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 $1,000,000 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, order our free booklet, “Seven Ways Retirees can cut Taxes,” by clicking here.