA or 401 (k) is subject to RMD s. To limit the total tax bill, the retiree can take the lowest possible distribution that year, favoring distributions from Roth and taxable accounts. If you find yourself with unusually high deductions in a given year—for example, you’ve made large charitable contributions or incurred extensive tax- deductible health-care expenses—that can be an ideal time to take more from your tax-deferred accounts than might otherwise be the case. You’ll be paying taxes at a lower rate for the year, and expe- diting your tax-deferred distributions can also serve to reduce the amount that will be subject to RMD s in the future. (The opposite tack is also reasonable: Favor distributions from Roth and taxable accounts if you find yourself in a high-tax year and have few available deductions.) Situation: Your RMD s are unusually high. Tactic: Favor lower-tax distributions from Roth or taxable accounts. Once RMD s start after age 70 1 / 2 , you lose some of the control over your tax situation that you had before. And because the percentage of your required minimum distribution will depend on your age, and the actual amount will be based on the size of your tax-deferred portfolio, there may be some years when your RMD s could leave you with more income subject to ordinary income tax than would otherwise be desirable. In those years, favoring addi- Situation: Your deductions are unusually high. Tactic: Favor tax-deferred distributions.

tional distributions from taxable or, ideally, Roth accounts will be preferable to taking those additional distributions from your tax-deferred account. Situation: One spouse is still working. Tactic: Favor lower-tax distributions from Roth or taxable accounts. As the above examples demonstrate, retirees have some flexibility to use withdrawal sequencing to finesse the amount of taxable income they receive in a given year. But if one partner in a couple is still working and the other retired, the couple may have reason to favor lower-tax distributions (from Roth and taxable accounts) in the years in which one partner is still drawing a salary. After all, the salary will be taxed as ordinary income, whereas the portfolio distri- butions don’t necessarily have to be. The ability to take tax losses on depreciated invest- ments can be a silver lining in a difficult market, espe- cially if you wanted to sell the investment anyway or can swap into a similar investment. You can use those losses to offset up to $3 , 000 in ordinary income or an unlimited amount of capital gains; what losses you don’t use in a given year can be used in future years. In years they’ve taken tax losses, retirees might give preference to distributions from their tax-deferred accounts, in that they can use the losses to offset at least a portion of the distribution. œ Contact Christine Benz at christine.benz@morningstar.com Situation: You have substantial tax losses. Tactic: Favor tax-deferred distributions.