How to Save on Retirement Taxes

Having a retirement account is an absolute must for today’s Americans. However, if these accounts are not used wisely, they can lead to having to pay lots of tax penalties, as well as other costs and fees.  

Therefore, the first thing you should do, when you open a retirement account, is to study the fine print. What are the penalties for drawing money out early or late? When you know the regulations surrounding your retirement account, you can make informed decisions about how to use it. If you do that and follow a few other tips, you can probably save quite a bit in retirement taxes.

Contribute to a 401(k)

Looking for a way to put off paying income tax? If so, then consider contributing to a 401(k). You can contribute as much as $18,000 to your plan without having to pay a dime of income tax on it until you withdraw it. That’s a pretty sweet deal, right? Definitely take advantage of this perk.

Withdrawal from a Roth

If you know you’re going to have to make a withdrawal, do it from your Roth IRA. Yes, the money in the account is taxed, but withdrawing doesn’t cost retired individuals anything. Obviously, you want to leave your money where it is as much as possible, but if you absolutely have to make a withdrawal, do it the smart (free!) way.

Take Advantage of the Saver’s Credit

If your adjusted gross income is below $30,500 (for singles) or $61,000 (for married couples), then you can claim the “saver’s credit” for contributions made to your retirement accounts. This credit, which can equal up to $2,000 for individuals and $4,000 for couples, is in addition to any other tax deductions for retirement accounts, so it’s a truly great way to save big. The more you contribute to a 401(k) or Roth IRA throughout the year and the lower your income, the higher the credit you are likely to receive.

Keep Working

In all seriousness, you should retire when you’re ready. If you’re not ready just yet and are still working, then know that you can delay withdrawals from your 401(k) until the day you actually retire. This option only extends to those who are over 70 and who don’t own the companies they work for. If you meet those eligibility requirements, then you can start saving!

Obviously, there are lots of great ways to save on retirement taxes. If you follow these tips and stay informed about all of your accounts and how they work, you can enjoy great savings and, eventually, an even greater retirement!

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Your Money Questions Answered

Commonsense solutions to your financial concerns
By Lea Ann Knight, CFP

Few Americans are without money woes—whether it’s planning for retirement, deciding what to do with a windfall or debating a switch to an online bank. Here, certified financial planner Lea Ann Knight, author of the weekly blog Financially Fit After 40 and owner of Garrison/Knight Financial Planning in Bedford, Mass., takes a stab at some frequently asked financial questions. 

Make the Most of Extra Cash

Q. I received a raise a few months ago and have been using the extra cash to pay down my new mortgage. Should I be doing something else with the money instead? 

A. Because mortgage rates have been at historic lows recently, consider putting those extra dollars to work somewhere else. The average return in the stock market has been around 8%, so one good alternative is to invest what’s left over from your paycheck each month in a basic stock-index mutual fund at a low-cost brokerage house. Or you could add the money to your retirement savings. But if you feel like you’re on track financially and you have surplus cash, then paying down debt with a low interest rate can be a smart move.

Maximize Your Retirement Savings

Q. My company is now offering a Roth 401(k) in addition to the traditional 401(k) plan. What would be the financial benefits of switching my 401(k) contributions to the Roth version?

A. The advantage of contributing to a Roth 401(k) is that, although you can’t take an annual tax deduction now, you will be able to withdraw your money tax-free in retirement. If you think you might be in a higher tax bracket when you’re older, a Roth 401(k) is a good idea. But if you like having that pretax deduction each year, you might prefer to keep your money where it is. Alternatively, as long as you are single and earn less than $110,000 yearly (or your combined annual income if married is less than $173,000), you may continue your traditional 401(k) plan at work and contribute up to $5,000 per year to a Roth IRA as well. Having both types of accounts in retirement will give you more flexibility with withdrawals and help you minimize taxes in your golden years.

Decide if an Elderly Parent Still Needs Life Insurance

Q. My dad has retired but is still paying premiums for a large life insurance policy. His house is paid for, and all his children are independent. Does he still need this insurance?

Insurance (Photo credit: Christopher S. Penn)

A. Assuming there will be no financial obligations for his estate to meet in the event of his death, your father might no longer need to keep paying for the insurance policy. If that’s the case and his is a term life insurance policy—which provides coverage for a set amount of time—with no cash value, he can simply stop paying the premiums to end his coverage. If, on the other hand, it is permanent life insurance, the policy might have a cash surrender value, meaning he could cash it in (and pay income tax on the proceeds) or use the cash value to start paying for his premiums. The latter option is appealing if he wants to keep enough value in the policy to help pay for his burial expenses or wishes to leave the death benefit to his heirs. Before he acts, however, he should review his choices with a financial planner to determine which option makes the most sense for him.

Consider Additional Disability Coverage

Q. My company benefits plan includes some disability coverage, but not at my full salary. Should I supplement with private disability insurance?

A. Many employers offer long-term disability plans that cover 60% to 70% of your salary if you become unable to work. Private policies can be pricey, so decide how much of your paycheck you need to meet your monthly expenses in such an event. If it’s within the employer-covered amount, you likely don’t need a private disability plan, but if you’re the sole breadwinner with young kids and a big mortgage, it might be a good bet. Also consider how close you are to age 65, when many such policies terminate anyway.

Weigh the Pros and Cons of Online Banking

Q. I’ve heard that online banks offer great interest rates, but I’m not sure if they’re safe. Are there any other drawbacks?

A. Before you switch, confirm that your account will be FDIC-insured, meaning your money will have the same protection as it would at a brick-and-mortar institution should the bank fail. And recognize that although many online banks can offer a higher interest rate because they don’t have the same overhead as traditional banks, it will take longer to get your hands on your money in an emergency and—if you must make deposits by mail—for checks to post to your account. Also think about how often you need services such as certified checks—which might not be as easy to obtain online. Consider two accounts: your local bank for day-to-day needs and an online one for savings. That way you’ll still have easy access to some of your money but will earn higher interest on what you don’t need today.

Adapted from the Aug. 24, 2012 issue of All You. © 2012 Time Inc. All rights reserved.

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Inherited IRA's come with Critical Choices

Many people who inherit a tax-deferred IRA are confronted with a complex array of rules, restrictions, and deadlines that may make it difficult for them to determine how to proceed. Unfortunately, beneficiaries must often make binding decisions about inherited retirement assets before they may be prepared to do so.

Of course, beneficiaries can liquidate inherited IRA assets as they wish, but they should keep in mind that amounts withdrawn from a traditional IRA are taxed as ordinary income. A better long-term strategy might be to take only the withdrawals required by the IRS, leaving the rest of the inherited assets untouched to keep accumulating on a tax-deferred basis for as long as possible. This strategy may also help spread the tax liability over a longer period of time.

Understanding RMDs

Traditional IRAs are subject to required minimum distributions (RMDs). For original owners, RMDs must begin no later than April 1 of the year after the year in which the investor reaches age 70½. In subsequent years, RMDs must be taken by December 31. Annual RMD amounts are calculated based on the account value (on December 31 of the previous year) and the owner’s life expectancy. This information can be found in the IRS Uniform Lifetime Table.

IRA owners (as well as people who inherit a traditional IRA) who fail to take an RMD could be hit with a 50 percent tax penalty on the amount that should have been withdrawn. IRA beneficiaries are subject to special distribution rules. Spouses typically have more choices than nonspouses.

Three Options for Spouses

1. Roll assets to a new IRA. If the surviving spouse is the sole designated beneficiary, the funds can be rolled into a new account in his or her name. In this situation, the surviving spouse does not have to take RMDs until age 70½, and he or she can name new account beneficiaries. However, a 10% early-withdrawal penalty would apply to distributions prior to age 59½.

2. Transfer assets to an “inherited” or “beneficiary” IRA. If the deceased spouse died before age 70½, the survivor’s first RMD must be taken by December 31 of the year after the decedent’s death, or by December 31 of the year the deceased would have turned 70½ (whichever is later). If the deceased spouse died after age 70½, the surviving spouse must begin taking RMDs before December 31 of the year after death.

3. Pass assets to children or grandchildren. The surviving spouse (as sole beneficiary) can disclaim the IRA and allow it to pass directly to the account’s contingent beneficiaries.

Other Heirs

Generally, nonspouse beneficiaries must begin taking RMDs by December 31 of the year following the year of the original account owner’s death. However, if the original owner passed away after reaching age 70½ and did not take a current-year RMD, the beneficiary must take a distribution by December 31 of the year of death. It’s important for the IRA to be properly titled with the words “beneficiary” or “inherited.” There is no 10% early-distribution penalty for IRA beneficiaries.

RMD rules are even more complex when multiple beneficiaries are designated, and each choice could have far-reaching implications. You may want to seek legal or tax counsel before making any final decisions.

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek Naperville tax, legal advice or Naperville investment advisor from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright © 2012 Emerald Connect, Inc.

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