Avoiding vs Evading

Written by Steven Pittser

“I haven’t filed taxes for six years— ever since I’ve been down here.” That was the comment from my co-expat from the States, who had just bought me a drink at my favorite bar in La Antigua Guatemala. “I have had income every one of those years, so I guess I should file, right?” he continued.

He was confiding this to me because I am a retired tax specialist from the States currently residing in Guatemala. My specialty is showing retirees and/or small business owners how to legally reduce and avoid U.S. taxes. I stress the words “legally” and “avoid.” The difference between tax avoidance and tax evasion is five years (in federal prison).

U.S. citizens are required to file a tax return, no matter where they live in the world, if there has been any taxable income during that year. That does not necessarily mean that there will be any taxes to pay.

I believe that the worst, and most common, tax problem for retired individuals are “Qualified Plan Accounts.” These include IRAs, 401(k)s, 403(b)s and SEPs. Every dollar removed from any of these plans is taxable and in many cases, causes tax on Social Security. The amount withdrawn can also place an individual in a higher tax bracket.

In 1998 a “qualified plan” called the Roth IRA (sponsored by Sen. William V. Roth Jr.) became available. If you contribute to a Roth IRA, you receive no tax deduction, but the account grows tax free, and you can take the money out TAX-FREE. Allow me to emphasize this point: You don’t pay taxes on withdrawals from a Roth account, and it does not create tax on other income (i.e., Social Security). A Roth account also goes tax free to your children or anyone you designate as an heir.
The second thing the government said was, in addition to being able to contribute to a Roth (from earned income), we could also “convert” any of our IRA money (or any “qualified plan” money that had first been transferred to an IRA account) in any amount to a Roth account. We would have to pay taxes, of course, on the amount we converted. They also told us that the taxes owed on any amount converted in the year 1998 could be paid over the next four years in four equal installments.
There were many people who converted their entire IRA to a Roth account in 1998. That was a big mistake on their part (but it created a huge windfall of tax revenue for the government).

The mistake was not in converting IRA to Roth, it was how it was converted from IRA to Roth. By mistakenly converting the entire amount in one year, they not only paid (or owed over the next four years) the highest tax bracket amount (assuming a typical IRA account is over $150,000), but they also put themselves in the highest tax bracket possible on their other taxable income that year.
Most people don’t know that the IRS code allows us to split up an IRA account into as many separate IRA accounts. For example, a $200,000 IRA in 1998 could have been split into four $50,000 IRAs, and one could have been converted each year for the next four years. The total tax paid would be much less than the tax created with the single $200,000 “conversion”—because of a much lower tax bracket.