Converting taxable income into tax-free income

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1 Converting taxable income into tax-free income Important information for people who still own a traditional IRA

2 Consider the future impact of your IRA Do you own a traditional IRA? Many people nearing or in retirement still own traditional IRAs. If you are one of them, it s important to look ahead and consider how this account may impact your financial future. Will you need your IRA funds during retirement? If you won t need your traditional IRA funds for retirement or will not exhaust your IRA funds, it s likely that they will be passed on to your beneficiary after your death. If your spouse is the beneficiary, your spouse has the option to roll the traditional IRA over into his or her own name at that time and continue the opportunity for tax-deferred growth; subject to required minimum distributions beginning at age 70 1 /2. Did you know there are some significant disadvantages to inheriting a traditional IRA? Example John and Betty Adams have diligently saved for retirement. Currently John s traditional IRA is valued at $500,000. Upon John s death Betty wishes to roll the IRA into her name. However, if Betty withdraws money from the IRA she will owe income taxes on the money withdrawn. In fact, she may owe over $193,000 in taxes on the $500,000. Since the entire balance of a traditional deductible IRA is taxed as ordinary income when it s distributed, your beneficiary will pay federal income tax plus state tax where applicable on all account distributions and any growth of the investment. The same IRA that provided a way to save on taxes during your accumulation years could become a significant tax burden to your spouse after you re gone. Traditional IRA value: $500,000 Taxes on IRA 1 : $193,000 After tax value of IRA: $307,000 1 Assumes the traditional IRA is taxed at 38.6%. The traditional IRA The Individual Retirement Account (IRA) was created by Congress in 1974 to encourage employees to increase their personal retirement savings. Key characteristics include: Tax deductible contributions up to prescribed limits. Tax-deferred growth of funds until they are withdrawn. Withdrawals are fully taxable. Mandatory taxable withdrawals beginning at age 70 1 /2.

3 Is the Roth IRA a better alternative? There are some distinct advantages to inheriting a Roth IRA When a Roth IRA has been established for at least 5 years and the owner satisfies a qualifying event, such as attaining age 59 1 /2, the entire account, including the investment growth, during your life and after your death may be distributed taxfree. At that time, beneficiaries can choose the tax-free income option that best fits their needs. The Roth IRA conversion option Tax law permits owners of traditional IRAs to make a full or partial conversion to a Roth IRA, subject to certain conditions. 1 A conversion is similar to a rollover in that it s an option to transfer your funds from one IRA or IRA provider to another one. The price of a Roth IRA conversion is that you must report the portion of IRA funds converted to a Roth IRA as ordinary income and pay income taxes accordingly. In order to maximize the Roth IRA benefits of tax-free growth and tax-free distributions, it is recommended that the taxes be paid with funds outside the IRA. The conversion dilemma Example Had John s IRA been a Roth IRA, upon his death Betty could still assume ownership. However, money Betty withdraws from the Roth IRA will be income tax-free. In spite of the significant tax advantages of a Roth IRA, many people who own traditional IRAs have not exercised this option because they don t have or don t want to use funds outside their IRA to pay the extra state and federal income taxes. They like the added benefit of tax-free income, but don t want the added tax liability of the conversion. 1 Your modified adjusted gross income MAGI federal income tax return must be $100,000 or less in the year of the conversion. You must not be filing your taxes married filing separate. Roth IRA value: $500,000 Taxes on IRA: $0 After tax value of Roth IRA: $500,000 The Roth IRA The Roth IRA was created as a part of the Taxpayers Relief Act of While it provides no deduction for contributions like the traditional IRA, the Roth IRA offers some significant benefits: Withdrawals are potentially income tax-free to you or your beneficiary. No minimum distribution requirements during the owner s life, so your earnings can continue to grow tax free. Options for early distributions without penalty.

4 A potentially cost-effective conversion solution Plan today for a Roth IRA conversion as part of your estate plan, using life insurance to cover the taxes Consider the benefits of a full or partial Roth IRA conversion following your death with money outside the IRA to pay the income tax. When spouses are the primary beneficiaries of IRAs, they have the option to roll them over into their own names, and then elect full or partial conversions to Roth IRAs. When you purchase life insurance and make it payable to your spouse, you are providing a source of funds to pay the taxes on the Roth IRA conversion, if your spouse chooses that option. Either way, the life insurance death benefit will enhance your spouse s financial position. Your spouse benefits from owning a Roth IRA Example To pay the taxes due on the Roth IRA conversion John purchased a life insurance policy on his life. Upon his death, Betty receives the life insurance proceeds income taxfree. Betty can use the money to pay the income taxes on the conversion to a Roth IRA. When spouses convert to Roth IRAs, they will have more flexibility than they would have had with traditional IRAs: The decision of converting to a Roth IRA if, when and how much is up to your spouse after your death. There are no government mandated distributions from a Roth IRA at age 70 1 /2 so your spouse is free to choose if, when and how much to withdraw. All distributions are income tax-free once the Roth IRA has been established for at least five years, and the owner satisfies a qualifying event, such as attaining age 59 1 /2. When your spouse dies, the balance of the account may be distributed income taxfree to a beneficiary(ies) who has the option of deciding when and how to take the funds, subject to certain limitations. Converting taxable income into tax-free income Converting a traditional IRA to a Roth IRA can be an effective strategy for converting taxable income into tax-free income. Consult your Woodbury Financial Services representative to see how this potentially cost-effective solution for a Roth IRA conversion may benefit your financial planning for the future.

5 The same IRA that provided a way to save on taxes during your accumulation years could become a significant tax burden to your spouse after you re gone. The importance of looking ahead How will your financial decisions impact your spouse after you re gone? Most of us want to leave our loved ones as financially secure as possible, so we make decisions with the intention of: maximizing the value of the financial assets they will inherit, minimizing the impact of income and estate taxes, and ensuring flexibility and control for them. Good intentions don t always bring about desired results Financial decisions are often made for the right reasons at the time. However, as investment options and income and estate tax laws change, those decisions may later prove to be less than desirable in terms of estate planning. That may be the case if you still own a traditional IRA that is likely to be passed on to your spouse.

6 For more complete information, including charges and expenses, ask your investment professional for a prospectus. Always read the prospectus carefully before investing or sending money. Investment products offered through Woodbury Financial Services, Inc. are not insured by the FDIC or NCUA, have no bank guarantee, and may lose value. WOODBURY FINANCIAL SERVICES, INC. Member NASD, SIPC P.O. Box St. Paul, MN (800) /02 Woodbury Financial Services, Inc.

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