Avoiding Tax Pitfalls In Retirement
As we transition and create our income plan for our golden
years, we uncover the painful reality that the road to retirement
has its own shares of taxation pitfalls. Here are a few of
the more common errors that most can avoid with a little planning.
Not understanding the difference between growth, income
and cash flow:
Cash flow is the after-tax cash you have to meet your needs.
Income is what you will have to pay annual taxes on and growth
is what you need from your portfolio in order to insure enough
money to last for your lifetime and allow for the impact
of inflation. When planning for retirement living, the goal
is to achieve as much cash flow as necessary, while paying
the least possible amount in income taxes and leaving enough
behind in your portfolio for it to continue to grow at a
rate that keeps up with (or exceeds) inflation.
Not taking required minimum distributions
If you have any qualified plans or traditional IRAs, you
must begin to take at least annual distributions when you
reach age 70 ½. If you fail to do so, you could be subject
to a penalty as high as 50 percent of the required distribution.
Roth IRAs are exempt from this requirement.
Not understanding the tax impact income can have on social
security
If your taxable income plus half your social security takes
your income above $25,000 (for single filers) this can cause
part or all of your social security to become taxable as
well. This is where managing cash flow versus income can
make a significant difference. A little advance planning
may lessen or eliminate this problem.
Not developing an estate plan .
. .
. . . especially when total net worth (including
life insurance proceeds) exceed the standard exemption:
This year the exemption is $1,500,000 and it will be rising
gradually until 2009, when it will be $3.5 million per
person. (Note the estate tax exclusion table is set to
expire on 2010, what will happen to estate taxes after
that time is unknown.) While you can leave everything
to a spouse without any estate taxes, if your combined
worth exceeds the exemption, the balance will be subject
to estate taxes upon the death of the second spouse. Estate
taxes run between 18-50 percent and are on top of any income
taxes that may be due. A large estate without a proper
plan can lose more than 70 percent to taxes. There are
ways to avoid or minimize this problem through the use
of trusts and other techniques. This is not an area for
amateurs. Estate planning is best left to quality professionals
and usually requires the team effort of an experienced
financial planner and an attorney to establish the best
plan for you.
Not naming beneficiaries for all qualified accounts
Qualified
accounts, in most cases, need to have individuals named as
beneficiaries. What is listed for each account supersedes
anything named in your will or trust. If you fail to name
a beneficiary, the money reverts to your estate. It is also
in your interest to name a successor beneficiary. You may
wish to talk to your estate-planning expert about creating
a special document for your IRA Trustee called a “Retirement
Assets Will.” This form offers explicit and complete
instructions for your IRA custodian to follow. An attorney
must complete this form.
Naming the wrong beneficiary
In most cases it is significantly
important to name an individual or individuals rather than
your estate or a revocable living trust. The reason this
is a problem is that if this happens, the entire amount becomes
taxable.
If you name a person, that person may be able to
continue the deferred growth over their life span or take
up to five years to liquidate the account (this may depend
upon your minimum distribution schedule). That added deferred
growth could be substantial. Another common mistake occurs
if you have multiple beneficiaries with a wide gap in age.
The "life
span" that is used to determine the minimum
distribution schedule will be that of the oldest beneficiary.
If this is a potential issue for you, you may be wise to
split your IRAs into separate accounts each with a different
beneficiary. If you have 401(k) or other pensions and have
multiple heirs with a wide spread in ages, you may wish to
do a rollover into an IRA and then divide it into several
accounts to resolve this issue.
It may also be possible
to address these concerns via a specialized trust. Consult
your financial planner or estate attorney for more information.
Doing an IRA rollover for an inherited account
Only
a spouse may roll over their spouses IRAs into their own
name. Other beneficiaries must not. If they do, the entire
amount becomes immediately taxable.
Undertaking a Roth conversion without a full understanding
of the tax consequences
Equally problematic is not
taking a Roth conversion due to a lack of understanding
of the consequences. Any amount you convert from a traditional
IRA to a Roth is taxable in the year converted as income.
If your tax bracket is high this may be worthwhile but
the answer isn't always that clear cut. Some of the considerations
that must be undertaken include: How long will this money
grow before you begin to draw off of it? Will this
be money you will eventually spend or is it meant to be
part of your legacy. On the other hand, Roths have no
required minimum distributions and since money withdrawn
from them is tax free, it doesn't impact the taxable status
of your social security. Roth IRAs can also be a useful
part of an estate plan as proceeds from the account are
also free of income taxes to the heirs. (Note the account
must be five years old or older for all distributions
to be tax-free.)
When to convert is also an issue. To begin with, your combined
income must be below current income limits to qualify for
a conversion. Also, since the contents of the traditional
IRA will become taxable, it may be a more attractive option
for investments that are currently down in value, but are
expected to appreciate considerably.
Last note, you cannot directly convert a 401(k) or other
retirement fund distribution to a Roth IRA. You must do a
rollover first to a traditional IRA before undertaking the
conversion.
Not seeking professional assistance when it's appropriate
to do so
As you can gather from this article, planning
your retirement cash flow, portfolio growth and taxation
issues can be complicated. It is the opinion of this
author that most folks, even those quite experienced
at managing their own investment portfolios would be
wise to seek advice as they begin their retirement income
plan. Mistakes can be costly, especially if you aren't
working and have no way to recreate money lost.
For more
tax saving secrets, request our
FREE booklet,
“Six Ways Retirees Can Cut Taxes,”
by clicking on the link below.
Get
Your FREE Retiree Financial Guide
|
