Issue 28: 2014

Web Exclusive — Your Future

Tax Considerations and Retirement

Dealing with federal and state taxes during retirement can be complicated, but some strategies may help relieve the burden.

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Taxes are an important consideration for everyone when it comes to retirement. For wealthy individuals — for whom retirement planning is less about having enough than about having enough to pursue certain goals — maximizing tax efficiency is of particular interest. Here is some of our latest thinking on federal taxes, state taxes and IRAs.

Federal tax

Taxable accounts

Proceeds from the sale of stocks, bonds and real estate are taxed as capital gains. Short-term gains, which are from investments held less than a year, are taxed at the same rate as ordinary income, while long-term gains rates are currently 20% for those in the top income tax bracket.

Tax-deferred accounts

Withdrawals from IRAs and 401(k)s are taxed as ordinary income, says Mitchell A. Drossman, national director of wealth planning strategies at U.S. Trust. “Withdrawals from Roth IRAs, on the other hand, are tax-free,” he says. “That is, if the account has been open for five years or longer, and you’re at least 59½.” When it comes to pensions, payments are usually taxed as ordinary income.

What about the 3.8% surtax?

Certain types of investment income are subject to an additional 3.8% surtax, a result of the Health Care and Education Reconciliation Act of 2010.

For individuals, the 3.8% surtax is imposed on the lesser of net investment income or, over a certain threshold amount, the excess of modified adjusted gross income. However, there is an exception for retirement plan distributions, says Drossman; for IRAs, Roth IRAs, qualified pensions, qualified annuity, profit sharing and several other plans, distributions are not regarded as net investment income. Distributions from IRAs would increase adjusted gross income, which could expose you to the 3.8% surtax. Roth IRA distributions, however, would not affect adjusted gross income.

Are Social Security payments taxed?

The Social Security benefits you receive may be subject to federal income tax. There’s a formula to determine how much of your Social Security benefits are taxable, but it is, unfortunately, convoluted and not easily summarized. The short answer is that up to 85% of your benefits could be included in your federal taxable income, in which case those benefits would be subject to income tax just like any other ordinary income. (Most states do not tax Social Security benefits.)

“The decisions you make about Social Security can affect payments you receive as well as the taxes that you owe,” says Kim Garcia, a wealth planning solutions executive at U.S. Trust. “We often provide clients with guidance on Social Security benefits and help manage income to reduce the tax impact.”

State tax

While Roth IRA distributions are tax-free, distributions from 401(k) plans and IRAs are taxed as income. “One way to minimize state income taxes is to move to a state with lower income-tax rates, ” says Drossman.

In general, a state can tax income earned in that state, regardless of whether it is earned by a resident or a nonresident. However, income contributed to a retirement account is generally not taxed as income at the time it’s earned or contributed, but rather when it’s distributed from the retirement account. According to Drossman, when it comes to distributions from certain qualified retirement plans, a state cannot tax a nonresident. These plans include 401(k)s, IRAs, simplified employee pensions (SEPs), tax-sheltered annuities (generally for schoolteachers or employees of charities), or deferred compensation plans under section 457 (generally for government workers or employees of tax-exempt organizations).

A state also can’t tax a nonresident on two types of deferred compensation that provide retirement income. The first is income from so-called “excess benefit” plans (also called “mirror” plans, “wraparound” plans or “restoration” plans), if certain conditions are met. The second is a payment that is part of a series of “substantially equal periodic payments” made at least annually for the life or life expectancy of the recipient (or the joint lives or the joint life expectancies of the recipient and the designated beneficiary of the recipient) or a period of no less than 10 years.

Other types of retirement income and deferred compensation are not addressed by current federal law. “That means that the state where you earned money can tax the income when you receive it as a retirement distribution, even if you are a nonresident at the time you receive it,” Drossman says.

Examples include income from the exercise of compensatory stock options, income from the vesting of restricted stock shares, deferred bonuses, severance pay, and distributions from plans that don’t meet the requirements above (e.g., they are not maintained “solely” to provide excess benefits, or they are distributed over less than 10 years, or distributed off track with life expectancy).

Says Drossman: “If you’re dealing with retirement income protected by federal law and you’re planning to establish residency in a new state with a more favorable income-tax rate, you should consider establishing the new state as your domicile before you recognize the retirement income.”

Similar planning could apply to a Roth conversion, he adds. “Since 2010, you are allowed to convert a traditional IRA to a Roth IRA, regardless of your level of income; however, such a conversion will trigger income taxation, as if the traditional IRA had been fully distributed.” If you are considering relocating to a state with a more favorable income tax, it could make sense to establish your domicile in the new state before the conversion.

Should you consider a Roth IRA conversion?

“If you expect taxes to go up in the future or if you expect to be in a higher tax bracket during retirement, you may want to roll over assets from eligible retirement accounts to a Roth IRA,” says Garcia.

If you choose to do so, you’ll pay taxes on the assets now at your current income tax rate. Then, qualified withdrawals in retirement will be federally (and possibly state-) tax-free, with certain restrictions. “Many people do not realize that qualified withdrawals from a Roth IRA do not affect the taxability of Social Security benefits,” she says. “Another advantage of a Roth IRA is its exemption from the required minimum distribution, or RMD, rules for the original owner. This offers the potential for preservation and growth of assets during the owner’s lifetime and subsequent transfer of tax-free assets to your next generation.”

For more on tax planning and retirement, visit ustrust.com/taxes or contact your advisor.

IMPORTANT INFORMATION

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust and its representatives nor its advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

Taxes are an important consideration for everyone when it comes to retirement. For wealthy individuals — for whom retirement planning is less about having enough than about having enough to pursue certain goals — maximizing tax efficiency is of particular interest. Here is some of our latest thinking on federal taxes, state taxes and IRAs.

Federal tax

Taxable accounts

Proceeds from the sale of stocks, bonds and real estate are taxed as capital gains. Short-term gains, which are from investments held less than a year, are taxed at the same rate as ordinary income, while long-term gains rates are currently 20% for those in the top income tax bracket.

Tax-deferred accounts

Withdrawals from IRAs and 401(k)s are taxed as ordinary income, says Mitchell A. Drossman, national director of wealth planning strategies at U.S. Trust. “Withdrawals from Roth IRAs, on the other hand, are tax-free,” he says. “That is, if the account has been open for five years or longer, and you’re at least 59½.” When it comes to pensions, payments are usually taxed as ordinary income.

What about the 3.8% surtax?

Certain types of investment income are subject to an additional 3.8% surtax, a result of the Health Care and Education Reconciliation Act of 2010.

For individuals, the 3.8% surtax is imposed on the lesser of net investment income or, over a certain threshold amount, the excess of modified adjusted gross income. However, there is an exception for retirement plan distributions, says Drossman; for IRAs, Roth IRAs, qualified pensions, qualified annuity, profit sharing and several other plans, distributions are not regarded as net investment income. Distributions from IRAs would increase adjusted gross income, which could expose you to the 3.8% surtax. Roth IRA distributions, however, would not affect adjusted gross income.

Are Social Security payments taxed?

The Social Security benefits you receive may be subject to federal income tax. There’s a formula to determine how much of your Social Security benefits are taxable, but it is, unfortunately, convoluted and not easily summarized. The short answer is that up to 85% of your benefits could be included in your federal taxable income, in which case those benefits would be subject to income tax just like any other ordinary income. (Most states do not tax Social Security benefits.)

“The decisions you make about Social Security can affect payments you receive as well as the taxes that you owe,” says Kim Garcia, a wealth planning solutions executive at U.S. Trust. “We often provide clients with guidance on Social Security benefits and help manage income to reduce the tax impact.”

State tax

While Roth IRA distributions are tax-free, distributions from 401(k) plans and IRAs are taxed as income. “One way to minimize state income taxes is to move to a state with lower income-tax rates, ” says Drossman.

In general, a state can tax income earned in that state, regardless of whether it is earned by a resident or a nonresident. However, income contributed to a retirement account is generally not taxed as income at the time it’s earned or contributed, but rather when it’s distributed from the retirement account. According to Drossman, when it comes to distributions from certain qualified retirement plans, a state cannot tax a nonresident. These plans include 401(k)s, IRAs, simplified employee pensions (SEPs), tax-sheltered annuities (generally for schoolteachers or employees of charities), or deferred compensation plans under section 457 (generally for government workers or employees of tax-exempt organizations).

A state also can’t tax a nonresident on two types of deferred compensation that provide retirement income. The first is income from so-called “excess benefit” plans (also called “mirror” plans, “wraparound” plans or “restoration” plans), if certain conditions are met. The second is a payment that is part of a series of “substantially equal periodic payments” made at least annually for the life or life expectancy of the recipient (or the joint lives or the joint life expectancies of the recipient and the designated beneficiary of the recipient) or a period of no less than 10 years.

Other types of retirement income and deferred compensation are not addressed by current federal law. “That means that the state where you earned money can tax the income when you receive it as a retirement distribution, even if you are a nonresident at the time you receive it,” Drossman says.

Examples include income from the exercise of compensatory stock options, income from the vesting of restricted stock shares, deferred bonuses, severance pay, and distributions from plans that don’t meet the requirements above (e.g., they are not maintained “solely” to provide excess benefits, or they are distributed over less than 10 years, or distributed off track with life expectancy).

Says Drossman: “If you’re dealing with retirement income protected by federal law and you’re planning to establish residency in a new state with a more favorable income-tax rate, you should consider establishing the new state as your domicile before you recognize the retirement income.”

Similar planning could apply to a Roth conversion, he adds. “Since 2010, you are allowed to convert a traditional IRA to a Roth IRA, regardless of your level of income; however, such a conversion will trigger income taxation, as if the traditional IRA had been fully distributed.” If you are considering relocating to a state with a more favorable income tax, it could make sense to establish your domicile in the new state before the conversion.

Should you consider a Roth IRA conversion?

“If you expect taxes to go up in the future or if you expect to be in a higher tax bracket during retirement, you may want to roll over assets from eligible retirement accounts to a Roth IRA,” says Garcia.

If you choose to do so, you’ll pay taxes on the assets now at your current income tax rate. Then, qualified withdrawals in retirement will be federally (and possibly state-) tax-free, with certain restrictions. “Many people do not realize that qualified withdrawals from a Roth IRA do not affect the taxability of Social Security benefits,” she says. “Another advantage of a Roth IRA is its exemption from the required minimum distribution, or RMD, rules for the original owner. This offers the potential for preservation and growth of assets during the owner’s lifetime and subsequent transfer of tax-free assets to your next generation.”

For more on tax planning and retirement, visit ustrust.com/taxes or contact your advisor.

IMPORTANT INFORMATION

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust and its representatives nor its advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.