Tax Planning as You Age
While tax planning should be a consideration through all phases of life, the nature of that planning changes as you approach retirement age. During your working years, your primary tax-planning objectives are to reduce your current income taxes while saving for retirement. After decades of accumulating money, you now need to ensure you withdraw and manage that money properly. Here are five tips you should consider:
Rolling out of a 401(k): If you don't want to leave your funds in your 401(k) plan, you should consider transferring your money to an individual retirement account (IRA). You can now transfer directly to a Roth IRA, provided your adjusted gross income does not exceed $100,000 in 2008 or 2009. Starting in 2010, there is no income requirement. While there are no income tax ramifications if you roll over from a 401(k) plan to a traditional IRA, you do have to pay taxes on the amounts that would be taxable when withdrawn when converting to a Roth IRA (i.e., contributions and earnings in deductible IRAs and earnings in nondeductible IRAs). However, if you pay the income taxes from funds outside the IRA, you have essentially increased the value of your IRA, since you won't have to pay income taxes on qualified withdrawals.
If you own stock in the company you work for in your 401(k) plan, consider those assets separately. There is a provision in the tax code that may save you a substantial amount of taxes. Instead of rolling over the company stock, have the shares distributed to you and put them in a taxable account. You will owe ordinary income taxes on the cost basis of those shares, which equals the price that was paid when the stock was purchased. (If you take the distribution prior to age 59 1/2, you may also owe the 10% federal penalty on the cost basis.) At this point, you do not pay taxes on any appreciation in the stock's value. When you sell the stock, provided you have held it for over one year, you will owe capital gains taxes at a maximum rate of 15% on the net unrealized appreciation, rather than ordinary income taxes that would be paid on other traditional IRA distributions. If you have substantial appreciation in your company stock and are in a high marginal tax bracket, this strategy can save you a substantial amount of taxes.
Handling an inherited IRA: IRAs are becoming an increasingly significant asset for many people due to 401(k) rollovers and asset growth. Thus, it is becoming more likely that you will inherit an IRA. Don't immediately cash out an inherited IRA, which requires the payment of income taxes on the distribution. If you inherit a traditional IRA from a spouse, you can delay distributions to age 70 1/2 and then take distributions over your life expectancy. No distributions are required during your life if it is a Roth IRA. If you inherit the IRA from someone other than your spouse, you must start taking distributions in the year following the owner's death, but you can take those distributions over your life expectancy. Make sure to investigate whether you are entitled to an income in respect of decedent deduction, which is available when federal estate taxes are paid on IRA assets. This deduction can help offset income taxes due on distributions.
Dealing with a second home: If you plan on moving after retirement, you might want to acquire a home in that location before retirement. But first, be aware of the 1031 exchange rules. These rules allow you to sell one property and purchase another of like kind, deferring any gains. For instance, this tax rule can be used to help acquire a retirement home. Start out purchasing a small investment property. You can sell it at a later date and purchase a more expensive property, deferring the gains. You can continue this process until you eventually purchase your retirement home. However, before living in the home, you must first rent it out to defer the gain. While there are no clear-cut rules on how long the home must be rented, the Internal Revenue Service has validated a two-year period. After that, you can move into your retirement home and use it as your principal residence. Currently, as long as you live in the home for two of the last five years before selling, you could then sell the home and exclude up to $250,000 of gain if you are single and up to $500,000 of gain if you are married filing jointly. However, the Housing Assistance Tax Act of 2008 will affect sales and exchanges after December 31, 2008. The home sales exclusion won't apply to the extent gain from the sale or exchange of a principal residence is allocated to periods of nonqualified use. Generally, nonqualified use is any period (other than the portion of any period before January 1, 2009) during which the property is not used as the principal residence of the taxpayer. The amount of gain allocated to periods of nonqualified use would reduce proportionately the home sale exclusion amount.
When purchasing the second home, be sure to get a mortgage on that property rather than a home-equity loan against your principal residence. Interest is only deductible on $100,000 of a home-equity loan, while the entire mortgage interest up to a $1,000,000 loan would be deductible.
Selling a business: Many business owners find that their business comprises a substantial portion of their net worth. Thus, when it comes time to sell that business, they naturally want to negotiate as large a selling price as possible. But keep in mind that there are many ways to structure a sale. You might want to consider an installment sale, so the gain is recognized over a period of years rather than a single year. You may want to consider including a consulting contract for a period of years. If you are selling the business to employees, an employee stock ownership plan may make sense.
Reviewing your estate plan: As you approach retirement, it's a good time to review your entire estate plan. While the estate tax exemption has increased (from $2,000,000 in 2008 to $3,500,000 in 2009) and the estate tax will be repealed in 2010, this amount will drop back to $1,000,000 in 2011 unless further legislation in enacted. Thus, individuals with estates over $1,000,000 still need to consider ways to use their exclusion amounts to minimize estate taxes. Those with large estates probably don't want to leave their entire estate to their spouse. While that will avoid estate taxes on the first spouse's death, estate taxes may be owed after the second spouse's death if the estate is larger than the estate tax exemption.
While increasing estate tax exemption amounts can make it more difficult to plan, you should still consider leaving part of your estate to other heirs. If you don't want to make outright distributions in case your spouse needs the assets, you can set up a trust (commonly referred to as a credit shelter or bypass trust) to hold those assets. Your spouse can then use the income and even some of the principal, with the remaining assets distributed to your heirs after his/her death. This preserves the use of your exclusion amount. You may also want to add a disclaimer provision to your estate planning documents, detailing what happens if one of your heirs disclaims his/her inheritance. With the estate tax exemption amount fluctuating over the next several years, this provides a way for heirs to decide after your death how much should be placed in various trusts.