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US: Withdrawing money and cutting taxes

12 February 2014   (0 Comments)
Posted by: Author: Arden Dale
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Author: Arden Dale (Wall Street Journal)

Investors can save a lot on taxes by putting money away in 401(k) plans and individual retirement accounts.

But many investors who are in or near retirement also can end up paying less in taxes in the long run by carefully timing withdrawals from those savings vehicles.

Retirement-account balances have ballooned in size as traditional defined-benefit pension plans have become rarer and the burden of saving for retirement has increasingly shifted to individuals. As of Sept. 30, investors held $11.8 trillion in IRAs, 401(k)s and similar tax-deferred accounts, up from $6 trillion at the end of 2003, according to the Investment Company Institute, a trade group.

But a high balance can be a curse as well as a blessing when it comes to taxes, particularly for older investors, financial advisers say. Once account holders reach the age of 70½, they often must withdraw a minimum amount each year, determined by their age and account balance.

If frugal investors delay taking money out earlier to let their accounts grow, then those required minimum withdrawals could push them into higher income-tax brackets and increase the taxes owed.

The solution: Start taking at least some money out in the decade or so before turning 70½, even if it isn't needed for current expenses, financial advisers and tax experts say. Beginning at age 59½, account holders can take money out of tax-deferred accounts without penalty.

This strategy works best for investors in a lower tax bracket—as many are in the early years of retirement, and in some cases before retirement.

Stefan Prvanov, president of Blankinship & Foster, an advisory firm in Solana Beach, Calif., that manages around $400 million, says one client came to him in his early 60s, when the man was in the 15% tax bracket.

The client had retired early to travel with his wife, and had about $800,000 in an IRA as well as other savings. Mr. Prvanov recommended the man take out $30,000 to $40,000 a year, pay income tax on it and put it into a Roth IRA, where gains and payouts aren't taxed.

Recently, the client turned 70, and he will move into a higher tax bracket when he starts taking the required minimum withdrawals. But the leap won't be as great as if he had left everything in the IRA, Mr. Prvanov says. Meanwhile, the client has built up $500,000 in the Roth IRA. Those accounts don't have annual minimum withdrawals.

"It's much better to plan ahead to have flexibility and better control of your taxes," says Mr. Prvanov.

Calculating whether the strategy is worthwhile can be tricky. Investors need to figure out which tax bracket they would end up in if they withdrew money from a tax-deferred account, and how much they would therefore end up paying on the withdrawals, Mr. Prvanov says.

Then they need to estimate their tax rate and the amount of their required minimum withdrawal after 70½, which is difficult because it depends to a great extent on how their investments perform, advisers say. But even an estimate will help them figure out how much in taxes they would pay in that scenario.

But the difference can be significant. Amy Weldele, a senior wealth manager at Budros, Ruhlin & Roe in Columbus, Ohio, says one retired couple she works with has about $2 million in IRA assets, and has been pulling out $75,000 each year for the past five years and putting the money into a Roth IRA.

The couple has itemized deductions for medical expenses, charitable contributions and tax payments that mean they would otherwise be paying no income tax currently. The withdrawals push them into the 15% federal income-tax bracket, Ms. Weldele says.

But if the couple had left everything in the original IRA until they turn 70½, they would likely end up in the 25% bracket. Instead, they will likely remain in the 15% bracket and probably pay less in taxes in the long run, she says.

Advisers favor this strategy if the investor can put the funds into a Roth IRA, where the money can grow and later be withdrawn tax-free.

This article first appeared on online.wsj.com.


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