Wealth Matters: Retirement tax planning may require a new tack

Why would anybody pay taxes when they don't have to? 

 This is the typical response that financial advisers hear when discussing tax saving strategies with retired clients.  Retirees are focused on maintaining their lifestyle and how much they can leave to their heirs, rather than on the best ways to coordinate withdrawals from investment accounts.

 Retirement Tax Planning

 The whole idea of tax planning during retirement is a relatively new one in financial planning, and it has created some interesting debates.  You've likely heard the conventional wisdom from the media: when you retire, take money out of your taxable accounts first, which allows the money in your Traditional IRA (i.e. tax-deferred account) and Roth IRA (tax-free account) to compound on a tax-advantaged basis for the longest possible time. 

 Unfortunately, conventional wisdom is often better in theory than in practice.  If you deplete your taxable accounts first, you might end up in a much higher tax bracket later if you have significant assets in your 401(k) or Traditional IRA. Retirees are required to start taking mandatory taxable distributions at age 70-1/2, even if they don't need the income.  These distributions can push them into significantly higher tax brackets and future tax brackets will likely be higher than they are today. 

 Another approach is to gradually take IRA distributions before the mandatory requirement--at lower tax rates.  This might mean taking out enough to fill up lower tax brackets, with the balance of your living expenses still coming from the after-tax account.  Paying a lower rate today could mean avoiding a higher rate tomorrow. 

Alternatively, people who don't need the income could make a partial conversion from the Traditional IRA to a Roth IRA. Again, just enough to offset various deductions and fill up lower tax brackets.  The advantage is paying taxes at a lower tax rate today to avoid any future taxation.  Since Roth IRAs don't have any mandatory distributions for the original owner, you are free to take the money out, tax-free or not, in later retirement years. Additionally, you have the option of leaving tax-free assets to your heirs if you don’t need them.

There are also a couple of strategies to postpone or reduce the tax impact of Required Minimum Distributions (RMD).

Still Working? The rule is - if you continue working past 70-1/2 and do not own more than 5 percent of the company you work for, you can postpone RMDs from your current employer’s retirement plan (usually a 401(k)) until after you retire. You can postpone RMDs from Traditional IRAs as well if you roll them into your employer’s plan.

Charitable Giving? Another strategy that may expire at the end of the 2013 tax year is the ability for those who are 70½ or older to give away as much as $100,000 from their individual retirement accounts (IRAs only) directly to eligible charities without having to include any of the transfer as part of their gross income. These transfers count toward that person's Required Minimum Distribution for the year.

 Estate Tax Planning 

 With the current estate tax exemption up to $5.25 million ($10.5 million for couples), the majority of investors face no federal estate tax exposure now or in the near future. Though this has shifted the focus from estate tax planning to true estate planning, there are still some estate tax strategies that make sense especially for the high-net worth investor. For example, if the estate planning goal is to maximize gifts to heirs, Roth Conversions, as mentioned earlier, could mean tax-free distributions to the beneficiaries over their lifetime even if they don’t provide immediate benefits to the retiree.

Bringing it All Together

 "Why would anybody choose to pay taxes when they don't have to?" It’s simple: When you can pay at a lower tax rate today than you would have to pay in the future, or when you can pay at a low rate today and avoid all future taxation on those assets altogether.  Because every situation is a little different, effective tax planning in retirement is important, and many times more complicated than most of us realize. Since managing investment and estate taxes is something that investors can control, it is an important component of sound financial and investment planning.


Mark Keating, CFP, AEP, is a Certified Financial Planner and an Accredited Estate Planner with Willow Creek Wealth Management, Inc., Sebastopol, one of the leading wealth management firms in California. For more information visit www.willowcreekwealth.com or call 707/829-1146. Wealth Matters is a monthly column from the firm’s advisors.

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