Retiring: Tax Tips

You’ve spent a lifetime saving for retirement. When the big day finally arrives, you’ll have to learn a whole new set of rules about:

• Rolling over your 401(k) to an IRA
• Tapping your pension
• Tax-smart ways to handle company stock
• How Social Security benefits are taxed

When you retire, your life changes in many ways—and so do your finances.

One of the biggest changes is that instead of contributing to tax-deferred retirement savings plans that reduce your tax bill, you'll start tapping those savings for income and pay taxes at your regular rate—not the preferential long-term capital gains rate reserved for stocks and bonds held in taxable accounts for more than one year.

One of the first decisions you'll have to make is what to do with the savings that you have accumulated in your 401(k) or similar workplace retirement plan.

As long as you have a balance of $5,000 or more, you can keep it with your former employer. You might want to do that if you like the investment choices and enjoy low fees in the employer's plan. And if you are at least 55 when you retire, you can start tapping your 401(k) funds penalty-free, although you'll still owe income taxes on your withdrawals.

If you roll the money over to an IRA, where you will have more investment choices, you must be at least 59½ to avoid early withdrawal penalties.

If you decide to roll over some or all of your 401(k) money to an IRA, you can preserve your tax deferral by transferring the funds directly to a new custodian, such as a discount broker or mutual fund company.

Don't make the mistake of having a check made out to you. If you do, your employer will be required to withhold 20 percent of the balance for taxes. You have 60 days to get your money safely ensconced in an IRA, but how are you going to come up with that 20 percent. Any money that's not in an IRA within that time period will be treated as a distribution and subject to income taxes plus a 10 percent penalty if you are younger than 59½.

You avoid this potential problem by having the money sent directly to your IRA or having the check written to your IRA account.

If you own highly-appreciated company stock, special rules for what's called Net Unrealized Appreciation (NUA) can result in significant tax savings.

When you take a lump-sum distribution from your 401(k), you can move the stock to a taxable account and roll over the rest of the assets to an IRA. You'll pay ordinary income taxes on your basis in the stock you shift to the taxable account—that's what you paid for the stock—but the remaining NUA (the appreciation while the stock was in your retirement plan) will be taxed only when the stock is sold

And, here's the kicker: At that point the profit will qualify for the 15 percent long-term capital gain rate. In contrast, if you roll over your entire balance to an IRA, all of your withdrawals, including those that come from the profit on your company stock, will be taxed at your top tax rate. This pays off best for company stock that has appreciated smartly inside your 401(k).

Tax deferrals on retirement savings don't last forever. You must start taking taxable withdrawals from your traditional IRA or 401(k) by April 1 of the following year after you turn 70½, and annual withdrawals by December 31 after that. (There is an exception if you are still on the job at 70½ or beyond. You don’t have to tap your 401(k) funds until you retire, but you will have to take annual distributions from your IRA.)

The Required Minimum Distributions (RMD) are based on your account balance divided by a life expectancy factor set by the IRS. If you don't take your full RMD each year, there's a stiff penalty—50 percent of the amount you failed to withdraw.

You can always take out more than the minimum required amount, paying taxes at your regular rate on all the withdrawals. You can ask your retirement account custodian to withhold taxes from your distributions so you can make quarterly estimated tax payments.

If you've been stashing money in a Roth IRA, you can start reaping your rewards as long as you are at least 59½ years old and the account has been open at least five years. At that point, all withdrawals are tax-free.

But unlike traditional IRAs, there are no mandatory distribution rules, so you never have to touch the money if you don't need it. That means it can continue to grow tax-free for years. Your heirs will thank you because they, too, can take distributions from an inherited Roth IRA tax-free. (Money in an inherited traditional IRA is taxed in the heir's top tax bracket.)

If you contributed to one of the latest innovations in retirement savings—the Roth 401(k—you can also benefit from tax-free distributions once you're 59½. But the hybrid Roth 401(k) does have mandatory distribution rules, like traditional 401(k) plans, starting at 70½.

It's easy to get around that, though. Simply roll over the Roth 401(k) portion of the account to a Roth IRA when you retire. There will be no tax consequences, and you never have to tap the money during your lifetime.

Once you move your retirement savings to a traditional IRA, you have another option: You can convert some or all of it to a Roth IRA.

Although you will pay taxes on money you convert, all future withdrawals will be tax-free as long as the account is open at least five years and you are at least 59½ years old at the time.

The longer the money sits in a Roth IRA allowing tax-free earnings to accumulate, the bigger the tax savings. As noted above, there are no mandatory distribution rules for Roth IRAs and if you decide to leave your Roth IRA to your heirs, they will inherit it tax-free.

Since your tax rate is based on your income, you may want to wait until you retire when your taxable income may be lower to convert a portion of your IRA to a Roth IRA each year, to prevent you from being bumped into a higher tax bracket.

To be eligible for a Roth IRA conversion, your income must be $100,000 or less. But starting in 2010, income limits on Roth IRA conversions will disappear.

As of 2008, those eligible for a Roth conversion can now convert directly from a 401(k) to a Roth IRA, without the trouble of rolling over to a traditional IRA first. And if you have any after-tax contributions in your 401(k) or similar employer-based retirement plans, such as a 403(b) or 457 plan, you can roll over those funds directly to a Roth IRA tax-free (assuming your income is $100,000 or less). If your income is too high, just wait until 2010 when income limits on Roth IRA conversions disappear.

This new 401(k) conversion rule is a much more liberal rule than the one that controls conversions from traditional IRAs to Roth IRAs. In that case, the tax-free portion of the rollover is based on the ratio of your non-deductible pay-ins to the total amount in all of your IRAs. So if your $60,000 IRA contains $6,000 in non-deductible contributions and you convert $6,000 to a Roth IRA, just $600 or one-tenth of the converted amount would escape income tax. The remaining $5,400 would be taxed at your regular income tax rate.

But in the same situation with the new 401(k) rules, the full $6,000 converted from your 401(k) to a Roth IRA would avoid tax. You still have to meet the $100,000 income limit before 2010 and, depending on your plan’s rules, you may not be able to roll over the after-tax contributions until you leave your job.

Another big decision is planning when to start taking your Social Security benefits. You can start as early as 62, but your retirement benefits will be reduced by 25 percent or more for the rest of your life. Or you can wait to collect your full benefits when you reach the standard retirement age, which is 66 for those born between 1943 and 1954.

For each year you delay collecting benefits after the standard retirement date up until age 70, you qualify for an even bigger retirement benefit. As you consider when to take your Social Security, factor in how your benefits will be taxed.

Also, consider whether you plan to continue working once you start collecting Social Security benefits. If you are younger than the standard retirement age, you will lose $1 in retirement benefits for every $2 you earn over the earnings cap, which is $13,560 in 2008 ($14,160 in 2009).

There are more generous earnings limits for the year you reach the standard retirement age, and no limits afterward.

Whether or not any of your benefits will be taxed depends on your income, which in this case is defined as your Adjusted Gross Income, plus tax-free interest, plus half of your Social Security benefits. If your income is less than $25,000 on a single return or $32,000 on a joint return, your Social Security benefits are tax-free. Individuals with incomes between $25,000 and $34,000 pay tax on up to 50 percent of their benefits. Individuals with incomes over $34,000 pay income tax on up to 85 percent of their benefits.

Married couples filing a joint return with incomes between $32,000 and $44,000 pay tax on up to 50 percent of their Social Security retirement benefits. Married couples with incomes over $44,000 pay taxes on up to 85 percent of their benefits.

Whether or not taxes are withheld from your benefits each month is up to you. You may want to ask the Social Security Administration to withhold federal income taxes from your retirement benefits if doing so lets you avoid making quarterly estimated tax payments. To start, stop or change withholding, file a Form W-4V with the IRS. State tax laws vary. Some states exempt some or all of your Social Security benefits from income taxes.

Pension and annuity payments from qualified retirement plans are fully taxable. As with Social Security benefits, it’s up to you whether taxes are withheld from your benefits as you receive them. Withholding can make sense if it lets you avoid making quarterly estimated tax payments.

State tax laws vary. Some exempt certain types of pensions, such as military or government pensions, from state income taxes. Others allow a portion of any type of pension income to escape state income taxes. A few states fully tax pension income. You should get a Form 1099-R from the payer each year showing how much income you received.

If you purchase an annuity with nonqualified funds (money outside a retirement account), payments you receive will be partially tax-free.

The portion of each payment that represents a return of your investment is tax-free; the portion that represents investment earnings is taxed in your top tax bracket. Again, you should receive a 1099-R from the insurance company showing the taxable amount.

Any distribution from an HSA used to pay for medical expenses is tax-free. Withdrawals for nonmedical purposes are taxable and, if you are under age 65, hit with a 10 percent penalty.

TurboTax Deluxe includes valuable tax tips to help you keep more money for retirement.

Updated for tax year 2008