Cut Your Taxes in Half During Retirement?

The IRS has a big red bull’s eye painted on your retirement accounts. Why?

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The answer is simple and straightforward: Our government is going to need your money – and that of lots of other Americans – to keep this country running.

The federal budget deficit in 2009 is projected to top $1.8 trillion! Yet, this is a mere drop in the bucket compared to the $107 trillion in unfunded liabilities for Social Security and Medicare as the baby boomers retire. That works out to a cool $367,000 per U.S. household.

You may be thinking, “But, I’m not wealthy.” Sorry – it doesn’t take a lot to be rich in the eyes of the IRS. Simply having your name on an IRA or 401(k) plan distribution list makes you fair game. All the IRS sees is a huge amount of collective dollars – $47 trillion, to be exact – stashed away in IRAs and retirement programs.

Many people believe that all they need to do for retirement is defer as much money as they can. When they retire, they’ll be in a lower tax bracket and can start withdrawing the money for spending purposes. This is rarely the case. It’s even less likely looking into the future.

Consider Dan and Teri, who are new retirees. Dan retired two years ago with a small pension. He started drawing Social Security and has $600,000 in an IRA rollover account from his old 401(k). Teri has just accepted an early retirement offer from her employer. She will also have a small pension and one year of severance. Her 401(k) account is worth $700,000. They have no other savings.

They need $100,000 per year of spendable income to maintain their lifestyle in retirement. Their two pensions amount to $25,000 per year. Social Security for both of them pays another $30,000. They will need to withdraw the difference of $45,000 from their retirement accounts to meet their income goal. A $45,000 withdrawal from a $1.3 million account balance equates to a withdrawal rate of 3.5%. A prudent withdrawal rate is 4% or less.

The couple wouldn’t have any problem with their retirement plans if it wasn’t for income taxes. Unfortunately, all of their pension income is subject to tax. All of their retirement-account withdrawals are subject to tax, as well. And, 85% of their Social Security benefits are subject to tax. They claim the standard deduction and two personal exemptions. They will need to forfeit $12,100 to the IRS. That’s 27% of their retirement account distributions!

In order to net $45,000 from their retirement accounts, they would need to take $61,000 per year and pay $16,000 in taxes. This is because every dollar they take from their retirement account to pay taxes is itself subject to tax. However, $61,000 is a withdrawal rate of nearly 5% per year and would be too high for their accounts to support.

The couple should have had a balanced approach to retirement savings, dividing their money equally between tax-deferred accounts (their 401(k) plans), after-tax accounts and tax-free accounts (Roth IRAs). They would not have received the tax deductions as they accumulated their savings, but let’s look at the impact on their retirement income.

The $45,000 of income they need will come equally from their three sources of savings:

  1. $15,000 from the 401(k)/IRA accounts will still be taxable.
  2. $15,000 from the after-tax account will be partially taxable, but at a capital-gains tax rate. The tax rate on capital gains is currently 0% for the couple because they will be in the 15% bracket now.
  3. $15,000 from the Roth IRA will be totally tax-free. Their tax bill has dropped to $5,000. This is a nearly 60% decrease in taxes!

Their tax bill can be paid from their non-taxable accounts, so it will not increase the amount. The total withdrawal amount of $50,000 per year is under the 4% target.

You need to start planning now to balance your retirement savings while the tax laws are still favorable. The current low tax rates are scheduled to increase on January 1, 2011. Congress could act sooner to increase rates but it is unlikely to do so until the economy recovers.

It is also a great time to make changes while account values are low due to the stock market decline. (The strategy of converting an IRA to a Roth IRA will help build up the tax-free part of your savings.)

A more complete explanation of how to build a balanced retirement can be found in my retirement book, The New Three-Legged Stool™: A Tax Efficient Approach to Retirement, which was released in June. The book explains in detail how to set up each leg of your retirement savings. The book is available in book stores or you can buy it online.

The place to start is to determine how much of your savings needs to be tax-deferred each year to minimize your current tax bill. (You may need the help of a tax professional to determine this amount.) Those taxpayers who are already in a 15% tax bracket may not want to defer any income because they are already in the lowest bracket. Their savings should go to maximize their Roth IRA contributions first and then to after-tax savings.

Taxpayers in the highest tax bracket may not want to defer their income either. Anyone with income over $250,000 can be assured of a significant tax increase in 2011. If you’re in this situation, you probably can’t make Roth contributions because of income limits. Check with your employer to see if a Roth 401(k) option is offered. Another strategy is to make nondeductible IRA contributions now and convert these accounts to Roth IRAs in 2010. The current tax law only allows Roth conversions if your adjusted gross income is under $100,000. This restriction is lifted in 2010.

The window of opportunity is closing quickly. You need to put a plan in place to minimize your taxes in retirement. Implementing the right strategy may cut your tax bill in half.

Note: Information and examples in this article are of a general nature. The information reflects the opinion of Rick Rodgers and Rodgers & Associates on the date written and is subject to change at any time without notice. Due to various factors, including changing market, tax and legal considerations, the content may no longer be reflective of current opinions or positions. The information provided should not be deemed to constitute financial, investment, tax or legal advice.

This article originally appeared in Lancaster County magazine.

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