With tax season upon us, it’s now clear that the policies put in place as part of the fiscal cliff negotiations are having a real impact—and taxpayers are facing some sticker shock. High earners in particular are facing some significant new tax burdens, making it all the more important to be strategic and savvy about finding new ways to reduce your tax burden.
One underutilized option that might make sense if you’re under the gun is to consider Roth conversions. As the Wall Street Journal and CNN Money have pointed out in some well-written articles, even those who earn too much to claim a traditional IRA contribution write-off can use a “back door” to take advantage of a Roth IRA. While a traditional IRA might be less effective as a savings instrument (compared to brokerage accounts or other vehicles that may be more flexible with regard to tax advantages) for those who are ineligible for a deduction, the ability to convert one to a Roth at any time, regardless of income, allows you to avoid paying taxes on the funds you roll over.
The only hitch in this plan is that it is only really effective for those who have just opened a traditional IRA and don’t already have active traditional IRA accounts. The reason is that in a Roth conversion, the bill on any earnings and previously untaxed contributions comes due.
Essentially, you are reimbursing the government for the past write-offs you took on the account. It is important to note that this strategy will not help for your 2013 taxes, but it could substantially lower your tax bill for next year. Similarly, another strategy that could help for 2014 is to use annuities to shelter unearned income (investment income). The key is to explore these strategies now if you want to avoid experiencing the same painful tax hit next year.