AARP PRODUCTS & SERVICES
HEALTH
FINANCIAL
TRAVEL
DISCOUNTS
INSURANCE
|
AARP.ORG HOME |
 Join AARP
|
When you retire, the alarm clock may not ring quite so early, and you can dress any way you like. But some things don't change—and one of those is taxes. You don't need to be an accountant, but there are some basic concepts to master about taxes and retirement.
If you have money invested outside your tax-deferred accounts, it's a good idea to use that money first and leave your tax-deferred accounts untouched until you have depleted your taxable resources. The longer your tax-deferred accounts have time to grow, the better. Stocks, bonds, mutual funds Certificates of Deposit and savings bonds that have fully matured are all candidates for income during your early years of retirement.
Another reason to postpone withdrawals from your tax-deferred accounts is that currently withdrawals will be taxed at your federal income tax rate—and not at the lower long-term capital gains rate of 15%, which would apply to any stocks or stock mutual funds you sell from your taxable account. Currently dividends you receive from securities held in a taxable account are also taxed at 15%. However, keep in mind that you must begin required minimum withdrawals from most of your qualified retirement accounts by age 70 1/2. You can generally postpone withdrawals from a 401(k) or similar workplace plan as long as you are still working (and if you do not own more than 5% of the company). However, there's no such reprieve for Traditional IRAs. And no required minimum withdrawals from Roth IRAs.
Of course, there are some exceptions to this advice. If you're in poor health, it may make more sense to tap your tax-deferred investments first and leave your taxable investments for your beneficiaries, who will receive a step up in "basis" if they inherit the assets in your taxable account. Stocks, bonds and other types of appreciable securities are accorded their market value at your death. Your heirs would owe no tax until the securities are sold, and then only on the appreciation after they inherited the assets. Of course, if your estate exceeds $3 million, these assets may be subject to federal estate tax under current estate tax law. Estate tax is a moving target so be sure to speak with a qualified tax adviser to stay current on estate tax liability.
Here's another reason to tap your tax-deferred assets first: If you expect your tax-deferred assets to provide adequate income for your retirement and leaving an estate for your heirs is a priority, you may want to preserve your taxable assets to pass on to your heirs because your tax-deferred assets will pass on with a built-in tax liability. Your beneficiary will pay income tax on withdrawals from inherited tax-deferred assets at his or her federal income tax rate—and withdrawals will be required, based on the beneficiary's life expectancy.
Generally speaking, you'll pay income tax at your current federal rate on any withdrawals from your tax-deferred accounts. Before age 59 ½, you could also be liable for a 10% penalty, and after 70 ½, a 50% penalty is assessed if you don't take required minimum withdrawals following an IRS-prescribed formula.
Distributions from IRAs and tax-deferred annuities are taxed according to the tax status of the original account. If you couldn't deduct your IRA contributions, only that portion of your IRA that can be attributed to earnings is taxable—there's a formula to figure the taxable amount out. And a portion of an annuity payment is considered a return of principal and is not taxed unless the annuity was purchased with pre-tax dollars, for example, with a rollover from a 401(k).
It's important to remember that any money that remains in a tax-deferred account continues to enjoy tax-deferred status until it is withdrawn. As a result, it's a good idea to withdraw no more than you need from these accounts—and not until you need it.
After age 59 ½ (and when your account is at least five years old), withdrawals from a Roth IRA are tax free. There are no required distributions in your lifetime. If you pass your Roth IRA on to a beneficiary, withdrawals remain tax free, but minimum withdrawals are required, based on the beneficiary's life expectancy.
It is possible to convert a Traditional IRA to a Roth IRA, pay the income tax on the conversion and enjoy tax-free growth going forward. However, this transaction rarely makes sense unless you have adequate funds outside your tax-deferred account to pay the income tax.
The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, or legal, tax or investment advice, or a legal opinion. Individuals should contact their own professional tax or investment advisors or other professionals to help answer questions about specific situations or needs prior to taking any action plan based on this information.
The Financial Advisors are investment adviser representatives of AARP Financial Inc., an investment adviser.