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How to Defuse the Tax Bomb in Your Retirement Plans

Remember: the accumulated earnings are just tax-deferred

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Featured Expert

In the retirement plans and other savings of every unsuspecting investor resides a surprise package from the Internal Revenue Service (IRS) that could blow up your retirement planning process. I call it a “tax bomb.”

We all owe taxes on our earnings, of course. So if you set aside a portion of your earnings in a 401(k) or IRA, that doesn’t mean taxes were forgiven — they were only deferred. And if you have appreciated securities in your savings, you’ll owe taxes when you sell them.

It can be a real shock when your IRA custodian asks you how much withholding you want taken out from your distributions, particularly when you’ve not had to concern yourself with taxes on your savings until now.

The question of how to optimize your after-tax income in retirement does not have a one-size-fits-all answer.

By anticipating the different requirements of each stage of our working and retirement years and by following IRS rules, however, you can maximize the after-tax income from these savings and defuse the coming tax bomb.

Understanding the Impact of Taxes

Let’s say you’ve saved $200,000 in a rollover IRA by the time you are 65. With Social Security, a pension and the equity in your home, you may be anticipating a retirement free of financial worry.

But you’d be mistaken, because you haven’t thought about your tax liability. Not only will your monthly Social Security payments be taxed, that $200,000 and your investment earnings will be taxed at the highest ordinary income rates.

As an example, if your investments earn 4 percent over the next 25 years, that $200,000 translates to just $6,500 per year in after-tax income (plus 3 percent inflation), assuming a combined state and federal tax of 30 percent.

Suddenly your financial future is not so worry-free.

You can do a similar analysis on fixed or variable deferred annuities (with tax-deferred interest or investment earnings), or stock and bond mutual funds with unrealized appreciation in your personal investment accounts.

But remember, taxpayers have the right to minimize the effect of taxes on their income while still obeying the tax laws. As you move toward, and into, retirement, you can decide which accounts you will allow to grow and which accounts you draw down for income.

How to Maximize Your After-tax Income

The question of how to optimize your after-tax income in retirement does not have a one-size-fits-all answer. (And, by the way, most retirement calculators don’t even address taxes.)

The solution involves devising the most efficient way to convert each of your major sources of savings to income. Here are some quick tips.

Rollover IRA. Consider using 25 percent of the account — up to $125,000 — to purchase a Qualifying Longevity Annuity Contract, or QLAC.

This is a form of deferred income annuity that starts paying you at an age you set, usually 80 or 85, in anticipation of late-in-retirement expenses. It also defers taxes until you start receiving QLAC payments. Once a QLAC is in place, consider a strategy that generates the highest income until the QLAC kicks in.

Fixed and variable deferred annuities. When you withdraw money from deferred annuities, the income could be fully taxed for a period of years. However, if you move their accumulated value into an income annuity that pays regular, guaranteed income, the IRS will exclude a portion of the payment from tax.

A tip: Shop around when you decide to annuitize your savings so you get the annuity with the features you like at the best rates. It doesn’t have to be the company you bought the deferred annuity from initially.

Personal savings. Stock dividends are assessed at lower tax rates than regular income; they might be tax-free or taxed at a 15 or 20 percent rate, depending on your tax bracket. By contrast, regular income is taxed up to a 39.6 percent rate.

In addition, your surviving spouse and children will get the best tax benefit from this account because, upon your death, they receive a “step-up in basis” and pay no taxes on prior accumulated gains. So if you can afford it, spend your dividends, but let the capital gains accumulate.

Equity in your home. This might represent your largest source of savings and it probably receives the most favorable tax treatment. You can tap the equity and receive tax-free cash with a reverse mortgage or a home equity line of credit with tax-deductible interest. Of course, you’ll want to have a long-term plan for paying interest and principal when required.

As you can see, addressing your tax liability requires thoughtful planning and careful decision-making. But when you take the time to understand your options, you can defuse a “tax bomb” to generate the highest amount of spendable, after-tax income.

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