Taxes & Your Retirement

This year, as the April 17 deadline for personal income tax filing draws closer, you should give some thought to minimizing your tax bill through your retirement planning.

It’s a complex topic that would require more than a few words to explain, but nationally-known tax expert Jordan Amin, a certified public accountant (CPA) and chair of the American Institute of CPAs’ Financial Literacy Commission, has a tip for three different groups of people: those who are 50+, still working and trying to save for retirement; those who have saved for years but now have to figure out the best way to crack open the various eggs in their nest; and those who are wealthy enough to leave a legacy.

For those who are still working, if your employer offers a tax-deferred savings plan like a 401(k) or 403(b) and they offer to match any part of your contributions to it, there’s just no excuse for not contributing to it.

Beyond that, Amin notes that people who are 50 or over are allowed to contribute even more money to their 401(k) and 403(b) plans. In 2012, that “catch-up contribution” limit is still $5,500.

His next lesson applies to people who are still working and saving, as well as to those who are now ready to tap their retirement funds. If you put all of your retirement money into your employer’s plan – thereby sheltering that income and the earnings on it from taxes until you withdraw it – you may actually end up paying more in taxes and management fees than you would if you spread that money around a little more.

Let’s say you make $80,000 a year, putting you in the 25 percent tax bracket. When you withdraw money from your tax-deferred accounts, like your 401(k), it’s treated as ordinary income, so you’ll pay 25 percent tax on it. But if you’ve put money into a taxable account at a brokerage firm, as long as you hold assets for at least a year, you’ll only pay the 15 percent capital-gains tax as you sell assets in that account.

Meanwhile, while you’re focusing on drawing down your taxable brokerage accounts, the money in your 401(k), 403(b) or IRA is still growing tax-free. Later, once you hit age 70 ½, you won’t have any choice – you will be required to start drawing down those accounts and paying taxes on the withdrawals.

If you can get by on the income from your taxable brokerage account until you’re 70 ½ – and delay claiming Social Security until you’re 70 – you will stand a much, much better chance of having enough money to last the rest of your life. That brings us to Amin’s final lesson, directed at those who are older, very wealthy and may have the luxury of leaving money to heirs. Think about whether you may want to pay taxes now to convert a traditional IRA (in which you invested pre-tax dollars) into a Roth IRA. Roths have no required minimum distributions, and neither you nor your heirs will pay taxes when you withdraw money from a Roth.

For people who are planning to use that money some day, it may not make sense to convert in a down market. With a conservative investment portfolio, it may take too long to recoup the money paid in taxes to do the conversion.

Jean C. Setzfand is Vice President of the Financial Security Team in the Education and Outreach group at AARP. She leads AARP’s educational and outreach efforts aimed at helping Americans achieve financial “peace of mind” in retirement.

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