By Albert B. Crenshaw
Special to The Washington Post
Wednesday, October 15, 2008
With the decline of traditional pensions, tax-deferred saving through 401(k) plans, IRAs and the like has become a key element of most Americans' funding.
But tax-deferred isn't the same as tax-free. And when retirement -- or at least relatively old age -- rolls around, people who have built up substantial tax-deferred nest eggs will find that they are required to start pulling that money out and paying taxes on it, whether they want to or not.
And these withdrawals, or "distributions," as they are called in tax jargon, get no special benefits, such as the lower rates for long-term capital gains. It's all "ordinary income," taxable at the same rates as wages and interest.
Thus, when the baby boomers, and the generations behind them, reach retirement, they will find that any tax planning they did while working and/or steps they took at and in retirement will make a major difference in the amount of spendable income they have late in life.
"People should think about tax planning in terms of maximizing their lifetime net worth," said Elissa Buie of Yeske Buie, financial advisers with offices in Vienna and San Francisco. For example, opting for tax-deferred saving over taxable investments that qualify for capital-gains rates "may or may not be the smartest thing for them to do," Buie said.
Knowing the right moves to make, however, isn't simple. Not only are the tax laws complicated, but individuals' circumstances vary, so that what works best for one person might be a bad idea for another.
But whether you are just setting out on a career or are on the cusp of old age, it's not too soon, or too late, to try to minimize your taxes. Remember, said Buie, when you have to pay taxes, "that's money that's just gone."
Here are some areas to look at as you try to work out the most advantageous strategy:While You're Working
· Get the match. Of course, for taxes to matter in retirement, you've got to have some income in retirement. So as soon as you begin work, be sure and sign up for your employer's 401(k) or other retirement plan if there is one.
Check also to see if your employer will match some of the money you put into the plan. If there is a match, find out what the maximum is and try to contribute enough to get all of it. The match is free money, tax-deferred, and if you don't sign up or if you contribute too little, you'll be leaving some or all of it on the table.
And remember, both contributions and any match are "pre-tax," meaning that they are not counted when you figure your taxable income next April 15, typically reducing the tax you pay. Taxes on the contributions and on any income earned in the account are deferred until you begin withdrawal, presumably after you have retired.
· Check out a Roth IRA. Once you're getting the full match in your 401(k), you have come to the first decision point.
Your can put more into the k-plan -- up to $15,500 this year, plus an additional "catch-up" contribution of up to $5,000 if you're age 50 or over -- and it will all go untaxed until retirement. But in retirement, it will be added to other income you have and taxed in whatever bracket that works out to.
This has led some advisers to suggest that if you have maxed out the match with your 401(k), you should consider funding a Roth IRA, if you are eligible to do so. These accounts are funded with after-tax money and thus do not reduce your current taxes. But withdrawals in retirement are tax-free.
To be sure, economists will tell you that in the long run the value of tax deferral today is exactly the same as the value of tax-free tomorrow, assuming that you're in the same tax bracket now and later. But if you are young and just starting out, you may in a lower bracket now than in retirement -- or tax rates in the future may be higher than they are now. Either way, money in a Roth account is protected.
Further, unlike a traditional IRA or 401(k), there are no mandatory withdrawals from a Roth. Thus, if the money is not needed, you can leave it there to grow tax-free, and perhaps bequeath it to an heir to create a tax-free lifetime stream of income for him or her.
But there are important drawbacks: Roth IRAs are available only to workers whose income is below certain levels, and the amount you can contribute is limited. Taxpayers may contribute no more than $5,000 ($6,000 if age 50 or over), and that only if their income is less than $159,000 for a married couple or less than $101,000 for a single. Above those limits, the amount you can contribute phases out, reaching zero at income of $169,000 for a couple and $116,000 for a single.
· Capital gains for the long term. Generally, it has been the government's policy to tax capital gains -- profits on the sale of assets such as stock -- at lower rates than wages, interest or other types of income. Also, as long as any profits remain on paper -- that is, until the asset is sold -- no tax is levied.
These features make stocks an appealing component of a retirement nest egg. Stock owners can defer taxes to a certain extent simply by not selling, and they will pay lower taxes when they do sell. (Keep in mind, however, that experts caution against holding something that ought to be sold simply because of taxes.) In addition, under current law, most dividends qualify for lower tax rates, too.
At and in Retirement
· Required beginning date. For holders of tax-deferred accounts, 70 1/2 is a key age. That is the age at which you must begin taking distributions from your account(s). The amount is based on the total value of all your deferred accounts and your life expectancy -- and that of your spouse if you have one -- as laid out in tables by the Internal Revenue Service.
This has been simplified in recent years, but some account holders still miss the date and are subject to stiff penalties, so as you approach that age, be alert. In fact, you actually have until April 1 of the year after the year in which you turn 70 1/2 to take your first distribution, but many experts advise taking that first distribution in the year you turn 70 1/2 rather than waiting. That is because if you wait, you have to take two distributions in the same year, which could raise your taxes. Make sure you include all your IRA and 401(k) accounts; you don't have to take the distribution from any particular one, but you have to get the overall percentage right. Consult an accountant or other expert if you are uncertain.
And there are some exceptions to the rule. Roth IRAs aren't subject to required withdrawals. And if you have a 401(k) with an employer for which you are still working when you turn 70 1/2 , you don't have to begin withdrawals until you retire from that company (unless you own 5 percent or more of it).
· State taxes. Once you are retired you may find it possible or even desirable to pack up and move to another part of the country. If you do, you may be able to cut your taxes considerably. And you don't always have to go very far. A District resident, for example, can cut his or her top state income-tax rate from 8.5 percent to 5.75 simply by moving across the river into Virginia. By moving farther -- to Florida, Texas or one of the half dozen states with no income tax -- you can cut the rate to zero.
Further, if you are lucky enough to have an old-fashioned pension, note that many states have special breaks for pension income, or for senior citizens in general. Government pensions qualify for complete state income-tax exemptions in a number states.
· Social Security. Although the Social Security Administration says that fewer than one-third of current Social Security benefit recipients pay taxes on their benefits, that is undoubtedly changing. The benefits are taxable if your income exceed certain thresholds, which were set in the1980s and '90s and have not been indexed for inflation. If the sum of one-half of your Social Security benefits plus other income you have, including interest on tax-exempt bonds, exceeds $25,000 for a single person or $32,000 for a married couple, then 50 percent of your benefits is taxable. If the sum of one-half of your benefits plus all your other income is more than $34,000 ($44,000 for married couples), up to 85 percent of your benefits is taxable.
Note that while distributions from traditional IRAs are included in figuring whether your Social Security benefits are taxable, distributions from Roth IRAs are not.
The interplay of Social Security benefits, other income, taxes, and the fact that the longer you wait to collect Social Security (up to age 70) the larger those benefits become makes for a very complex stew of choices for retirement.
For example, if you receive income that is a combination of Social Security benefits and distributions from a traditional IRA, it's likely your benefits will be 50 or even 85 percent taxable and your distributions fully taxable. But suppose early in retirement you defer collecting Social Security and draw more from your IRA until at age 70 your IRA is exhausted. You then begin drawing Social Security benefits. Since you've waited, your benefits will be quite a bit larger than they would have been at age 62 or even 65, and if they are your only income they may well be tax-free. Further, future Social Security cost-of-living adjustments will be calculated off your higher benefits, giving you bigger COLA boosts later on.