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Tax Planning as You Age

2130025216_110b12d5b9While 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 some tips:

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.  While there are no income tax ramifications if you rollover from a 401(k) plan to a traditional IRA, you do have to pay taxes on the amounts that would be taxable when withdrawn when converting to a Roth IRA (i.e., contributions and earnings in deductible IRAs and earnings in nondeductible IRAs).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 your employer’s company which is 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 ½, you may also owe the 10% federal income tax 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 at least one year, you will owe capital gains taxes at a maximum rate of 20% 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 FR2014-0513-0305 distributions until age 70 ½ 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 a 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 your 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.  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 $250,000 of gain if you are single and $500,000 of gain if you are married filing jointly.

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 deductable on $1,000,000 of a home-equity loan, while the entire interest on a mortgage up to $1,000,000 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 is large ($5,340,000 in 2014), estate-planning strategies should still be considered.  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 changing 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 out-right distributions in case your spouse needs the assets, you can set up a trust (commonly referred to as a credit shelter of 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.  This provides a way for heirs to decide after your death how much should be placed in various trusts.

These are only a few situations to consider as you approach retirement age.  Please call if you’d like to discuss your specific situation in more detail.

Photo Credit: Rachel Zack via Compfight cc

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