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Here’s a disturbing thought—boomers might be the first generation to face a higher tax burden in retirement than they did while they were working. That’s because the bulk of their retirement savings is in tax-deferred accounts like 401(k) plans and Individual Retirement Accounts (IRAs), so money they withdraw for everyday expenses in retirement will be subject to income taxes.
Furthermore, swollen federal deficits make it likely that income tax rates will rise when the tax cuts enacted by President George W. Bush expire after 2010.
So, what’s a pre-retiree to do? Don’t put all of your eggs in that tax-deferral basket, counsel a growing number of advisers. Firms like Financial Consulate Inc. in Hunt Valley, Md., are encouraging their clients to put some money in after-tax or tax-free investments, so they have some tax-planning flexibility in how they manage withdrawals in retirement.
“We would like to see them build a diversification of income streams, so that down the road, they’ve got more than one place from which to draw.” says Tim Maurer, the firm’s vice president and author of the book The Financial Crossroads.
“Most baby boomers have most of their wealth locked up in the 401(k), and they will be on a fixed pathway for any money they want to spend. If they want to buy a car or go on a vacation, they will have to take money out of their 401(k).”
Those who will feel the most pain are likely to be retirees whose retirement earnings puts them on the cusp of having much of their Social Security benefits taxed, says Drew Tignanelli, president of Financial Consulate.
The Social Security benefit tax works like this: If your income (including municipal bond interest and half of your Social Security benefits) tops $25,000 ($32,000 for couples), you’ll have to pay income tax on up to 50 percent of your benefits. Once your income tops $34,000 ($44,000 for couples), up to 85 percent of benefits are taxed.
For example, a retiree earning $35,000 from a mix of Social Security and IRA withdrawals would have to pay $2,681 in extra federal taxes for withdrawing an additional $10,000 from her IRA, “and that doesn’t even include state taxes,” says Tignanelli, who splits his own savings between tax-deferred and tax-free (Roth IRA) accounts.
Options for your savings
Folks who want to give themselves options in retirement can invest their money in several different “pots,” each of which will have a different tax treatment.
• In addition to tax-deferred vehicles, you can set aside money in a Roth 401(k) or Roth IRA. While those contributions are made with after-tax money (so there’s no tax deduction for the initial contribution), all of the earnings in those accounts come out tax-free in retirement.
In 2010, individuals earning less than $105,000 ($167,000 for couples filing jointly) can contribute $5,000 each (with an extra $1,000 if you’re 50 or older) to a Roth IRA. Contribution limits phase out when income levels of $120,000 ($176,000 for joint filers) are reached. And anyone, regardless of their income, can convert an existing tax-deferred IRA into a Roth. He or she will owe income taxes on the tax-deferred portion of the money that was rolled over.
• Health care savings accounts, often paired with high-deductible health insurance plans, allow tax-free withdrawals in retirement if they are used for medical costs.
• Don’t overlook taxable investments in individual stocks, bonds or mutual funds that are not tucked into tax-favored retirement plans, says Maurer. In 2008 and 2009, many people who had these investments were able to sell them for tax losses that they could use to offset gains and other taxable income.
• Retirees who are already facing big tax bills may decide to put some of their money into tax-free municipal bonds. While that interest is counted in the calculation for determining how much of Social Security benefits are taxed, it isn’t taxed directly.
A vote for diversification
Finally, savers who can’t decide how much to put away in each “pot” should spend some time trying to estimate how much they’ll be spending and whether their tax bracket will be higher or lower in retirement.
Despite big-picture predictions that tax rates will go up, most people downsize their lifestyle and income to the point where their tax rates actually are lower than during their working years, says Gordon Bernhardt of Bernhardt Wealth Management in McLean, Va. “And we’re talking about rates rising in 2011, but do we know what they are going to look like in 2030?”
His point? Anything can happen. And that might be the best argument yet for tax diversification.
Linda Stern writes on retirement and taxes.