Business & Real Estate

Examining the impact of taxation in retirement

There is a notion that taxes will be minimal in retirement. That may not be the case, especially in high-cost-of-living states like California.

A variety of taxes can affect retirees – federal and state income taxes, Social Security taxes and estate taxes, to name a few. Remember that tax deferral of qualified assets – 401(k), IRA and 403(b) – is not forever. With required minimum distribution of your qualified assets when you reach age 70 1/2, your tax rate could significantly increase.

A simple way to visualize the impact of taxation is to categorize your assets into four buckets, in obviously descending order of desirability for many:

• Free money. Examples include inheritances, winning the lottery and corporate 401(k) matching funds. Obviously, some of these may have tax consequences, but the treatment of each may be different.

• Tax-free money. Such a thing does exist, so it is worth your time to learn more about tax-free money and how it works. Examples include municipal bonds, Roth IRAs and fixed indexed universal life insurance policies.

• Tax-deferred money. This means you don’t have to pay taxes now, but you will have to later when you start drawing income from these assets. The logic is that during your peak earning years, your tax rate is usually higher. When you retire, it should be lower; hence, drawing income from this bucket of assets in retirement should hopefully keep you in a lower income-tax bracket. Depending on your retirement income and where you live, that may not always be the case. Examples of such assets include your IRA, 401(k), 403(b), 457(b), qualified and nonqualified annuities, unrealized gains of equities and mutual funds.

• Taxable money. This is obviously the least preferred asset bucket from a tax strategy perspective, as such assets may be taxed at regular income levels. Examples of this asset class include interest on certificates of deposit, dividends and capital gains from stocks and mutual funds, and interest and capital gains from bonds.

Retirement tax strategies

To help minimize taxes in the future, consider the fact that the more wealth you acquire, the more advantageous it could be to move assets from the taxable buckets to more income-tax and estate-tax advantaged arenas. If all of your retirement assets are in qualified funds, you may have a significant tax liability on distributions when you retire.

Tax diversification is the strategy of spreading your assets across a mix of taxable, tax-deferred and tax-free accounts. Some strategies used for tax diversification include:

• Roth IRA conversion. You can reposition traditional IRA and qualified plan assets from tax-deferred to tax-free buckets by converting them to a Roth IRA. Conversions are considered distributions for tax purposes, so you will have to pay income taxes on the amount converted in the year of conversion.

• Reliable income with tax advantages. You can move taxable assets to tax-deferred assets using a taxable investment, like a CD, to purchase a nonqualified annuity for a tax-deferred growth opportunity and partially taxable distributions. This is another way to deploy a tax diversification strategy to help avoid having all of your income be taxable during the run-up to retirement.

An annuity is a contract between you and an insurance company under which you make a lump-sum or a series of deposits into the contract and, in return, the insurer agrees to pay interest on the deposits and make periodic payments to you immediately or at some point in the future. Annuities offer tax-deferred growth potential, a death benefit during the accumulation phase and, when you’re ready, income payout options backed by the financial strength and claims-paying ability of the issuing insurance company. Most annuities have provisions that allow you to withdraw a percentage of the value of the contract each year, up to a certain limit, without any contractual penalty.

It is important to have an updated trust/will to avoid the time-consuming and expensive probate process. The top estate tax rate is 40 percent on assets over $5.49 million, an amount adjusted annually for inflation. Currently, you may make a gift of up to $14,000 to an individual family member each year without triggering gift-tax consequences.

Arvind Ven is a Los Altos resident and financial adviser with Liberty Group LLC, guiding clients through multigenerational financial and retirement planning strategies. For more information, call (510) 658-1880 or email This email address is being protected from spambots. You need JavaScript enabled to view it..

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