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NEW YORK (Reuters) - During your working years, it is usual to focus more on gaining an immediate deduction for retirement account contributions than on how future withdrawals will be taxed. Financial advisers say that as a result, affluent people often retire with a portfolio of huge tax-deferred IRAs and 401(k) accounts -- and belatedly realize they must tap the accounts for substantially more than living expenses to cover annual taxes on their withdrawals.
But there is a "sweet spot" -- between the ages of 59½ and 70½ -- when withdrawals from tax-deferred accounts are penalty-free, but not yet required. Advisers say those 11 years are the ideal time to protect yourself by moving some money into taxable and tax-free accounts instead of continuing to plow it into tax-deferred accounts.
"Most of the time, people are in the same tax bracket in retirement as when they were working, because of money coming out of IRAs and 401(k)s," says Ronald W. Roge, chairman and chief executive of R. W. Roge & Co., a Bohemia NY financial planning firm. "I tell clients, 'If you have a $1 million IRA, after federal, state and local taxes, you own about $600,000.'"
Most advisers say tax rates are likely to rise in the future. "In a down market, those big taxable distributions can kill you," says Eleanor Blayney, a Mclean, Virginia adviser.
With a tax-diversified portfolio, you can plan cost-effective withdrawals, says Barry C. Picker, a Brooklyn New York tax accountant and IRA expert. He lays out an example of how helpful it is to have more than one type of account to draw on:
You retire at 65 with a $1 million IRA and a $500,000 taxable account. Assuming 3 percent annual growth, the accounts will throw off $45,000 of income a year - $30,000 from the IRA and $15,000 from the taxable account. But what if you withdraw the entire $45,000 from the taxable account? You've taken $30,000 of principal, so you're only taxed on $15,000 of income.
Now you're in a lower bracket, so your Social Security may be only partially taxable. And it may now cost less to transfer money from your IRA into a Roth IRA. That makes your IRA smaller, which may reduce your future required annual distributions.
How can you achieve that kind of flexibility?
1. Don't assume you should wait until you are 70 years old to withdraw money from your tax-deferred accounts. "After you turn 59½, you need to make an active decision about this every year," says Joel Isaacson, president of Joel Isaacson & Co., a New York City financial planning firm. High-earners' taxable income often falls dramatically in the first years of retirement, he says - and it's often offset by deductions for state and local taxes paid the previous year, mortgage interest and investment management fees. In some cases, new retirees can claim deductions for the cost of starting a small business or consulting practice.
The upshot: In early retirement, you may be able to move money out of your tax-deferred accounts at little or no cost. A retiree in the 'sweet spot' may pay a 3.6 percent combined federal and state tax on a $100,000 IRA withdrawal, says Isaacson.
2. Consider small annual Roth conversions after you turn 59½ while you're still working, especially if your income fluctuates from year to year. "You want to maximize the use of your tax brackets in any given year," says Robert Schmansky, founder and principal of Clear Financial Advisors in Bloomfield Hills, Michigan. Ask your adviser every year how much additional income you could take without being bumped into the next tax bracket.
3. Seize the opportunity of a down market to convert a hammered IRA into a Roth IRA. The tax bill will be smaller because you're converting a smaller amount.
4. Find out whether you're eligible for a state tax break on IRA withdrawals. Hawaii doesn't tax withdrawals from contributory retirement plans after age 59½, for example. Michigan and New York allow annual tax-free withdrawals of $34,920 and $20,000, respectively. "If you're a New York City resident, that could save you as much as 15 percent," says Isaacson. "Maybe that makes it worth taking out $20,000 a year if you can get it at a relatively low federal rate."
5. Contribute to a Roth 401(k) plan if you have access to one. Later, you'll transfer it to a Roth IRA. Meantime, your Roth 401(k) contributions still effectively boost your traditional 401(k) account; by law, any employer matching contribution must go into the tax-deferred account.
6. If you've maxed out 401(k) contributions, save in a taxable account. "People who want to save outside their employer's plan often want more tax deferral, so they buy variable annuities," says Blayney. "But this is an ideal time to set up a taxable account. If we see tax rates moving up, people will get socked in tax-deferred accounts."
(The author is a Reuters contributor. The opinions expressed
are her own.)
Editing by Beth Pinsker Gladstone and Andrea Evans