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Tax Tips for Retirement Investments

Be sure you know whether your money is in tax-deferred or taxable accounts

As the April 17 federal income tax filing deadline draws closer, I’m sure you’re putting the final touches on your tax return. While it will be nice to have that annual nightmare out of the way, don’t finish the job without giving some thought to how to minimize your tax bills through retirement planning.

See also: Taking the Retirement Road Less Traveled

I asked a nationally known expert, Jordan Amin, to narrow down the two or three most important tax issues to think about concerning your retirement investments. Amin chairs the Financial Literacy Commission with the American Institute of CPAs.

In today’s economy, most of us are working with no end in sight. If your employer offers a tax-deferred savings plan like a 401(k) or 403(b) and offers to match any part of your contributions to it, there’s just no excuse for not contributing to it.

“That’s free money, why would you ever say no to that?” Amin asks.
You shouldn’t. You wouldn’t. You won’t — right?

Amin reminds us that people who are 50 or over are allowed to contribute extra money to their 401(k) and 403(b) plans to make up for all those years when they were busy paying for their kids’ college degrees. In 2012, that “catch-up contribution” limit is $5,500. And subject to certain income limits, some people can qualify for up to $1,000 in federal tax credits for contributing to their retirement accounts. This little-known gift is called the saver’s credit. A married couple filing jointly would qualify for this credit in 2012 if their income is less than $57,500 ($43,125 for heads of household and $28,750 for singles or married individuals filing separately).

Amin’s next lesson applies to people who are still working and saving, as well as to those who are ready to tap their retirement funds. Just as there are dozens of types of retirement savings vehicles, there are almost as many tax treatments for each of those types of savings.

If you put all of your retirement money into your employer’s plan — sheltering that income and the earnings on it from taxes until you withdraw it — you may actually end up paying more in taxes and management fees than you would if you spread that money around a little more.

Let’s say you make $80,000 a year, putting you in the 25 percent tax bracket. When you withdraw money from a tax-deferred account, like your 401(k), it’s treated as ordinary income, so you’ll pay 25 percent tax on it. But if you’ve put money into a taxable account at a brokerage firm and your investments have risen in value, you’ll only pay the management fee plus the 15 percent capital-gains tax as you sell assets in that account (provided you’ve held them for at least a year).

And if you sell assets in your taxable account at a loss, you can use those losses as deductions from your ordinary income.

Once you’re ready to retire and start drawing from your accounts, you need to start thinking about the different assets you have and which is the most tax-efficient to use and when, Amin says.

If you focus on living on money from your taxable brokerage accounts, the money in your 401(k), 403(b) or IRA will still be growing tax-free. Once you hit age 70½, you won’t have any choice — you’ll be required to start drawing down those accounts and paying taxes on the withdrawals.

The amount of this required minimum distribution, or RMD, depends on how much money you had in your account at the end of the previous year, and the IRS’ projection of your likely lifespan.

If you can get by on the income from your taxable brokerage account until you’re 70½ — and delay claiming Social Security until you’re 70 to maximize your monthly check — you’ll stand a much, much better chance of having enough money to last the rest of your life.

Social Security is another beast in itself. If you’re interested in learning more about Social Security and taxes, check out our webinar series.

That brings us to Amin’s final lesson, which is directed at people who are older and well-off and may have the luxury of leaving money to heirs. Rather than focusing on estate tax law, Amin says, “think about whether you may want to pay taxes now to convert a traditional IRA (in which you invested pretax dollars) into a Roth IRA instead.” Roth IRAs have no required minimum distributions, and neither you nor your heirs will pay taxes when money comes out of a Roth.

Now, get back to work on that tax return.

Jean C. Setzfand is vice president of financial security at AARP.

You may also like: Test your money instincts.

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