Many financial planners assume tax rates – on income, at least, if not on capital gains – will increase after 2013. To take advantage of the current low rates before they rise, first make sure you’re withdrawing from the most tax-efficient accounts: in this case, your traditional IRA and 401(k). Because those withdrawals are taxed as income, you’re likely to pay less in taxes now than in the future, says Keith Weber, CFP, author of “Rethinking Retirement.” This is especially important for those who may be facing large required minimum distributions,” he says. “Even a 3% increase in future rates could cost a retiree an additional $300 on every $10,000 they’re required to take out.”
Then, to stretch that tax benefit further, consider withdrawing extra money from those tax-deferred accounts, and plowing it right back into the markets, in a Roth IRA (or simply partially converting a traditional IRA to a Roth). Because investments in a Roth grow tax-free, making that conversion now locks in lower income tax rates on the initial amount, and zero capital gains taxes on any additional growth, says David M. Hill, a CFP with Madison, New Jersey-based financial advisory firm Brinton Eaton. Other advantages: the tax burden for a Roth IRA conversion can be split over 2011 and 2012, and there’s no age limit for the Roth IRA, so anyone can do the conversion.
To illustrate the strategy, Hill gives this example: Let’s say you’re 59 1/2 or older (the age at which you are no longer penalized for withdrawing from your IRA), in the 35% federal tax bracket, and want to withdraw $50,000 from your IRA. You could save about $2,000 by taking the distributions now, rather than after a potential tax rate increase (let’s assume a 39% rate), he says. Once you’ve put that money into the Roth IRA, you won’t have to pay those taxes again. And as an added bonus, the more you take out of your IRA now, the less you will have to take as required distributions after age 70 1/2.
This strategy isn’t foolproof, planners say. Because withdrawals from traditional IRAs and 401(k)s are considered income by the IRS, taking higher distributions from these accounts could push you into a higher tax bracket or, in some situations, trigger the alternative minimum tax. And regardless of strategy, the important thing, planners agree, is that bigger withdrawals don’t lead to higher spending, if that could jeopardize your future financial security. ”Most people will be better off letting their investments continue to grow," says Nick Barnwell, the vice president of retirement planning for Weiser Capital Management.
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