TAX PLANNING


Tax Planning for Retirement

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When you retire, your life changes in many ways — and so do your finances. One of the biggest changes is that instead of contributing to tax-deferred retirement savings plans that reduce your taxes, you'll start tapping those savings for income and paying taxes at your regular rate (unless you’re tapping a Roth account) — not the preferential capital-gains rate reserved for stocks and bonds held in taxable accounts.

See Also: Tax Planning for Life's Major Events

What to Do with Your 401(k)

One of the first decisions you'll have to make is what to do with the savings you have accumulated in your 401(k) or similar workplace-based retirement plan. As long as you have a balance of $5,000 or more, you can keep it with your former employer until the plan’s normal retirement age (often 65) or, in some cases, until you reach age 70 1/2. You might want to do that if you like the investment choices and the low fees of your employer's plan.

And if you are at least 55 by the end of the year in which you leave your job, you can start tapping your 401(k) funds penalty free — although you'll still owe income taxes on your withdrawals. If you roll the money over to an IRA, where you will have more investment choices, you must be at least 59½ to avoid early withdrawal penalties when taking money out of the account.

Rollover to a Traditional IRA

If you decide to roll over some or all of your 401(k) money to an IRA, you can preserve your tax deferral by transferring the funds directly to the new custodian, such as a broker, mutual fund or life insurance company.

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Don't make the mistake of having a check made out to you. If you do, your employer will be required to withhold 20% of the balance for taxes even if you plan to complete a rollover to an IRA within 60 days. Any money that's not in an IRA within that time period — including any part of that 20% withheld from the IRS that you aren't able to come up with elsewhere — will be treated as a distribution and subject to income taxes plus a 10% penalty if you are younger than 55. You avoid this potential problem by having the money sent directly to your IRA or having the check written to your IRA account.

Company Stock

If you own highly appreciated company stock, special rules for what's called net unrealized appreciation (NUA) can result in significant tax savings. When you take a lump-sum distribution from your 401(k), you can move the stock to a taxable account and roll over the rest of the assets to an IRA. You'll pay ordinary income taxes on your basis (what you paid for the stock), but the remaining NUA (the appreciation while the stock was in your retirement plan) will be taxed only when the stock is sold.

And, here's the kicker: At that point, the profit will qualify for the favorable long-term capital-gain rate. In contrast, if you roll over your entire balance to an IRA, all of your withdrawals, including that which comes from the profit on your company stock, will be taxed at your top tax rate. This pays off best for company stock that has appreciated smartly inside your 401(k).

Mandatory Distributions

Tax-deferrals on retirement savings don't last forever. You must start taking taxable withdrawals from your traditional IRA or 401(k) by the April 1 following the year you turn 70½. Subsequent annual withdrawals are due by December 31 of each year. Each year’s required minimum distribution (RMD) is based on your account balance at the end of the previous year divided by a life expectancy factor set by the IRS.

If you don't take your full RMD each year, there's a stiff penalty — 50% of the amount you failed to withdraw. You can always take out more than the minimum required amount and pay taxes at your regular rate on all the withdrawals. You can ask your retirement account custodian to withhold taxes from your distributions, or you can file quarterly estimated tax payments.

Roth IRAs

There is a great deal of confusion about how withdrawals from Roth IRAs are taxed. There’s a widespread belief, for example, that money comes out of a Roth tax free only after age 59 ½ and then only if the account has been open for at least five years.

It is true that to withdraw earnings from a Roth tax-free, you must be at least 59 ½ and the account must have been opened for at least five years. But earnings are the last thing to come out of a Roth. The IRS assumes that the first money withdrawn comes from any annual contributions you made (and this money can be tapped tax- and penalty-free at any time). Next, you dip into funds that went into the Roth via a conversion from a traditional IRA or 401(k) and these amounts are always tax-free, and penalty-free, too, if you are over age 59 ½ or the account has been open for at least five years. Only after you retrieve all of your contributions and converted amounts do you touch earnings . . . and if at least five years have passed and you’re over age 59 ½, the earnings are tax- and penalty-free.

So, if you convert $100,000 today, you can withdraw it all tomorrow tax-free (but not penalty-free unless you’re at least 59 ½). Unlike traditional IRAs, there are no mandatory distribution rules with Roth IRAs, so you never have to touch the money if you don't need it, allowing the money to grow tax-free for years. Your heirs will thank you because they, too, can take distributions from an inherited Roth IRA tax-free. (Money in an inherited traditional IRA is taxed in the heir's top tax bracket.)

Roth 401(k) Plans

If you contribute to the latest innovation in retirement savings — the Roth 401(k) — you can also benefit from tax-free distributions once you're 59½. But the Roth 401(k) does have mandatory distribution rules, like traditional 401(k) plans, starting at 70½. It's easy to get around that, though. Simply roll over the Roth 401(k) portion of the account to a Roth IRA when you retire. There will be no tax consequences, and you never have to tap the account.

Convert to a Roth

Anyone can convert a traditional IRA or 401(k) to a Roth IRA to enjoy tax-free withdrawals in retirement. The rule that used to ban such conversions if your adjusted gross income was more than $100,000 has been abolished. There’s a high price of admission to a Roth, however. You must pay tax on any as yet untaxed money that you convert — and for most taxpayers that means 100% of the converted amount. For more on Roth conversions see our Roth Conversions special report.

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