Author Topic: Has anyone converted large Traditional IRA balances to Roth’s tax efficiently?  (Read 7171 times)

Mister Fancypants

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I know this is a very 1st world problem to have so I am not complaining just looking for people who might have had to deal with this and see how they have addressed it.

Does anyone have any experience or suggestions on strategies on how to convert large Traditional IRA account balances to Roth accounts?

I am looking to plan for the future, right now my wife and I are in our late 30's with two young children and we currently fall into the 25% marginal tax bracket. We are currently in the contributing phase, I max out my 401(k) for the full $17,500 my company matches 25% of my contributions, and my current vesting is 33% in June is goes to 50%. My wife has a 403(B) that she cannot contribute to but she receives $6200 match contribution annually that account currently has a balance of $10k which we are about to roll into her IRA.

My Traditional IRA balance is about $220k, I have another $38k in my 401(k) that is vested and another $7k that is not vested, half of that will be vested in June if I stay with my current job which is up in the air. If I switch jobs I will rollover my 401(k) to my IRA as well. My wife also has about $210k in a Traditional IRA, I will be making a spousal contribution to my wife’s Traditional IRA as well for 2013 in the next month. I have $22k in a Roth IRA and will be making a 2013 contribution and my wife has $20k in her Roth IRA.

  • Total Traditional IRA assets $445k
  • Total 401(k) assets $45k
  • Total Roth IRA assets $48k

Between the 401(k) and spousal contributions we are getting $23k in tax savings at 25% (+ 6.85% NYS), so it would be self-defeating to try to convert any of our account balances now, not to mention we are in a higher tax bracket to start out with (it used to be higher), I see our contributions continuing at the current rate over time probably for at least the next 10 years maybe 15 so our account sizes are going to grow substantially, and the bigger they get the harder it will be to convert them to Roth’s without having an excessive tax burden.

Somewhere along the line we are probably going to inherit several hundred thousand dollars of additional IRA money as well which will only complicate matters

So does anyone have any experience with how to mitigate the long term tax issues with large IRA account balances, the 10 year window between 59 1/2 and 70 is nowhere near enough time to convert everything and we will still remain in slightly elevated tax bracket even during that age window and our children will age out of being dependents then as well.

Thanks in advance,
-Mister Fancypants

foobar

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You pay the taxes and move on. You have a 1/3 more money because of tax deferral so having to pay 15-20% shouldn't bother you. If you don't want to pay taxes live a cheaper lifestyle and save less:)

the fixer

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The only way to do it that makes any sense is to have two completely distinct phases: accumulation and optimization. You accumulate balances in tax-deferred accounts when your income is high, as you are doing now. When your income is lower, you convert some pretax dollars into post-tax dollars with Roth conversions. You can only make this work if you stop earning high incomes. If you never stop working until a normal retirement age, you'll just pay regular income taxes on distributions.

Worst case should be that you end up paying 25% on your conversions/distributions, which is exactly what you saved on putting the money in. This is still an okay outcome:
  • If you do the math, you'll see that you essentially avoided paying capital gains taxes by putting that money in a pretax account and paying income taxes on the whole amount rather than just investing after-tax dollars.
  • For any amounts you can convert, you essentially did a gigantic backdoor Roth contribution. There's no other way you can get that much money in a Roth IRA, other than using the recent Roth 401(k) options.
The only way to do better is to reduce your income for a few years, such as by taking a sabbatical from work or something.

Mister Fancypants

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@foobar this topic really has nothing to do with lifestyle cost, I choose to save in tax defered accounts now as it is a great way mitigate my current high tax bill.

In the future I will be hit with RMD's and have the defered tax bill, I am looking for a strategy to minimize that tax bill as much as I can.

Thanks

Mister Fancypants

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@fixer If I the same tax rate at withdrawal as I would have at deferral I would be better in a taxable account, Cap Gains tax is lower than income tax, that worst case scenario is not a selling point for tax deferral.

I do plan on RE just not "E" enough to move all of the money before RMD's kick in and the tax bill becomes larger than I would prefer. I am aware that if the contributions continue straight through until withdrawals that there is little chance to convert, there will be a gap, just not long enough.

I am curious if anyone has had success in moving large sums of IRA money to Roth's and if so how they did it.

foobar

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Why are you seeking to minimize a tax bill rather than maximize the amount of money you have to spend? The point is that if you choose to retire and live on 40k, this is a non issue as you don't need to save 2 million dollars in assets. RMDs are low and you can suck the rest of the money out over time. Choose to retire and live on 100k, and your going to pay 100k lifestyle taxes.

That being said as soon as you retire, figure out how much you need to take out to drain the ira by ~70/71 and roll that amount over to a roth every year while you live off savings is about the best you can do for minimization.  You will likely pay about ~15-20% in taxes. If you do it over 20 years, you can lower the rate down closer to 10 and if you do it over 5 you get up to 25% or so. Or could also choose to stretch that spend down past 70 (it makes more of you SS taxable) as RMDs start off at 4% before ramping up. Back of the envelope math suggests you are looking at 1-2 million in assets (in todays dollars) when you retire which is a nice chunk of change but it isn't an amount that is going to be putting you in some high tax bracket in retirement. And if stocks go on a tear and you end up with 4 million instead of 2 million, I would try and be happy with the added cash rather than complaining about paying taxes on it.


@foobar this topic really has nothing to do with lifestyle cost, I choose to save in tax defered accounts now as it is a great way mitigate my current high tax bill.

In the future I will be hit with RMD's and have the defered tax bill, I am looking for a strategy to minimize that tax bill as much as I can.

Thanks

the fixer

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@fixer If I the same tax rate at withdrawal as I would have at deferral I would be better in a taxable account, Cap Gains tax is lower than income tax, that worst case scenario is not a selling point for tax deferral.
It's not the capital gains tax rate that's important, it's that capital gains taxes are applied on gains from principal that was earlier reduced by income tax: effectively a double taxation. I explained it in an old post here:
http://www.mrmoneymustache.com/forum/ask-a-mustachian/why-max-out-your-401k/msg170628/#msg170628
Quote
Suppose I have a 401(k) and a taxable account. Both accounts invest in the same index fund with the same expenses. My tax bracket stays at 25% throughout the scenario. I have $20000 of excess income I can invest in a given year. I put $10000 into the 401(k). The remaining $10000 I pay income taxes on, and after taxes I have $7500 to invest in a taxable account. For simplicity, let's assume the investment I use does not throw off dividends and there is no return of cost basis (sheltering of tax-inefficient assets is an undisputed benefit of tax-deferred accounts).

After 10 years, the average annual return on my investment in both accounts is 10%. The ending balances are: $25937 in the 401(k), and $19453 in the taxable account (principal * (1 + 10%) ^ 10 years). It looks like I have more money in the 401(k), but do I? If I did a penalty-free withdrawal from the 401(k) of the entire sum, it would get taxed at 25% and I'd have: $19453. Exactly the same balance in the taxable account.

The 401(k) is still better off than the taxable account, though, because I haven't revealed what would happen if I sold the taxable asset. If I did that, I'd be subject to capital gains taxes on $11953 of gains. My takeaway would only be $17660 at a 15% capital gains rate. So it's actually the capital gains tax being compounded with ordinary income tax on investment principal that makes tax-deferred accounts better, so long as everything else is equal.

Cheddar Stacker

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I agree with foobar and fixer on their points. On fixer's, you are better off even if you pay the same rate, but hopefully you won't have to, see below. On foobar's, if you can live on less, you can stop working sooner which will give you more time to convert, and it will give you more exemptions/credits (Kids) to do it with.

If you can convert while you still have 2 dependents, particularly with child tax credits, education credits, and anything else you can find, this will accelerate the amount you can convert.

You can do about $10K/year tax free as a single person. Married filing joint goes up to about $20K. Having 2 kids adds another maybe $5K/kid, but it could be more if you're paying for college. Having other big deductions like mortgage interest and charity can help as well, but that's tough to do while living on less income.

A few other tips:
1) Stay within the 15% bracket. This has many advantages, but at the very least you're saving a net 10% on all this income due to the reduced rate. With a married couple, you could convert around $94K/year, take the standard deduction + exemptions, and you'd be just inside the 15% bracket. Combine this with using the funds you've already saved in Roth and you should have plenty of money to live on.
2) Convert depreciated assets - market timing essentially. Pay close attention to trends, and try to convert when your assets have lost value. You pay the tax based on the value of the holdings on the date you convert them.
3) Capital losses - I didn't see you mention anything held in after tax brokerage accounts. If you don't have anything there, get some funds invested there to use for this strategy. You can harvest capital losses and use up to $3K/year to offset TIRA to Roth conversions.
4) Take advantage of any disasters - I had a client who lost a ton in a real estate deal. He ended up with a $500K loss on his 1040, which carries over to the next year. We used that, and a huge dip in the market back in 2010 for him to convert $400K to Roth while paying almost no taxes on the deal. Not for everyone, but a big medical emergency, a casualty loss on property, or anything else that negatively impacts your taxable income should be used to shelter conversions.

If you haven't already, read this post regarding this strategy: http://www.gocurrycracker.com/never-pay-taxes-again/

seattlecyclone

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There's no magic bullet here. You're going to pay regular income tax rates on this money whenever you withdraw it. To minimize your tax bill, the best thing to do is use the progressive nature of the income tax in your favor. Pick a tax bracket that is acceptable to you and max it out every year after you retire, without going over by much.

It sounds like you're going to have a pretty sizable balance in these tax-deferred accounts by the time you retire. Let's say you keep working for a couple of decades, until age 60. You max out your 401(k) and roll it over into your traditional IRA at retirement. Let's say that these contributions plus normal investment gains will put your IRA balance at an even $1 million (in 2013 dollars) by that date.

If you stop working completely at 60, there's no reason to expect that you'll ever need to be in the 25% federal bracket after retirement (assuming tax brackets don't change much between now and then, etc.). The 15% bracket ends at $72.5k of taxable income for a married couple. Add in your $20k from the personal exemption and standard deductions, and you get $92.5k of gross income taxed at 15% or less. So, in your first year of retirement, roll over enough from your traditional IRA to your Roth IRA so that your total income is about $92.5k. You'll pay $9,979 in taxes on this money, for an effective tax rate of 10.8%. Not too bad, eh?

Doing this for ten years won't completely drain a $1 million traditional IRA balance by age 70.5, but it should make enough of a dent that your RMDs won't bump you up past the 15% bracket that you had already been in for the first ten years of retirement.

I will agree with the other posters that your current stash and savings rate indicates you have no true need to work as long as you say you plan to work. I trust that you're aware of this already and are planning to keep working longer than you have to because you truly enjoy your job. In that case, you shouldn't need to be too concerned about your tax brackets. You'll earn enough to be FI, and everything past that is gravy. What does it matter how much tax you pay on money you don't need anyway?

Mister Fancypants

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@fixer If I the same tax rate at withdrawal as I would have at deferral I would be better in a taxable account, Cap Gains tax is lower than income tax, that worst case scenario is not a selling point for tax deferral.
It's not the capital gains tax rate that's important, it's that capital gains taxes are applied on gains from principal that was earlier reduced by income tax: effectively a double taxation. I explained it in an old post here:
http://www.mrmoneymustache.com/forum/ask-a-mustachian/why-max-out-your-401k/msg170628/#msg170628
Quote
Suppose I have a 401(k) and a taxable account. Both accounts invest in the same index fund with the same expenses. My tax bracket stays at 25% throughout the scenario. I have $20000 of excess income I can invest in a given year. I put $10000 into the 401(k). The remaining $10000 I pay income taxes on, and after taxes I have $7500 to invest in a taxable account. For simplicity, let's assume the investment I use does not throw off dividends and there is no return of cost basis (sheltering of tax-inefficient assets is an undisputed benefit of tax-deferred accounts).

After 10 years, the average annual return on my investment in both accounts is 10%. The ending balances are: $25937 in the 401(k), and $19453 in the taxable account (principal * (1 + 10%) ^ 10 years). It looks like I have more money in the 401(k), but do I? If I did a penalty-free withdrawal from the 401(k) of the entire sum, it would get taxed at 25% and I'd have: $19453. Exactly the same balance in the taxable account.

The 401(k) is still better off than the taxable account, though, because I haven't revealed what would happen if I sold the taxable asset. If I did that, I'd be subject to capital gains taxes on $11953 of gains. My takeaway would only be $17660 at a 15% capital gains rate. So it's actually the capital gains tax being compounded with ordinary income tax on investment principal that makes tax-deferred accounts better, so long as everything else is equal.

@fixer Thanks for the link and the math, I hadn't actually thought that through but it makes perfect sense.

Mister Fancypants

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A few other tips:
1) Stay within the 15% bracket. This has many advantages, but at the very least you're saving a net 10% on all this income due to the reduced rate. With a married couple, you could convert around $94K/year, take the standard deduction + exemptions, and you'd be just inside the 15% bracket. Combine this with using the funds you've already saved in Roth and you should have plenty of money to live on.

My wife collects SSDI currently around $27k (adjusted for inflation), so that impacts how our tax bracket situation as 85% becomes taxable once we make over $32k (current thresehhold).

2) Convert depreciated assets - market timing essentially. Pay close attention to trends, and try to convert when your assets have lost value. You pay the tax based on the value of the holdings on the date you convert them.

I have never converted assets from TIRA to Roth to they convert in kind or as cash? I would think you would want to convert the assets that grow the fastest first? I generally have my fastest appreciating assets (my least tax effiecient assets) in my Roth accounts as they are my most tax effecient accounts.

3) Capital losses - I didn't see you mention anything held in after tax brokerage accounts. If you don't have anything there, get some funds invested there to use for this strategy. You can harvest capital losses and use up to $3K/year to offset TIRA to Roth conversions.

We do have substantial assets in taxable accounts but very few losses of note to use for this purpose.

4) Take advantage of any disasters - I had a client who lost a ton in a real estate deal. He ended up with a $500K loss on his 1040, which carries over to the next year. We used that, and a huge dip in the market back in 2010 for him to convert $400K to Roth while paying almost no taxes on the deal. Not for everyone, but a big medical emergency, a casualty loss on property, or anything else that negatively impacts your taxable income should be used to shelter conversions.

I do have a $32k K-1 trading loss from an LLC I am not sure how it is handled though, still need to speak to an accountant, I posted on the forums to see if anyone knew but got no responses. http://www.mrmoneymustache.com/forum/investor-alley/can-k1-trading-losses-offset-w2-income/

If you haven't already, read this post regarding this strategy: http://www.gocurrycracker.com/never-pay-taxes-again/

I will check the link out thanks

Cheddar Stacker

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Anyone converted large Traditional IRA balances to Roth’s tax efficiently?
« Reply #11 on: February 11, 2014, 04:16:31 PM »
1) You just need to find the goldilocks spot where you get to the top of the 15% bracket and stop there. There are a few exceptions (long-term capital gains, qualified dividends, etc.) but nearly all your income should be added to get to the top of the bracket.

2) I haven't converted any either, but my clients have and my understanding is it's simply a re-characterization. You still hold the asset in whatever form it previously was, so a stock, bond, REIT, or mutual fund would still be held, it's just now in a Roth and you pay taxes on the value transferred. Your least tax efficient assets should be in the Roth, so good job there. Now find the next least tax efficient ones that are in your TIRA and move them to the Roth when you are ready.

3) Read go curry cracker and madfientist on this point. You can create capital losses and capital gains in some circumstances. It might be tougher for you since you will continue to have a high income, but worth the read anyway to understand how working less could benefit you.

4) I just answered your question in the other thread via the link you provided, but I'm not 100% sure what the trading loss is. If it's a capital loss, I answered it correctly - if it's something else please elaborate. However, this can also be used now at $3K/year to reduce your earnings, so it would be best to use up now.

foobar

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Would you consider getting divorced?:) I bet a good lawyer dividing up the assets could save you thousands/yr:)


I though about this in terms of social security and that income limit does limit some of  the tax maneuvering you can do as you add in ~3k of taxes  and lose 27k of cap room. 

  But lets run some numbers to see how bad the tax situation is
Lets assume 2 50 year olds, no kids (they would allow you to do more), standard everything. % is on the distribution

80k distribution =  12.6 = 16%
100k distribution = 17.5k
150k distribution = 30k = 20%
200k distribution  =  44.4 = 22%
300k distribution = 76.8k = 25%

Thats not too bad.

Or lets say you wait for retirement: Assume 27k for her 20k for you
60k (starting ~ RMD on 1.5 million) = 11.7k
80k (RMD at 80) = 16.8k
100k (~85) = 21.8k

 Making 150k/yr and paying 15% tax isn't too bad.

Now there is a lot of guesses here. Some thing are not index for inflation, ACA subsidies might matter, and so on but the point is that the taxes are pretty low for a pretty substantial numbers.






My wife collects SSDI currently around $27k (adjusted for inflation), so that impacts how our tax bracket situation as 85% becomes taxable once we make over $32k (current thresehhold).


beltim

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@fixer If I the same tax rate at withdrawal as I would have at deferral I would be better in a taxable account, Cap Gains tax is lower than income tax, that worst case scenario is not a selling point for tax deferral.
It's not the capital gains tax rate that's important, it's that capital gains taxes are applied on gains from principal that was earlier reduced by income tax: effectively a double taxation. I explained it in an old post here:
http://www.mrmoneymustache.com/forum/ask-a-mustachian/why-max-out-your-401k/msg170628/#msg170628
Quote
Suppose I have a 401(k) and a taxable account. Both accounts invest in the same index fund with the same expenses. My tax bracket stays at 25% throughout the scenario. I have $20000 of excess income I can invest in a given year. I put $10000 into the 401(k). The remaining $10000 I pay income taxes on, and after taxes I have $7500 to invest in a taxable account. For simplicity, let's assume the investment I use does not throw off dividends and there is no return of cost basis (sheltering of tax-inefficient assets is an undisputed benefit of tax-deferred accounts).

After 10 years, the average annual return on my investment in both accounts is 10%. The ending balances are: $25937 in the 401(k), and $19453 in the taxable account (principal * (1 + 10%) ^ 10 years). It looks like I have more money in the 401(k), but do I? If I did a penalty-free withdrawal from the 401(k) of the entire sum, it would get taxed at 25% and I'd have: $19453. Exactly the same balance in the taxable account.

The 401(k) is still better off than the taxable account, though, because I haven't revealed what would happen if I sold the taxable asset. If I did that, I'd be subject to capital gains taxes on $11953 of gains. My takeaway would only be $17660 at a 15% capital gains rate. So it's actually the capital gains tax being compounded with ordinary income tax on investment principal that makes tax-deferred accounts better, so long as everything else is equal.

This assumes a constant tax rate, which may or may not be a good assumption. And you only pay long term capital gains or qualified dividend taxes if you're in the 25% tax bracket or higher.

Your general point is correct, but there are some cases where a taxable account is better than tax-deferred - most of which involve a higher tax rate in retirement than when the investment was made.

Cheddar Stacker

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Would you consider getting divorced?:) I bet a good lawyer dividing up the assets could save you thousands/yr:)

Obviously foobar is joking, but it brings up an interesting point. You need to look into the possibility of married filing separately. I'm not saying it will be beneficial, but it's worth a look. You mentioned your accountant a few times already in this thread and the other, so have him/her calculate this for you since he knows your situation best. If he can't do it, find a way to do it yourself.

Married filing jointly almost always wins out, but in this circumstance you might be able to come out ahead if you split up the income into two returns.

foobar

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IRS is way ahead of you. If you live with your spouse, that exemption drops from 25k to 0. Maybe some of the other filing separately clauses kick in but you would definitely need to talk to your attorney.

Forbes and the wall street journal have had bunch of articles about people getting divorced for tax purposes. If you are both making like 200k, you can save ~30k by doing it.

Would you consider getting divorced?:) I bet a good lawyer dividing up the assets could save you thousands/yr:)

Obviously foobar is joking, but it brings up an interesting point. You need to look into the possibility of married filing separately. I'm not saying it will be beneficial, but it's worth a look. You mentioned your accountant a few times already in this thread and the other, so have him/her calculate this for you since he knows your situation best. If he can't do it, find a way to do it yourself.

Married filing jointly almost always wins out, but in this circumstance you might be able to come out ahead if you split up the income into two returns.

Mister Fancypants

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Would you consider getting divorced?:) I bet a good lawyer dividing up the assets could save you thousands/yr:)

Obviously foobar is joking, but it brings up an interesting point. You need to look into the possibility of married filing separately. I'm not saying it will be beneficial, but it's worth a look. You mentioned your accountant a few times already in this thread and the other, so have him/her calculate this for you since he knows your situation best. If he can't do it, find a way to do it yourself.

Married filing jointly almost always wins out, but in this circumstance you might be able to come out ahead if you split up the income into two returns.

We are not going to be filling for divorce anytime soon and hopefully not later either :)

I think that is a bit extreme to save some taxes and by no means I'm I in such a high tax bracket that I would even consider such extreme measures, but thanks for the creative thinking :)

Cheddar Stacker

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IRS is way ahead of you. If you live with your spouse, that exemption drops from 25k to 0. Maybe some of the other filing separately clauses kick in but you would definitely need to talk to your attorney.

What does this bold part mean foobar? Are you referring to exemptions plus standard deductions, because in my experience those still apply when married filing separately? Is there something else in the conversation above that I missed?

Mister Fancypants

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4) I just answered your question in the other thread via the link you provided, but I'm not 100% sure what the trading loss is. If it's a capital loss, I answered it correctly - if it's something else please elaborate. However, this can also be used now at $3K/year to reduce your earnings, so it would be best to use up now.

I posted a more detailed response on the other thread but basically I am not sure if it will be considered a capital loss or an operating loss at this point. My guess is it will just through to Schedule D as a capital loss and I will use the $3k now on top of whatever capital gains I took this year and carry forward the remaining loss for future years use.

You mentioned your accountant a few times already in this thread and the other...

The accountant I am using right now is strictly for dealing with the failed LLC and really only specialized in trading entities like the one I mentioned in the other thread, I am generally a DIY type of person, we do also have a cousin who is a CPA that I bounce things off of. I did use a CPA years ago when I owned various C-corp's for consulting, but these days things have been a bit more vanilla so I haven't found the expense to have been justified recently.

Cheddar Stacker

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Your CPA will determine how to report this on the K-1, and the data entry of the K-1 into your 1040 will determine how it's taxed. If the loss turns out to be ordinary, and you have basis to take the deduction, you will apply it all to the year the loss occurred which presumably is 2013. If it's a capital loss it will slowly leak a $3K deduction onto page 1 unless you have other capital gains before it runs out. Either way, I see no reason to use this against future IRA conversions even if it's possible to do so. It's better to take the deduction now against ordinary income taxed at your 25% rate.

But, this is the type of scenario I was referring to earlier. If anything like this happens again in the future, be sure to utilize the unfortunately loss in your IRA conversion planning.

foobar

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Amount of income that is exempt from social security.  See http://www.bogleheads.org/wiki/Taxation_of_Social_Security_benefits Not their numbers are after the standard exemption.  They don't do the married filing seperating there but in that case you basically start having to pay tax on SS benefits starting at the first dollar. Using CalcXML, if you do married filing sep and have zero other income, you will pay taxes on 11k of ss earnings and owe ~2.8k.


IRS is way ahead of you. If you live with your spouse, that exemption drops from 25k to 0. Maybe some of the other filing separately clauses kick in but you would definitely need to talk to your attorney.

What does this bold part mean foobar? Are you referring to exemptions plus standard deductions, because in my experience those still apply when married filing separately? Is there something else in the conversation above that I missed?

Redfive20

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Depend on your goal, have you thought about buying a life insurance? I work in the insurance industry. A important portion of customers who own life insurance policies come from high wealth clients who would like to pass along a large sum of money to heirs while being avoid of much taxation. It is not uncommon that a team of advisors including lawyers, trust company experts and accountants work together to decide the right life insurance policies needed.

foobar

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I am unaware of any way to use life insurance to get money out a 401(k)/traditional ira.  Life insurance is very useful when you have like a 20 million dollar estate and you don't want to pay estate taxes and a few other cases. I would definitely talk to an agent but don't buy anything until you really understand what your buying and the long term implications of it.

Depend on your goal, have you thought about buying a life insurance? I work in the insurance industry. A important portion of customers who own life insurance policies come from high wealth clients who would like to pass along a large sum of money to heirs while being avoid of much taxation. It is not uncommon that a team of advisors including lawyers, trust company experts and accountants work together to decide the right life insurance policies needed.