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Many companies offer employees a choice between two 401(k) plans. The version with which you’re probably most familiar As before, you can choose to defer some salary and defer the income tax as well. You’ll also defer the tax on any investment earnings. However, when you withdraw tax-deferred earnings and tax-deferred investment income, you’ll owe income tax. You’ll probably owe a 10% penalty on withdrawals before age 59 1/2, too.

Another option you may have is a Roth 401(k). With this account, you’re not deferring income tax, so you’re contributing after-tax dollars. Again, you wont owe tax on any investment income inside the plan. After you’ve had a Roth 401(k) for 5 years and after age 59 1/2, all withdrawals are tax-free.

Aside from those key differences, the two 401(k) options are similar. You can contribute up to $16,500 of income this year. If you are 50 or older in 2011, you can contribute an extra $5,500, for a maximum total contribution of$22,000. With either the $16,500 or the $22,000 cap, you can divide your contribution between the two plans in any way you choose, or you can put all the money into one type of 401(k).

Making the choice

Generally, you are better off contributing to a Roth 401(k) when you are in a low tax bracket.

Example 1: Jacob Benson is in the15% tax bracket. If Jacob defers tax by contributing to a traditional401(k) this year, he will get little benefit from the tax deferral because he will defer few tax dollars. Jacob eventually may pay tax at a higher rate when he takes money out. Therefore, Jacob chooses the Roth 401(k), where he will pay relatively little tax on the money he contributes while arranging for possibly tax-free withdrawals in the future. With the same reasoning, workers in a high tax bracket may be better off in a traditional 401(k).

Example 2: Diane Evans is in the 35% tax bracket. Diane will get a substantial benefit from tax deferral this year, so she chooses the traditional401(k). Diane hopes to be in a lower tax bracket after she retires. If that is the case, Diane may be able to convert her traditional 401(k) funds to a Roth IRA and pay less tax than she would pay by contributing after-tax dollars to a Roth 401(k) now. Diane might choose to convert her traditional 401(k) to a Roth IRA after she retires because all withdrawals will be tax-free 5 years after the conversion, as long as Diane is at least age 59 1/2. In addition, Roth IRA owners never have to take required minimum distributions.

Not so simple

At first glance, you might think this is a simple matter. You can look at your income tax return from last year and see the taxable income you reported, adjust for any increase or decrease in anticipated income from this year, and then go online to see the tax tables for 2011. If you’ll be in the 10% or the 15% bracket, you might lean towards the Roth 401(k); in the 33% or 35% bracket, a traditional 401(k) may be appealing. In between (25% or 28% brackets), you could straddle the fence, contributing some to a traditional 401(k) for immediate tax relief and some to a Roth 401(k) for possible tax-free cash flow in the future.

However, the calculation of your real tax rate for 401(k) purposes is far from simple. That’s because of all the income-based tax breaks in the Internal Revenue Code. Going from a traditional 401(k) to a Roth 401(k) will raise your income and may increase your vulnerability to losing tax benefits. You also might move into a higher tax bracket. Conversely, going from a Roth 401(k) or no 401(k) at all to a traditional 401(k) will lower your income and may provide other tax savings on your return.

Example 3: Previously, we had seen that Jacob Benson is in the 15% bracket. Assume that Jacob is married and reported $60,000 in taxable income on the joint tax return that he and his wife filed for 2010. That was because Jacob deferred $15,000 of his salary in 2010. If he puts that $15,000 into a Roth 401(k) for 2011, the Bensons’ taxable income will go from $60,000 last year to $75,000 this year. That will move them over the $69,000 cap for the 15% tax bracket and into the 25% bracket.

What’s more, increasing taxable income by switching from a traditional 401(k) to a Roth 401(k) generally will increase your adjusted gross income (AGI) and your modified adjusted gross income (MAGI) as well. With a higher AGI and MAGI, you may lose tax benefits, such as the student loan interest deduction, the child tax credit, the passive loss deduction for real estate losses, and so on. Losing tax benefits will drive up the immediate cost of switching from a traditional 401(k) to a Roth 401(k).

On the other hand, moving into a traditional401(k) will lower your AGI and MAGI, providing additional tax benefits.

As you can imagine, determining the tax implications of choosing between a traditional 401(k) and a Roth 401(k) can be complicated. Our office can go over your tax return to help you determine the true tax cost so that you can make a well-informed decision.

2011 Q3 | Avoid Higher Medicare Premiums

For several years, upper-income Medicare enrollees have had to pay higher-than-standard premiums for Medicare Part B, which covers doctors’ bills and other outpatient charges. Starting in 2011, those same seniors also owe elevated premiums for Part D, which covers prescription drugs. These added charges use income “cliffs,” meaning that you pay the full amount if you go over the threshold by even $1.

Many Medicare enrollees pay $96.40 a month for Part B, and some others pay $110.50 or $115.40 a month. (This depends on when they enrolled in Part B and whether the premium is deducted from their Social Security checks.) However, you will pay much more this year if your modified adjusted gross income (MAGI) exceeds certain levels. For this purpose, MAGI includes tax-exempt interest from municipal bonds and muni funds.

Here are the numbers for Part B premium payments in 2011:

The monthly premiums are per person, so a married couple would pay double that amount if both spouses are on Medicare. Thus, a married couple on Medicare with MAGI of $170,001 would pay $323 a month for Part B ($161.50 times two). Considering that a married couple with MAGI of $170,000 might pay as little as $192.80 a month ($96.40 times two), the extra dollar of MAGI could cost the first couple about $130 a month in extra Part B premiums in 2011.

Additional expense

The same income thresholds now apply for Medicare Part D plans for prescription drugs. Premiums vary for these plans, which differ in the drugs they cover. However, some seniors will pay a surcharge to Medicare in addition to the normal premium. Surcharges in 2011 range from $12 to $69.10 a month depending on income, and the breakpoints are the same as for Part B. Therefore, an individual with MAGI of $85,001 will pay a $12 monthly surcharge, whereas an individual with MAGI of $214,001 will pay a $69.10 monthly surcharge.

In your planning, keep in mind that your Part D and Part B premiums will be based on your MAGI from two years before. Your 2011 MAGI, for example, will set your premiums for 2013, if you are enrolled in Medicare then. That’s how long it takes for the federal government to mine information from tax returns and apply it to Medicare premiums.

Some tactics may help you hold down these Medicare premiums. For example, you might want to take capital gains and execute Roth IRA conversions before the calendar year you reach age 63. Then, those transactions won’t enlarge your MAGI at age 65 or older, when you’re enrolled in Medicare.

You also can keep the MAGI breakpoints in mind at age 63 or older.

Example: George Caldwell, an unmarried Medicare enrollee age 70, estimates his MAGI at $50,000 this year. George has a $60,000 traditional IRA he wants to convert to a Roth IRA. That would boost his MAGI by $60,000, to a total of $110,000. With that MAGI, George’s Part B premiums and Part D surcharge would total $261.80 per month (assuming 2011 premium levels): $230.70 for Medicare Part B plus a $31.10 surcharge for Medicare Part D.

George now pays only $96.40 a month for Part B and owes no Part D surcharge. Thus, besides paying income tax on the $60,000 Roth IRA conversion, George would increase his Medicare costs in 2013 by about $165 a month, or approximately $2,000 for the year. Instead, George could convert $30,000 of his traditional IRA to a Roth IRA in 2011 and the remaining $30,000 in 2012 and avoid any extra Medicare costs.

MAGI
Individuals Couples Filing Jointly Monthly Premium
$85,001-$107,000 $170,001-$214,000 $161.50
$107,001-$160,000 $214,001-$320,000 $230.70 $160,001-$214,000 $320,001-$428,000 $299.90
Above $214,000 Above $428,000 $369.10

2011 Q3 | With Savings Bonds, Prepaying Tax May Be a Good Tactic

U.S. savings bonds can be good investments, especially if purchased for young children. They’re issued by the federal government, so bond holders don’t have to worry about a default. Yields are comparable to the yields on bank accounts. They’re fairly liquid: owners can cash in savings bonds one year after the purchase and can redeem these bonds with no loss of interest after five years. (If you redeem savings bonds within five years, you’ll lose the interest for the latest three months.)

Taxes, too

Owners of savings bonds also receive tax advantages. The interest is exempt from state and local income tax. Savings bonds are issued by the U.S. Treasury Department so they enjoy this tax treatment, along with all Treasury bills, notes, and bonds.

Moreover, individual owners of savings bonds can defer the tax on that interest as long as the bonds aren’t cashed in.

Example: John Smith buys a $100 I Bond (an inflation-protected savings bond) as a birthday gift for his newborn niece, Kaylyn Jones. Buying online at www.treasurydirect.gov, he pays face value for a $100 bond.

Kaylyn puts away the bond until age 36, when she decides to cash it in. She redeems the bond then for $400, which represents an annualized return of around 4%. Kaylyn reports a $300 gain on the bond and owes tax at ordinary income rates. Because Kaylyn will be established in her career by then with a substantial income, she’ll owe tax at a high rate. Although Kaylyn’s actual tax bill is modest in this example, an individual taxpayer who cashes in a large amount of savings bonds in one year could owe a significant amount of tax.

An alternative approach

When a child owns a savings bond, the parents may prefer to pay the tax each year rather than defer the tax. In the Kaylyn Jones example, the annual income might be around $4 or $5 a year while she is a youngster. As long as Kaylyn has little or no taxable income, the tax bill will be scant.

A parent can make this choice for a child at any time. To do so, you file a tax return for the child and report all the interest earned on the bonds from the date of their acquisition through year-end that has not previously been reported. You’d also state on the return that your child chooses to report the interest each year. Be sure to keep a copy of this return indefinitely. If your child is not required to file a tax return for any year after making this election, he or she does not have to file a return just to show the annual accrual of U.S. savings bond interest. Public Debt Form 3501, available at www.treasurydirect.gov, shows annual interest on savings bonds, which will help you keep track of interest accruals. You’ll include the annual interest on the child’s tax return in any year that he or she is required to file one.

This strategy is not necessarily limited to children who own savings bonds. A taxpayer who finds himself in a low tax bracket in a given year might choose to pay tax on accrued savings bond interest at that time if he expects to return to a higher bracket in the future. When you make such a payment, you’re electing to pay tax each year on all savings bonds you own as well as any purchased in the future. You can, however, revoke this election and go back to deferring interest income by attaching a statement to a future tax return.

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