Tax preparation and why it’s important for retirement

Taxes are much like rust; once they are allowed to erode, they just keep on eroding. As a saver or investor, both fees and taxes can erode the potential future balance of a savings or retirement account. For this reason, strategies should always include tax considerations, especially for those in higher marginal tax brackets.

During a person's working years, if they used a defined contribution plan like a 401k, they realized a tax decrease as their contributions were not currently taxed. The effect this has was generally to reduce a workers taxes.

With the exception of Roth accounts, a retiree must start tapping those retirement savings, and when they do, they will pay taxes at their current tax rate. Their marginal tax rate will be higher in most cases than if they were simply paying long-term capital gains on investments.

One thing that holders of a 401k plan should avoid is rolling their money over, but having the check made out to themselves. It is far better to have the funds move directly between two custodians. If the check is made out to the account holder directly, the issuer will be required to withhold 20 percent of the amount for taxes. If the entire amount withdrawn isn't redeposited into an IRA within 60 days, then the account holder could be subject to taxes and a potential 10 percent tax penalty as well. The 20 percent amount would also have to be deposited or the entire amount could be viewed as a distribution.

Allowing a rollover to happen directly between two custodians can avoid a very unpleasant tax surprise.

 

The Money has to be for Retirement

Retirement plans do not let participants hold onto those funds perpetually until they can be handed off to heirs through the disbursement of an estate. When retirement plans, like 401k's and traditional IRA's, were first passed into law, there were requirements that the account holder would begin to take funds by age 70 1/2. That is the age when mandatory distributions must begin. A person can defer that first distribution until April first of the year after they turn 70 1/2, but then they have to take two distributions in that year.

Failure to take the amount that the IRS expects you to take can result in a stiff 50 percent penalty of the amount that should have been withdrawn. Conversely, you can take out more than the minimum requirement, keeping in mind that taxes will be due if you are withdrawing from a traditional 401k or IRA. The custodian will withhold taxes at your request.

Holding company stock in your retirement plan can offer a tax strategy that is a twist on other holdings. If that stock has gone up in value substantially, you can take a lump-sum distribution of that stock and move it to a taxable account. The remainder of the account would have to be rolled to an IRA to remain tax-deferred. The benefit for the stock portion is that you pay ordinary income tax on the basis (your original cost for the stock) and the remaining unrealized appreciation or gain (NUA), will only be taxed when sold. When it is sold, that appreciated portion will only be taxed at the long-term capital gains rate. Contrast this with rolling over the entire amount and then paying ordinary income on all withdrawals later on.

Up to now, we have discussed traditional retirement plans. Roth 401ks and IRA's work differently. The IRS views contributions to Roth's on a FIFO (first-in, first-out) basis. This means that your contributions are withdrawn first. The rule with Roth's is that you need to be 59 1/2, and have participated in the Roth for at least five years, to take distributions tax free; but that applies to your earnings, not contributions.

The withdrawal of conversions from traditional IRAs work somewhat different and this is a good topic for a conversation with your financial professional. A little tax planning can go a long way to hold onto more of your money.