Planning Your Retirement Tax Strategy
What will your taxable income look like after you begin withdrawing from your retirement savings accounts?
December 2008
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When you retire, your life changes in many ways -- and so do your finances. One of the biggest changes is that instead of contributing to tax-deferred retirement savings plans that reduce your taxes, you'll start tapping those savings for income and paying taxes at your regular rate -- not the preferential capital-gains rate reserved for stocks and bonds held in taxable accounts.
What to do with your 401(k). One of the first decisions you'll have to make 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.)