Don't Let the Rules Overtax Your Retirement

When planning for retirement, make sure you know how these rules could change your financial picture after age 70

Due to common pension plan requirements and Social Security rules, ages 55, 60, 62, and 65 often surface as benchmarks in retirement planning. But planning for your 70th year and beyond could also be crucial because of Social Security and tax rules that change when you reach age 70 and 70½.

Social Security presents the more straightforward issue: Although you can start receiving your benefit when you turn 62, the underlying formula will raise your benefit slightly each year—until you reach 70. Here's a very simple hypothetical example of the difference that waiting could make. You were born Jan. 1, 1960, and your current salary is $150,000. According to the calculator on the Social Security Web site, your benefit at age 62 would be $1,680 per month in current dollars. At your full retirement age of 67, the benefit would be $2,425 per month, and at 70, you would receive $2,992. Once you are 70, the amount would rise with annual cost-of-living adjustments, but there would be no other financial advantage to delaying.

When Can You Withdraw Money?

My previous column, "Timing Your Social Security Benefits" (, 12/6/07), lays out factors other than your age—such as your other potential income sources—to consider before choosing the date to start your benefit.

The second rule relates to withdrawing money from your retirement accounts. In general, you can remove money from a 401(k) or traditional IRA starting at age 59½, without incurring a 10% penalty. (See IRS Publication 590 for a list of exceptions and for details on all IRA rules.) After this age, you can start withdrawals any time you want, and for any amount you want or need.

What many people don't realize is that once they reach 70½, the decision to withdraw funds is no longer discretionary. A tax rule mandates you to take out a specified amount annually—known as a Required Minimum Distribution (RMD)—by Apr. 1 in the year after you turn 70½. This sum is based on a life expectancy formula for you and a spouse who's your beneficiary, and you must pay income tax on it. Failure to withdraw will get you a penalty of 50% of the amount you were supposed to have taken out. (There is no RMD for withdrawals from a Roth IRA, because your contributions to the account have already been taxed.)

Account-Rich But Cash-Poor

With the Social Security and RMD rules in play, the size of your income and the size of your tax bill could both vary quite a bit after you reach age 70, depending on the choices you make. Take this hypothetical example: Charlie retires at 70 and receives $2,900 a month in Social Security benefits. In his first year of taking RMDs he must withdraw $54,000 from the $1.5 million IRA into which he rolled his 401(k) after retiring. This combined income—without even considering income from other sources such as a pension, dividends, or real estate—will almost certainly result in having to pay federal income tax on either 50% or 85% of his Social Security benefit, in addition to the income tax on the RMD.

You should also be aware that if all or most of your income-generating assets are in the retirement account, no matter how lush the account is, you can find yourself cash-poor, says Mari Adams, a financial planner in Boca Raton, Fla. When you need a new car or have to pay for hurricane damage, you'll have to take money beyond the RMD out of the account and pay the extra taxes. And the IRS will not credit the amount of that extra withdrawal toward your next year's RMD.

Adrian Eddleman, an investment adviser in Jackson, Tenn., points out another pitfall. "If you live beyond the IRS's life expectancy for you, and your only investments were all tax deferred (with RMDs), you may find yourself living on 'Social Security only' in your latest twilight years." But he emphasizes that although the IRS makes you take the RMDs, you don't have to spend the money instantly. You can save it or invest it so it's still there for those years.

The financial hit from RMDs can hurt regardless of whether you're strapped for retirement income or not. If your retirement budget is tight, the taxes can eat into your disposable income. If you're well off, the taxes will reduce the size of the estate you can leave to your heirs. Denisa Tova, a financial planner in Colorado Springs, says, "I see too many people putting money away into tax-deferred vehicles, not realizing they will be taxed at their highest ordinary tax rates on all of this money."

Accumulate Assets Outside IRAs

The best way to minimize these taxes on your retirement savings is to anticipate the problem, and in the years before retirement, try to accumulate some assets outside of your 401(k) or traditional IRA. With the current relatively low capital-gains rates, one option to consider, along with contributions to your 401(k) or similar retirement account, is to put some of your savings into an investment account.

While you're still working, another solution is to put some savings into a Roth IRA, which will allow for tax-free withdrawals when you retire. In 2008 you may contribute up to $5,000 if your age is below 50; and $6,000 if you are 50 or older. However, these contributions are subject to income limits—in 2008, a Modified Adjusted Gross Income (MAGI) of $169,000 for taxpayers who are married and filing jointly, or a MAGI of $116,000 for single taxpayers—and the amount of your contribution may be phased out at the higher income levels. If your employer offers a Roth 401(k), your contribution is not subject to these income limits, and in 2008 you may put up to $15,500 into a Roth 401(k), or $20,500 if you're 50 or older.

If you're no longer working and your MAGI is less than $100,000, you can convert some or all of your traditional IRA into a Roth, but you do have to pay income tax on the amount converted. Eddleman points out, however, if you wait until 2010 to convert, you could reduce the tax bite under a special one-year provision in the Tax Increase Prevention & Reconciliation Act of 2006. This provision offers a tax benefit to those who convert in 2010: to postpone paying the tax that year and then pay it in two equal installments, in 2011 and 2012. (Caveat: This or any other tax law can always be changed with little notice.)

A popular saying suggests "70 is the new 50," and that seems increasingly to be true. If you agree, you should also realize the appropriate time for retirement financial planning extends beyond the traditional deadline for ending your work life, and probably for as long as you live and need income to pay your bills.

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