Retirement and Taxes

As we enter the final weeks of tax season, now is a great time to review your goals and look towards your retirement planning. If you are closing in on retirement or many years away, what better time to revisit your situation than tax season! You need to collect all your tax “stuff” anyway, so add a few documents and update your retirement planning. However, the one variable that is hard to plan for in retirement will be taxes. We don’t know what the tax rates will be in 2013, so how can you plan for 20 years or more in the future? Will rates be higher, lower, or will we have a flat tax? But not knowing doesn’t mean that you shouldn’t be planning.

Gather the Data

Once you have completed your taxes, gather all your investment and bank statements. Put together a net worth statement. In other words, figure out what you own and what you owe. Then divide your investments into two categories, taxable accounts (i.e. brokerage accounts) and tax deferred [i.e. Individual Retirement Accounts (IRAs), 401(k) and 403(b) plans and annuities]. Within the taxable accounts, list what you own that may have special tax treatment such as tax free bonds or holdings that may be subject to a lower capital gains tax rate when they are sold.

Within the tax deferred category, look at your statements to see if you have any after tax money that you have contributed. In a company retirement plan, when you retire, chances are you will roll over the assets to an IRA. The after tax contributions (not the growth) can be taken out and not rolled over. If you have different types of IRAs, make a list of what they are. For example, you may have deductible IRA contributions, non-deductible contributions and Roth IRAs. With Roth IRAs, in retirement, you can withdraw these dollars tax free. It gets tricky with non-deductible IRAs. When you withdraw from these accounts, the contributions are tax free, but the growth is taxable. It would be easy if you could take the contributions out first, but the laws don’t allow this. For every dollar you withdraw, some will be considered “basis” and some growth. The basis portion will be free while the growth will be taxable. What confuses this even more is that if you have various IRAs including a rollover from a company plan, you need to look at all accounts when you calculate the tax free percentage. Your non-deductible contributions should have been tracked on IRS Form 8606. If you never filed this form and made non-deductible contributions, the IRS will assume all the money in the IRA is tax deferred and therefore taxable upon distribution. You should speak with your adviser or tax preparer immediately to correct this.
 
Now that you collected and organized your information, make a list of your retirement goals in measurable terms. When will you retire, how much will you need, where do you want to live, etc. Will you sell your house? Even if you are many years from retirement, start the thought process now. Each year you can revisit your goals and make adjustments as needed.

How Do Taxes Fit In?

More often than not, retirees have more income than they thought they would, especially when turning 70 ½. That’s the magic age that Required Minimum Distributions (RMD’S) must start. Planning for taxes many years down the road is difficult, but must be considered. A slight change in tax rates can have a large impact on your finances, especially when compounded over many retirement years. What is often recommended is to plan based on current tax laws. Chances are your tax deferred monies will still be taxable under any tax law changes. Will rates be higher or lower? Will capital gains and qualified dividends still have preferential treatment? The answer is probably yes to all of this.

Over the next 20 or more years, we will most likely have many tax changes that will raise tax rates in some years and lower tax rates in others. So what to do? When planning, build in a higher tax rate to some of your assumptions. See how that impacts your planning. When deciding where to live, even if the plan is to live in a state with no income tax, consider building some state tax into your projections. States that currently have no income tax may impose a tax rate in coming years.

You want your retirement years to be a stress free as possible, and we all know how stressful tax time can be. So invest a little time now to help plan for the future. If all of this is overwhelming, reach out to a CERTIFIED FINANCIAL PLANNER™ professional who can help steer you in the right direction.

FPA member Scott M. Kahan, CFP^®, is president and founder of Financial Asset Management Corp. a fee only Wealth Management firm in New York City.