Wednesday, October 14, 2009

Retirement Planning: Tax Implications and Tax Strategies

Advantages for Early Starters
While it's not difficult to understand that building a sufficient retirement fund takes more than a few years' worth of contributions, there are some substantial benefits to starting your retirement savings plan early.

One of the most important determinants impacting how large your nest egg can get is the length of time you let your savings grow. The reason for this is that the effects of compounding can become very powerful over long periods of time, potentially making the duration of your retirement savings plan a much more critical factor than even the size of your monthly contributions.

The bottom line is if you don't start saving for retirement early on in your working life, it will be more costly trying to play catch-up later on. It's much easier to put aside a small amount of money each month starting from a young age than it is to put aside a large amount of money each month when you are older. Unless you have other serious financial pressure to take care of, such as a lot of credit card debt, you should seriously consider starting to save for your retirement as early as possible.

For example, consider the hypothetical case of Earl and Lance, two 24-year-olds. Earl makes $1,000 annual savings contributions for 10 years and then never makes another contribution ever again. Lance makes no contributions during those 10 years, but then makes $3,000 annual contributions for the next 20 years. Assuming a 15% constant growth rate for both investors, who comes out ahead?

The answer, somewhat surprisingly, is that even though Lance contributed three times as much each year for twice as long, he ends up with the smaller nest egg because he started late!

The table below tracks their progress, starting at the end of their first working year:
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In fact, even if Lance keeps paying $3,000 annually (while Earl contributes nothing) until the end of time, he will never catch up to Earl, provided they both earn the same 15% annual growth rate. As you can see, it really does pay to start your retirement savings early.

Compounding Your Tax Savings
The power of compounding works when it comes to taxes, too. It is important that you use government-sponsored investment accounts (such as IRAs) as much as possible while carrying out your retirement plan, since they will usually afford tax-deferred benefits.

What may surprise you, however, is how substantial the effects of deferring taxes can be over the long term. Again assuming an annual 15% growth rate on investments and 20% tax on capital gains and investment income, the chart below details just how much value there is in deferring your taxes for as long as possible.

Consider two investments of $1,000 invested for 30 years, one in a tax-deferred account and the other in a taxable account. Assume that taxes are paid each year on all capital gains in the taxable account. The end result after 30 years is that taxes leave the taxable investment's size at about half that of the tax-deferred account.
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Of course, this graph is based on the assumption that the taxable investment account turns over its portfolio each and every year (i.e., 20% capital gains tax rate is applied to all capital gains each year). If the taxable portfolio held on to stocks for the long term, for example, the capital gains taxes would be delayed.

Regardless, it is usually not beneficial to incur taxes sooner, as opposed to later, and this example should make it clear that failing to take advantage of the tax-sheltering options available could be very costly.

What to do with your 401(k)
One of the first decisions you'll have to make when you are approaching the retirement age is what to do with the savings that 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. 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 when you retire, 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 discount broker or mutual fund company.

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 59½. 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 15% 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 and annual withdrawals by December 31 after that. The required minimum distributions (RMD) are based on your account balance 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
If you've been stashing money in a Roth IRA, you can start reaping your tax-free rewards as long as you are at least 59½ years old and the account has been open at least five years.

But unlike traditional IRAs, there are no mandatory distribution rules, 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 contributed 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 hybrid 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 money during your lifetime.

Convert to a Roth
Once you move your retirement savings to a traditional IRA, you have another option. You can convert some or all of it to a Roth IRA. Although you will pay taxes on money your convert, all future withdrawals will be tax free as long as the account is opened at least five years and you are at least 59½ years old at the time. The longer the money sits in a Roth IRA allowing tax-free earnings to accumulate, the bigger the tax savings. There are no mandatory distribution rules for Roth IRAs, and, if you decide leave your Roth IRA to your heirs, they will inherit it tax free.

Because your tax rate is based on your income, you might want to wait until you retire when your taxable income may be lower and then convert a portion of your IRA to a Roth IRA each year to avoid being bumped into a higher tax bracket. To be eligible for a Roth IRA conversion, your income cannot be more than $100,000. But starting in 2010, income limits on Roth IRA conversions (but not contributions) will disappear. Also, starting in 2008, those eligible for a Roth conversion can convert directly from a 401(k) to a Roth IRA, without rolling over to a traditional IRA first.

Social Security
Another big decision is when to start taking your Social Security benefits. You can start as early as 62, but your retirement benefits will be reduced by 25% or more for the rest of your life. Or you can wait to collect your full benefits when you reach your normal retirement age, which is 66 for those born between 1943 and 1954. For each year you delay collecting benefits after your normal retirement date up until age 70, you qualify for an even bigger retirement benefit. As you consider when to take your Social Security, factor in how your benefits will be taxed.

Also, consider whether you plan to continue working once you start collecting Social Security benefits. If you are younger than your normal retirement age, you will lose $1 in retirement benefits for every $2 you earn over the earnings cap, which is $13,560 in 2008 ($14,160 in 2009). There are more generous earnings limits for the year you reach your normal retirement age and they disappear after that.

A portion of your benefits will be taxed based on your income, which for this test is defined as your adjusted gross income, plus tax-free interest, plus half of your Social Security benefits. If your income is less than $25,000 on a single return or $32,000 on a joint return, your Social Security benefits are tax-free.

Individuals with incomes between $25,000 and $34,000 pay tax on up to 50% of their benefits. Individuals with incomes over $34,000 pay income tax on up to 85% of their benefits. Married couples filing a joint return with incomes between $32,000 and $44,000 pay tax on up to 50% of their Social Security retirement benefits. Those couples with incomes over $44,000 pay taxes on up to 85% of their benefits.

You can ask the Social Security Administration to withhold federal income taxes from your retirement benefits, or you can pay quarterly estimated taxes. To start, stop or change your withholding, file a form W-4V with the IRS. State tax laws vary. Some state exempt some or all of your Social Security benefits from income taxes.

Pensions
Pension and annuity payments from qualified retirement plans are fully taxable. You can elect to have federal income taxes withheld from your pension or annuity check, or you can file quarterly estimated tax payments. State tax laws vary. Some exempt certain types of pensions, such as military or government pensions, from state income taxes. Others allow a portion of any type of pension income to escape state income taxes. A few fully tax pension income. You should get a Form 1099-R from the payer each year showing how much income you received.

Annuities
If you purchase an annuity with non-qualified funds (money not inside a retirement account), the payments you receive will be partially tax free. The portion of each payment that represents a return of your investment is tax-free; the portion that represents investment earnings is taxed in your top tax bracket. Again, you should receive a 1099-R from the insurance company showing the taxable amount.

Health savings accounts
Any distribution from an HSA used to pay for medical expenses is tax free. Once you reach 65, you can use your HSA just like any other retirement account. HSA distributions used to pay for non-medical expenses are subject to income taxes but avoid the 10% penalty that applies to those under age 65 who use the money for non-medical reasons.

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Tax Planning Ideas for Retirees (Examples)
Based on the information provided earlier, there is a brief overview of the possible actions, a retiree may take to reduce taxes during retirement years. A retiree may save taxes and thus enhance retirement income by:

•   Maximizing the nontaxable amount of retirement plan benefits by taking a lump sum
distribution limited to previous employee contributions.
•   Planning the order and timing of (1) retirement plan rollovers and (2) IRA distributions – to maximize the nontaxable amount.
•   Eliminating withholding tax on retirement plan distributions by making a trustee-to
trustee rollover to his or her IRA.
•   Electing to defer tax on the distribution of employer stocks and bonds.
•   Carefully considering whether (and when) to transfer regular IRA or retirement plan
assets to a Roth IRA.
•   Planning the order and timing of (1) retirement plan rollovers and (2) Roth IRA conversions – to maximize the nontaxable amount.
•   Reversing a previous conversion of an IRA to a Roth IRA – because of changed
circumstances.
•   Obtaining temporary use of retirement or IRA funds without paying tax or interest on the funds.
•   Deferring or accelerating income or deductions between tax years to minimize tax on
social security benefits.
•   Choosing distribution alternatives that delay taxation of required minimum distributions from retirement plans and IRAs.
•   Taking a partial lump sum distribution from a personally purchased annuity or a funded nonqualified plan after the annuity has started – rather than before.

Sources and Additional Information:

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