Most of the people we serve tell us they don’t mind paying their “fair share” of taxes, but then they follow up by saying, “but I’d prefer not to pay more than my fair share.” I think the term “fair” is kind of funny. I’ve learned that taxes always seem fair as long as I’m not the one having to pay them. I remember my Dad used to tell me, “Life is not fair, but it favors the prepared mind.” I also recently read that “ignorance may be bliss, but it’s expensive” and not planning or ignoring your future tax liability could create a future tax time bomb.

When I talk about retirement accounts, I am generally referring to accounts such as IRAs, 401(k)s, TSPs, and 403(b)s. These are accounts which you have contributed pre-tax dollars and those dollars are growing tax deferred, but when you begin taking money out of these accounts they will be 100% taxable as ordinary income and taxed at your effective income tax rate.

According to the taxfoundation.org the top marginal income tax rate in 1950 was 91%, by 1980 the top marginal income tax rate was 70%, and today the top marginal income tax rate is 39.6%.

According to the USdebtclock.org our national debt is currently 16.9 trillion dollars and growing by about 1 trillion dollars per year.

In a recent report from the social security board of trustee’s they reported, “The combined assets of the Old-Age and Survivors Insurance, and Disability Insurance (OASDI) Trust Funds are projected to become depleted in 2033, unchanged from last year, with 77 percent of benefits still payable at that time.”


Is this economic world we live in sustainable? Can we continue to run deficits, increase our nations debt and provide medicare and health care for all AND make good on our promise of social security income to retiree’s with 10,000 baby boomers retiring every day and yet at the same time maintain all time low marginal income tax rates? 

If I had to make an educated guess about the future, then I’d say our current economic situation just doesn’t seem sustainable. I’m not a betting man, but if I were I’d bet that taxes in the future are likely to increase for some people, and that benefits for some people will likely decrease.  


When the “fair standard” is applied, the “some people” will likely be hard working Americans who have been responsible with their finances, those who have managed to save and live within their means and who have accumulated wealth and are deemed to have accumulated more than their “fair share”.   

Let’s consider a hypothetical scenario. Mr. & Mrs. Jones are currently both 60 years old and getting ready to retire. In retirement they will both have guaranteed income from Social Security, and Mr. Jones will have a pension. They’ve always been frugal, and as they review their budget, they realize they’re going to be able to live comfortably off of their guaranteed income sources in retirement. 


Mr. Jones has always been a saver and has managed to save about $500,000 in his 401(k). When I asked Mr. Jones what the purpose is for that $500,000, he said it is to make sure Mrs. Jones can supplement her income after he dies and continue to maintain her standard of living.

He realizes when he turns 70 1/2 he must begin taking required minimum distributions or face a 50% penalty from the IRS. If it were not for the required minimum distribution, then Mr. & Mrs. Jones would have no plans to take money out of this account.  

Mr. and Mrs. Jones are conservative investors at this point in their life and like so many of the people we have met they say they’re not trying to hit any home runs with their retirement savings. They just want to earn a fair rate of return and outpace inflation. So for this example we’re going to assume a hypothetical 5% rate of return per year on their investments. We will also assume that Mr. Jones lives to age 86.

His $500,000 IRA, growing at 5% per year, assuming no distributions, will be worth $814,447 by the time he is 70 years old. Based on current calculations his required minimum distribution at age 70 would be $29,724. If all he does is take the required minimum distribution every year until age 86, then he will end up taking $735,979 of taxable distributions from his IRA over his lifetime.  


Because Mr. & Mrs. Jones don’t need the money to live on, they pay taxes on the IRA distribution and then turn around and purchase a certificate of deposit (CD) with the net after-tax distribution, which is also paying 5%. (I know 5% is unrealistic in today’s interest rate environment, but we’re only using it as an illustration here.)

Because this after-tax money is now in a CD, Mr. Jones will receive a 1099 at the end of every year and have to pay tax on the interest that he earns in that CD. When he dies at age 86, he will still have approximately $818,848 dollars remaining in his IRA. So assuming tax rates stay where they are, he will pay $191,000 in taxes just based on his required minimum distributions. 

The after-tax money growing in the CD will cause him to pay taxes on interest earned over his lifetime of an additional $68,185. And the remaining balance in his IRA of $818,848, assuming his wife has predeceased him and that his adult children who inherit this balance at the time he dies choose to take a lump sum distribution and pay 35% taxes in one year, would create an additional $286,597 in taxes.

Today at age 60, Mr. Jones has an IRA valued at $500,000 and based on the scenario above this IRA will cause he and his family a total tax liability of $546,427. In the scenario we assume the tax rates do not increase in the future although it likely will.


By intelligently designing a strategic IRA to Roth IRA conversion where they pay taxes from non-IRA resources and convert over a number of years, they are able to reduce this projected future tax liability to just $141,532 which reduces his families’ future taxes by $404,895 and increases his after-tax net worth by $434,555.  


As you can see in this scenario converting an IRA to a Roth IRA is a tremendous opportunity. I read that 86 year old billionaire Charlie Munger who is business partners with Warren Buffett told attendees at the Berkshire Hathaway meeting that he would be converting an old IRA to a Roth IRA. 


Remember this scenario above assumes tax rates stay the same. Do you believe it is likely that marginal income tax rates will stay at all time low historically low rates? If you are like me, and you think taxes may go up in the future, then Mr. & Mrs. Jones family will end up paying even more taxes by not converting to a Roth. Marginal income tax rates are currently at an all time historical low. This may be the opportunity of a lifetime to think about diffusing your retirement account tax time bomb.


Please do not take action based on this information. I’ve learned that tax planning especially with retirement accounts really depends on your specific situation. So please, before you consider converting your IRA to a Roth IRA be sure to sit down with an expert and make sure it works within the context of your overall financial, estate & tax plan.

This article was also featured in the August 2013 Kitsap Peninsula Business Journal.