Prepare for the Retirement Tax Bite

EDITOR'S NOTE: This article was originally published in the December 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.

One of the nastiest surprises awaiting some retirees is the devastating impact that taxes can have on their cash flow. Although many people welcome the upfront tax breaks of contributing to traditional IRAs and 401(k) plans during their working years, they're not so thrilled when Uncle Sam demands his cut when they start tapping those retirement accounts.

Imagine you are retired, plan to buy a new car for $30,000, and have all your savings tied up in a traditional IRA or company 401(k) plan. If you're in the 25% tax bracket, you'll need to withdraw $40,000 to have enough after-tax money to buy that $30,000 car. Ouch! Welcome to the IRA tax trap.

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The same issue arises if you're following the 4% rule of thumb for withdrawing assets from your retirement portfolio. Many experts believe that your nest egg has a far greater chance of lasting throughout your lifetime if you withdraw no more than 4% of your portfolio during your first year of retirement and then increase later withdrawals to keep pace with inflation. But that 4% withdrawal rule does not take taxes into account.

So if you have a $2 million IRA, $80,000 in the first year of retirement may seem like enough to meet your needs, but you'll only have $60,000 of spendable after-tax income. "Life is about cash flow whether you are retired or not," says Craig Brimhall, vice-president of retirement wealth strategies at Ameriprise Financial. "It's not what you make but what you keep."

To avoid such pain, some financial advisers are suggesting that investors diversify their retirement assets among taxable, tax-deferred and tax-free accounts. Because no one knows what future tax rates will be, retirees with a tax-diversified portfolio are in the best position to manage cash flow, says Brimhall.

When it comes to taxes, not all income sources are created equal. Withdrawals from traditional retirement accounts are taxed at ordinary-income rates. So is interest on taxable savings. Depending on your income, your Social Security benefits may be tax-free, or you may pay taxes on up to 85% of the benefits at your ordinary-income tax rate. Meanwhile, withdrawals from Roth IRAs are tax-free, and interest earned on municipal bonds is tax-free, too.

Long-term capital gains from the sale of investments held more than one year, as well as qualified dividends, are taxed at a maximum 15%. But investors in the two lowest tax brackets -- individuals with up to $34,000 of taxable income and married couples with up to $69,000 of joint income in 2011 -- pay no tax on long-term gains and qualified dividends (and pay 15% on long-term gains and dividends that lift taxable income above those thresholds).

Tax Diversification Can Boost Net Income

Brimhall demonstrates how two retired couples with the same pretax income of $144,000 per year can have very different tax liabilities. He assumes each couple receives identical amounts of income from Social Security ($24,000), interest on savings ($3,360), qualified dividends ($38,664) and distributions from a company retirement plan ($36,000). The only difference is the first couple withdraws $41,976 tax-free from a Roth IRA, while the second couple withdraws the same amount from a traditional IRA.

Based on 2011 tax rates, the first couple would owe $7,278 in federal taxes while the second couple would owe $18,446. Why the huge difference? Tax-free distributions from a Roth IRA allowed the first couple to shield nearly 30% of their gross income from taxes, reducing their taxable income and tax bracket and allowing some of their dividend income to be tax-free.

Withdrawing assets in a tax-efficient way will not only reduce your tax bill, it will allow your remaining assets to last longer. Learn about strategic withdrawals at www.retireeincome.com. For $500, you can also get a personalized plan to reallocate your investments and minimize future taxes.

The best time to start planning for the impact of taxes in retirement is while you are working. Consider contributing to a Roth IRA or Roth 401(k) if you are eligible or converting some of your traditional retirement savings to a Roth account. You'll owe taxes on the amount you convert now, but future appreciation and withdrawals will be tax-free. Also strive to build up a stash of savings and investments outside your retirement accounts.