As April 17 rapidly approaches, people all across the
fruited plain are sharpening their pencils, firing up their
calculators, and figuring out what, if anything, they owe Uncle
Sam. For all the ink spilled lamenting the complexity of the
tax code, doing your taxes during your working years is a
pretty straightforward task for most people. Just add up what
you made, subtract any allowable credits or deductions, and
then grab your checkbook.
The process is similar during retirement, with the exception
that you have greater control over your income, which means
greater control over your tax bill. That control means you can
stretch your nest egg further by making good distribution
decisions. With that in mind, here are five ways to minimize
your tax bite during retirement.
Know Which Accounts to Access First
The money you've saved for retirement is likely held in
different types of accounts that are taxed differently. Some
accounts are fully taxable, while others, like traditional
Individual Retirement Accounts (IRAs), defer taxes until you
withdraw the money. Still other accounts, like Roth IRAs, may
be free from federal taxes altogether.
Which accounts should you tap first? A good rule of thumb is
to take money from your taxable accounts first. This will allow
the money in your tax-deferred accounts to continue
compounding. Access tax-free accounts last.
One exception to the rule of thumb might be if you are in a
lower tax bracket now and anticipate that you will be in a much
higher tax bracket in the future. In that case, you may want to
begin taking distributions from your tax-deferred accounts
earlier. In any event, work closely with your tax and financial
advisers each year to make distribution decisions that make the
most sense for your specific situation.
Minimize Taxes on Social Security
If Social Security is your only source of income, chances
are that you will not need to pay taxes on those benefits. If
you have other income sources, however, you may need to pay
taxes on a portion of your benefits if your modified adjusted
gross income (MAGI) plus one-half of your Social Security
benefits exceeds what the IRS calls the base amount for your
filing status.
For example, if your MAGI plus one half of your Social
Security benefits is between $32,000 and $44,000 (for those
married filing jointly) in 2012, you may need to pay taxes on
50 percent of your Social Security benefits. If your
income exceeds $44,000, you will likely need to pay taxes on 85
percent of your Social Security benefits. Armed with this
knowledge, it's easy to see how a poorly timed IRA distribution
or acceptance of some part-time work during retirement can
impact your tax bill in a given year.
Relocate to a Tax-friendly State
Different states tax things differently. Consequently, where
you decide to live during retirement is no small decision when
you think about the various types of taxes that you pay (e.g.
income taxes, Social Security and Medicare taxes, capital gains
taxes, dividend taxes, property taxes, sales taxes, estate
taxes and inheritance taxes). If a particular state is willing
to cut you a break in one or more of these areas, it is worth
factoring that into your decision making.
For example, do you plan on working at least part time
during retirement? There are seven states that do not impose
personal income taxes. Will most of your income be from Social
Security? Thirty-six states don't tax Social Security benefits.
Do you anticipate a free-spending retirement? There are five
states with no sales taxes. Do you have a pension? Ten states
don't tax federal, state and local pension income. Before
deciding where to live, inventory your income streams and
decide which state will allow you to keep more of what you
make.
Consider Tax-free Bonds
Municipal bonds are issued by states or municipalities and
are usually exempt from federal taxes. They may also be exempt
from state and local taxes if you live in the state that is
issuing the bond. This preferred tax treatment along with their
historically low default rate make municipal bonds a staple in
many peoples' retirement accounts.
Take Advantage of Net Unrealized Appreciation (NUA)
If you own highly appreciated company stock in your 401(k)
or other employer sponsored plan, you should review your
options carefully before rolling that money into an IRA when
you retire. That's because tax law permits you to distribute
those shares from your 401(k) and pay income tax on the basis
(your original purchase price) of the shares while continuing
to defer the taxes on the unrealized gains. Once the stock is
eventually sold, you will only pay capital gains taxes on the
difference between your basis and the sale price. If, however,
you roll all of those shares into your IRA at retirement, you
will pay ordinary income taxes on the entire amount when you
eventually distribute it from your IRA.
This strategy might be particularly appealing to someone in
a high marginal tax bracket who currently pays income taxes at
a much higher rate (35 percent) than capital gains taxes (15
percent).
Unfortunately, your tax bill doesn't retire when you do, but
there are actions you can take to minimize what you owe. By
working closely with your advisers, you can maximize your
income and increase retirement security.
FPA member Joseph R. Hearn is the Vice President at
Teckmeyer Financial and author of the books
If Something Happens to Me
and
The Bell Lap: The 8 Biggest Mistakes to Avoid as You
Approach Retirement.