We can take a lesson from MacGyver in preparing for any tax situation. Too often we see folks who think they are adequately diversified heading into retirement. They believe that building a portfolio and selecting different asset classes provides adequate diversification. It may take more than that.
While working, Americans have taken the instant gratification of a reduced tax bill through IRAs and 401k plans. Many retirees have stored up a huge portion of their wealth in tax deferred accounts, but in retirement these individuals may find themselves at the mercy of their tax bracket.
With just a bit of knowledge and a good look at the surrounding tax environment, there may be a few ways to get yourself out of a real pickle.
Retirees can benefit tremendously by understanding how different retirement assets are taxed. Retirement assets may be tax-free, tax-deferred or taxable. Simple tax planning may allow you to save a small fortune in taxes and have some control over when and how you pay.
The talk of the town. With rules changing in 2010 and the $100,000 income limit for Roth conversions being eliminated, the Roth IRA has taken center stage. The new changes will create opportunities for many to convert IRAs into tax free income later by paying taxes today. If your account suffered losses during 2008, it may also benefit you to convert while account values are down. Be careful about converting too much. If you pay all of your taxes now and there are favorable tax breaks in the future you may miss out.
Net Unrealized Appreciation - Use it or lose it! A little known rule in the Internal Revenue Code could create real tax savings for those with highly appreciated company stock in qualified retirement plans. The rule allows individuals to pay ordinary income tax on only the basis of the company stock, instead of the entire amount. The appreciation is then subject to the more favorable capital gains tax. This could potentially reduce the tax liability by up to 20% or more. In the end, you wind up more diversified and you may save some real money. To benefit from NUA, you must take advantage of this favorable treatment before terminating employment.
Planning doesn’t stop at retirement. Throughout retirement your tax brackets will change. Early on, many retirees spend more money traveling and on entertainment. In years that you are in a relatively low tax bracket it might make sense to draw from an IRA and pay ordinary income tax at a favorable rate.
The amount of income that you receive during retirement affects your Social Security benefits. Certain thresholds determine if your Social Security is 0%, 50% or 85% taxable. Strategic distributions from your Roth IRA and taxable account may help you to reduce your overall tax burden by reducing the amount of ordinary income tax that you pay.
When you reach age 70½, assets in IRAs and other tax-deferred accounts are subject to a Required Minimum Distribution (RMD). Roth IRAs and taxable accounts do not have this requirement. If you still have substantial assets in tax-deferred accounts you may be forced to draw more than you would like at high ordinary income rates. If you have worked to diversify your taxes by drawing on each of your accounts, the RMD may not be a burden.
The IRS likes it when you share. For folks that are charitable, there are even more opportunities to manage taxes. The IRS offers a number of tax-advantaged options for charitable giving including the Charitable IRA Rollover, Gifting Stock, and Charitable Trusts. It is always wise to plan ahead and to look at the current tax structure to maximize giving and minimize taxes. Implementing tax strategies may allow you to give more to organizations you care about and less to Uncle Sam.
Leave a legacy. When you leave assets to your beneficiaries they will reap the benefits of your tax planning. Assets within IRAs will continue to be taxed at ordinary income and may be subject to minimum distributions for your heirs. Assets that you leave behind in a Roth will continue to provide tax free income. The appreciated assets within taxable accounts will receive a step-up-in-basis when you pass away. Instead of assuming your basis and owing substantial capital gains, your heirs will receive a clean slate with a new ‘stepped up’ basis.
Managing your tax liability throughout retirement is as important as the investments you make. The tax environment is constantly changing. Always seek the guidance of a tax professional. Understand how your assets are taxed, keep an eye on changes to tax rates, and watch for opportunities provided by the IRS to save money. When you find yourself in a tricky situation, you may have just the tool you need right in your back pocket.