When planning for your retirement, you may focus on trying to figure out how much income you'll need, where that income will come from, how the stock market will affect your investments, what your expenses will be during retirement and whether they will change over time. But one aspect of retirement savings that you may have forgotten could end up costing you plenty. The effect that taxes have on your retirement savings and income is often overlooked, but it can mean all the difference to your level of financial security.
“It is crucial for investors to understand how much income they will need in retirement, where that income is going to come from and how it is expected to grow in retirement in order to manage the potential tax burden that it can create,” says Mark Hebner, founder and president, Index Fund Advisors, Inc., in Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.”
In this article we'll take a look at five of the common tax issues you should be aware of to keep the financial luster on your golden years. (For more tips on saving for retirement, check out Annuities: How to Find the Right One for You.)
1. Understanding Growth, Income and Cash Flow
This is a distinction that can make a difference in your bottom line. Income is money that you receive and is subject to income taxes. Cash flow is the after-tax proceeds available to you to meet your retirement expenses. Growth is the earnings that you need on your savings and investments to ensure that you have enough income to last for your lifetime and to keep up with inflation.
In retirement, a key goal should be to minimize the impact of taxes on your income, which will increase the cash flow needed to meet your expenses, while leaving enough in your savings to give them the opportunity to grow at a rate sufficient to keep up with (or exceed) inflation. There are many different strategies you can employ to accomplish this goal, depending on your income, pension (if any), Social Security, etc. and the kind of assets you have in your portfolio. (For more information on Social Security, read How Much Social Security Will You Get? and 10 Common Questions About Social Security.)
However, recognizing the differences between growth, income and cash flow is the first step in pointing you in the right financial-planning direction.
2. Taking Required Minimum Distributions
If part of your savings consists of qualified plans, 403(b)s, SEP IRAs, 457(b) plans and traditional IRAs, you must begin to take required minimum distributions (RMDs) each year, beginning the year you reach age 70½, even if you neither need nor want the money. There is an exception that permits employees to defer beginning their RMD past age 70½ on a qualified plan at their current employer, providing the employee does not own more than 5% of the company. Failure to take the distribution can result in a penalty of 50% of the deficiency.
Let's say your RMD for the year is $7,000, but you miscalculate and only withdraw $3,000. You will be subject to an excise tax equal to 50% of the deficiency, or in this case, $2,000, which is half of the $4,000 deficiency. You can ask the IRS to waive the penalty if you feel that you have “reasonable cause” for missing the deadline. “Fortunately, the IRS has a history of showing forgiveness to retirees who forget to take their RMD,” says Kevin Michels, CFP®, financial planner with Medicus Wealth Planning in Draper, Utah. “However, if it becomes a habit, the IRS will make you pay.” (To learn more, see 3 Steps to Take If You Miss Your RMD Deadline.)
It is not uncommon to forget or neglect to take an RMD, or to miscalculate the amount and not take out enough. The RMD amounts for each retirement account must be calculated separately. However, if you have multiple traditional, SEP and SIMPLE IRAs, the total RMD for these accounts can be taken from one or more of the accounts. Roth IRA owners are exempt from this requirement. (Sound confusing? Keep reading about it in Strategic Ways to Distribute Your RMD and Preparing for Retirement Plan RMD Season.)
3. Minimizing Tax on Your Social Security Benefit
If the total of your adjusted gross income (AGI), nontaxable interest, and half your Social Security benefit is above a certain dollar amount based on your individual filing status, then as much as 85% of your Social Security retirement benefit may be subject to income taxes. You should talk to a financial advisor about this amount prior to your retirement to know what you're in for.
This scenario illustrates the important difference between cash flow and income. Managing your income to reduce the tax impact on Social Security benefits may increase your cash flow.
However, there are strategies that may be available to you to minimize the income tax on your Social Security, including changing your tax filing status and reducing your AGI by changing the type of assets you own. For instance, interest earnings in a deferred annuity are not included in your AGI until they're withdrawn, whereas interest earnings on CDs and most bonds are included, even if the interest is reinvested. “If your income is above $34,000 as a single individual or $44,000 as a married couple, utilizing a charitable trust or annuity may be an alternate solution to avoid Social Security taxation,” says Carlos Dias Jr., wealth manager, Excel Tax & Wealth Group, Lake Mary, Fla.
4. Rolling Over an Inherited IRA
If you inherit an IRA or another qualified plan, you cannot roll over the account into an IRA you own if you are a non-spouse beneficiary. Only if you are a surviving spouse may you roll over your deceased spouse's IRA or qualified account into your own name.
If you are not a surviving spouse, you can roll over the qualified plan account into an inherited IRA in your name (as beneficiary) and the name of the decedent, but only if this rollover option is permitted under the plan. For IRAs, you can transfer the amount to an inherited IRA in your name (as beneficiary) and the name of the decedent. A spouse beneficiary also has that option, but can also chose to transfer the amount to his or her "own" IRA. (For more, see Common IRA Rollover Mistakes.)
5. Converting a Traditional IRA to a Roth IRA
A Roth IRA is a beneficial retirement asset because none of the earnings within the Roth are subject to income tax when withdrawn, if the distribution is qualified. The tax treatment of traditional IRAs is just the opposite – with a few exceptions any earnings, as well as principal, will be subject to income tax when withdrawn. The favorable tax treatment of Roth IRAs makes them very popular. Traditional IRAs can be converted to Roth IRAs if certain minimum income requirements are met. (For more info on IRAs, check out 11 Things You May Not Know About Your IRA.)
However, any taxable amount you convert from a traditional IRA to a Roth is taxable as income in the year converted. You could face significant income taxes if the amount you convert dramatically increases your taxable income. Often, the income tax-free benefits of the Roth outweigh the potentially devastating tax hit that can ensue from the conversion.
Before deciding whether to convert your traditional IRA to a Roth IRA, consider the increased income taxes you will have to pay due to the conversion. Where will you get the money to pay the tax? If you must take the money from the IRA to pay the income tax, less will be invested in the Roth. How long will it take for the Roth to grow before it equals the amount of the IRA before conversion? Will you pay the tax from other sources and how will depleting those savings affect your future retirement income? (For more, see Tax Treatment of Roth IRA Distributions.)
“Converting to a Roth can be expensive in the short term because you will be taxed on the entire amount. The plus side is that the growth going forward will not be taxed when withdrawn if it’s after age 59½ or five years, whichever is longer,” says Allan Katz, president of Comprehensive Wealth Management Group, LLC, in Staten Island, N.Y. “I think it is important to be able to pay the taxes without using proceeds from the IRA. I also think [the conversion] can be more beneficial the younger someone is: The longer they have for the account to grow potentially tax free, the larger the benefit will be.”
The Bottom Line
These points illustrate some of the more common tax issues that can affect your retirement if you're unaware of them or fail to take appropriate action. It is certainly not an exhaustive list. Retirement income planning is too important to approach without thorough knowledge of all the issues that can affect the financial aspects of your non-working years. If you haven't already done so, it may be time to consult with a financial professional to keep your nest egg safe.