Keeping Your Nest Egg Away From The Taxman

Ed Slott offers advice on handling retirement savings

If you think your hard-earned retirement nest egg belongs to you and your kin, you'd better think again. Without smart tax planning, Uncle Sam can grab as much as 80% of the money in your individual retirement account (IRA) or other tax-advantaged savings plan. So says veteran tax accountant Ed Slott, 46, who publishes a monthly newsletter, Ed Slott's IRA Advisor ($79.95 yearly; 800 663-1340; Personal Finance Editor Susan Scherreik recently spoke by telephone to Slott, whose offices are in Rockville Centre, N.Y.

Q: Why do people fumble tax planning with retirement accounts?

A: People are so focused on investing that they fail to pay attention to the complicated tax rules that govern their IRAs, 401(k)s, and other tax-advantaged retirement savings plans. But it won't matter if you make 30% a year on your investments if you drop dead and most of your gains are eaten up by income and estate taxes. We're not talking about small change here. IRAs are many investors' largest asset, worth more than their homes.

Q: What's a common mistake?

A: When people quit a job or retire, too often they leave their retirement account with their former company rather than rolling it over into an IRA. Putting your retirement money in an IRA gives you a lot more investment options and can also reduce your heirs' potential tax liability.

Q: How so?

A: When you die, most company retirement plans make payouts to your heirs in a lump sum, or at most, spread them out over five years. That won't matter if your spouse is the beneficiary, since spouses can roll over the money into their own IRA. When children are the beneficiaries, they aren't allowed to roll over the inherited 401(k) into their own retirement accounts. However, if the money is in an IRA instead, the children can make withdrawals over their entire lives. That allows the inherited retirement account to grow tax-deferred for a longer period. Another plus is that withdrawals can be small. Otherwise, getting your 401(k) in a lump sum could bump your kids into a higher tax bracket, and they'll pay more in taxes.

Q: What other tax strategies do you recommend?

A: It's a good idea to buy life insurance to protect your IRA from estate taxes. When you die, the proceeds from the life insurance policy can be used to pay the estate taxes due on the IRA. That way, the money in your IRA can continue to grow tax-deferred for years, resulting in a bigger inheritance. You'll have to pay life insurance premiums, but that cost will be a lot less than having as much as 80% of the IRA paid out to cover estate and income taxes.

Q: Any advice for investors who lost money in their IRAs this past year?

A: This is an ideal time to convert a traditional IRA to a Roth IRA. But to qualify, your annual income must be $100,000 or less, married or single.

Q: How does it work?

A: Roth IRAs are great because you can withdraw investment gains tax-free in retirement. But you must fund the account with aftertax dollars. That's the opposite of the traditional IRA, which lets you contribute pretax dollars and then pay income tax on withdrawals in retirement. Let's say the value of your traditional IRA plummeted from $100,000 to $50,000 in 2000. Convert to a Roth IRA, and you'll pay income taxes on the $50,000. When the stock market rebounds, you'll owe zip in taxes on future gains. It's like a half-off sale.

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