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Your Retirement Exit Plan

A top-down strategy for getting money out at retirement can have a dramatic effect on lowering future taxes.

By Janet Arrowood

For people who put money away in tax-deferred or other retirement vehicles, advance planning on how to get the money out at retirement is just as important as determining how and when to invest the money. A top-down strategy (working from the desired end result back to the starting point) can have a dramatic effect on lowering future taxes.

One point often overlooked or misunderstood: Maximum deferral of current income taxes doesn’t ensure maximum retirement income, but it can greatly increase future taxes.

Most people pay income taxes at a marginal rate of 15% and 28% (plus state taxes). If you are contributing to a tax-deferred retirement plan, you are probably deferring taxes at the 28% (or possibly the 31%) bracket. If you can truly live on far less income in retirement, this approach probably makes great sense. However, most people cannot afford to retire on significantly less than they take home today. Many, in fact, will need more cash to live their retirement dreams.

So part of your retirement income will be taxed at 15% and part at 28% (assuming Congress doesn’t change the tax brackets). There is an inherent value in deferring dollars that would be taxed at 28% if you can withdraw the money (and all the tax-deferred growth it earns) at 15%. Clearly, it is far less valuable to defer current dollars from 28% taxation to pay taxes during retirement at the same 28% or an even higher bite. There are retirement plan exit strategies that can greatly reduce the total taxes you will owe when you start taking withdrawals. These strategies work because retirement plan withdrawals, except for Roth IRAs, are taxed at ordinary income rates.

How? Take full advantage of the benefits found in the 1997 Taxpayer Relief Act. These include reduced long-term capital gains rates, Roth IRAs, and the recurring capital gains exclusion on the sale of your primary residence. Consider the following:

Long-term capital gains are taxed at a maximum 20% (subject to the alternative minimum tax). Investments that can produce long-term gains include stocks and mutual funds. Non-retirement (outside of qualified plans) mutual funds are interesting. Almost every year, fund investors get a notice of how much the fund generated in long and short-term capital gains and earned in dividends. Most investors reinvest these payouts and, yes, taxes are due right away. But by paying the taxes as you go, the basis (the amount on which you owe no further taxes) in non-retirement mutual funds should increase every year. If the majority of these funds are growth-oriented, you will have little or no dividend income, just capital gains.

This means that if, over many years, you contribute $100,000 to a diversified portfolio of funds, and over that same period, the investments grow to $500,000, you will already have paid the taxes on the majority of that appreciation. If, for example, cumulative annual capital gains and dividends are $250,000, you will have already paid taxes on your original $100,000, plus $250,000 of the increase in value. That leaves you with an undeclared gain of $150,000.

If you began withdrawing money from these funds, you would only owe taxes on this undeclared gain when you actually withdrew the money or the mutual fund company sent a statement indicating additional gains or dividend distributions. That means you can take out a significant amount of money without reporting it at all or at a favorable tax rate of 20% (on the undeclared gains.) Note that this is a highly simplified example. Consult a tax advisor before implementing this strategy.

Here is an example of two investors, both of whom have accumulated the same amount for retirement. One took the maximum tax deferral approach and the other looked farther ahead to minimize taxes at retirement but maximize tax deferral while working. This examples assumes the money comes out at a rate of 4% a year from all sources.

Again, this is highly simplified since one paid less in taxes through the years than did the other. When you are earning current income, paying taxes is much less painful than when you are retired. You can better manage the expenses to compensate for slightly higher taxes. You also have a significant pool of retirement assets you can get to if you need it.

There are a few other basic truths. Roth IRAs, employer matches to company-sponsored retirement plans, and tax-free gains on selling a house can all reduce the effective tax cost of retirement income. And it doesn’t make sense to flat-out avoid taking any distributions from qualified retirement plans (regular IRAs, SEPs, SIMPLEs, etc.). Eventually income taxes will be due on this deferred money and if the income is considered to be “income in respect of a decedent,” the entire amount gets added to the deceased’s final year’s income, taxed at the top applicable income tax rate. It is also subject to inclusion in the estate, where combined tax rates can approach 85%. It may therefore make enormous sense to take money out of these qualified plans as soon as you are eligible even if you don’t need to spend the money. You can pay the taxes, which will be at a lower rate than in death, and reinvest the money or just put it in the bank.

Janet Arrowood is managing director of Investment Decisions, Inc., in Denver, a provider of advanced business and estate planning for business and individuals. She is a registered representative and has written for various business and legal media. She can be reached by phone at 303-567-0996 or by e-mail at jcarrow@mstg.net.


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