Many of our clients have successfully accumulated large retirement account balances throughout their lifetimes. This was excellent planning on their part, as they deferred paying considerable income tax while they still had high taxable earned income.
But the IRS doesn't want you to defer paying income taxes forever. They force you to start taking "Required Minimum Distributions" (RMDs) starting at the age of 70 1/2. These distributions are taxed as regular income. The RMD at age 70 is about 4% of the IRA account balance and this percentage increases each year based upon an IRS life expectancy table.
After age 70, the larger the account balance, the larger the taxable distribution from your retirement accounts - possibly driving up your marginal tax bracket. That may mean a hefty amount of income taxes will be due.
Those clients that have successfully built up large retirement account balances should now focus on avoiding some tax planning mistakes that can be costly for them and their heirs.
Mistake #1 Wrong Investment Location
Your IRA should hold your least tax-efficient investment assets, like taxable bonds or stock or bond portfolios that might see a lot of short-term capital gains. Consider having your more tax-efficient investment assets, like stocks and real estate, in non-retirement accounts. The income and long-term capital gains from stocks and real estate may be taxed at lower capital gains tax rate and, therefore, should be held in non-retirement accounts.
Mistake #2 Small Distributions
If you have retired and are in a low tax bracket, it might be a tax planning mistake not to take some small distributions from retirement accounts. Consider taking distributions from your IRA, 401(k) or profit-sharing plan if you have a large retirement account balance and are between ages 59 1/2 and 70 1/2. Work with your tax advisor to estimate the amount that you can withdraw without moving into a higher tax bracket. At age 70 1/2, you will be forced to take large RMDs, possibly catapulting you into the highest tax bracket.
Mistake #3 IRA Income Taxes
Converting your traditional IRA to a Roth IRA without considering future income taxes: Roth IRA's offer plenty of advantages - but it is ill-advised to consider a taxable conversion unless you are certain you will be in a lower tax bracket in the year you convert, and a higher tax bracket in the years you or your children will take distributions from the Roth IRA.
Mistake #4 Planned Giving
Not coordinating your tax, charitable and distribution planning: Consider making large charitable donations in years you take large distributions from your retirement accounts. Taking the charitable deductions in high income and high tax years gives you greater tax efficiency.
Mistake # 5 Death Beneficiaries
Not gifting the correct asset to charity at your death: Are your children the ultimate beneficiary of your IRA and does your will or trust direct your estate to leave other assets to charity? The IRA will ultimately be taxed and is the least tax-efficient asset your heirs will inherit. Consider naming a charity as the beneficiary of a portion of your IRA (your estate will get a charitable deduction) and leave your children your non-retirement assets like stocks and bonds. This is a tax-efficient charitable planning strategy because traditional IRA's are fully-taxable to your heirs while stocks and bonds might not have any income tax ramifications (due to the step-up in basis at death rule).
Mistake #6 Asset Protection for Beneficiaries
Not considering the "asset protection" needs of your named beneficiaries: Inherited IRAs are not exempt from creditor claims in bankruptcy proceedings. In coordination with your estate planning attorney, consider how you might protect inherited retirement plan assets from claims of a beneficiary's creditors.
We see large retirement plan account balances as a good problem to have. Think of it as a planning opportunity to maximize your family's wealth. As you prepare for retirement, consider the consequences of deferring the income tax into later years. Consider your investment choices and tax, estate and charitable planning. This is a complicated decision tree and your professional advisors (tax, legal and financial) should coordinate and come up with the best strategy for you and your family. Please call the Raskin Planning Group so we can help you with this planning and coordination.
Peter Raskin is a registered representative of Lincoln Financial Advisors Corp. Securities and advisory services offered through Lincoln Financial Advisors Corp., a broker/ dealer and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Lincoln Financial Advisors Corp does not provide legal or tax advicen Raskin Planning Group does not provide legal or tax advice.