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Retirement savings and taxes

Chris Farrell Sep 4, 2009

Question: Hi Chris – my husband and I are in our 50’s and trying to plan well for retirement, including how to protect our retirement money from being “taxed to death” when the time comes for us to take distributions. I have recently heard lots of “caution” about the inevitability of everyone’s tax liabilities increasing greatly in the coming years in order to deal with our national budget deficit, health care reform, etc. What is your advice for how we can best protect our 401-k and IRA money so it isn’t taxed to exhaustion when the time comes for us to take distributions? Currently our retirement accounts are invested in index mutual funds linked to the S&P 500. Thanks for your time and expertise, Chris. Helene, Watsonville, CA

Answer: I have a middle-of-the-road position when it comes to future tax rates. In light of the government’s obligations that you mention, such as national defense, Social Security, health care, and the budget deficit it’s likely that taxes will go up. I agree with Tyler Cowen, the libertarian economist at George Mason University, who argues that the tax cuts from the Bush years were really deferred tax increases. That said, I don’t buy the scare stories that taxes will go so high that our savings will be wiped out. My own guess is that the pressure for revenue without pushing rates too high will lead to major tax reform. The deal would be to offer everyone lower rates in return for closing many loopholes. But that’s just a guess.

On a practical what-can-I-do-today level, one of the best moves anyone can make is diversify the tax treatment of their retirement savings. When you withdraw money from your 401(k) and traditional IRA it will be taxed at your ordinary income rate. I would also save in a Roth-IRA. Your contributions are with after-tax dollars but your withdrawals will be tax free. That could be a huge benefit in retirement.

The other thing is to consider converting money from a traditional IRA into a Roth-IRA in 2010 (or after). You could only convert an IRA into a Roth if your modified gross adjusted income was under $100,000. But the income limit lifts in 2010. The argument for converting strengthens the longer your money can compound. There is also a one-time perk for anyone who converts in 2010. You can pay any taxes owed on the conversion in one year or spread it out over the following two years.

However, if you have to use tax-deferred savings to pay the tax bill it doesn’t pay to convert under most scenarios. You can begin exploring whether conversion makes sense for you at such online sites as rothretirement.com. Amy Feldman of BusinessWeek has a nice story on this: Is a Roth IRA Right for You?

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