8. How Can I Manage Taxes?

If you participated in your employer-sponsored retirement plans like 457 deferred compensation and/or 401(a), many of your contributions were made with pretax dollars. Once you begin receiving distributions from these accounts, you’ll probably have to pay income taxes on all or part of the funds withdrawn. In addition, your Social Security and defined contribution pension payments may also be subject to income taxes.

Which Accounts To Use First

Money that you deposit into a regular bank account has already been subject to tax and is called after-tax dollars. Therefore, when you withdraw that money, you don’t owe any taxes on it. In addition, you don’t owe taxes on any interest earned on those dollars, because it was declared when you filed your annual income taxes.

On the other hand, many of the contributions in your tax-deferred retirement accounts were made with pretax dollars - you saved for your retirement and saved income taxes as well. You didn’t pay taxes on any of the earnings either.

But now that you’re retiring and you’ll be withdrawing funds from these accounts, your disbursements are considered income and are subject to income taxes. Because of the tax consequences, you need to plan which accounts to withdraw your money from first.

As a rule, money withdrawn from a regular savings account is not subject to taxes. Withdrawing those funds should occur before withdrawing money from tax-deferred accounts. That way, you can postpone paying income taxes on tax-advantaged accounts.

A Roth IRA, with after-tax contributions and tax-free growth, has the additional advantage of exemption from required minimum distributions that apply to other retirement accounts. This means that after age 70½, when distributions must be started from other retirement accounts, the entire Roth account can continue to grow tax-free. Any amount still in the Roth account at the time of the owner’s death can be used by any beneficiary tax-free. These advantages mean that the Roth account generally is best utilized as late in life as possible.

Tax law is highly complex and technical, and it often calls for guidance from a tax professional to help you develop the best strategy. Your plan depends on many things, including the following:

• Account/asset types
• How long you have owned the assets
• Cost basis (the amount of the account that has already been taxed)
• Rate of return earned and expected
• Estate considerations

Penalty Taxes

The purpose of tax-advantaged retirement accounts is to encourage saving for your future. However, if you withdraw the funds too soon or wait too long, you will be subject to tax penalties in addition to paying regular income taxes.

Withdrawing early

If you use most kinds of retirement funds before the usual retirement age of 59½, you will have to pay a 10 percent penalty tax on money withdrawn.

Here are some exceptions to this penalty tax:

• 457 plan withdrawals are never subject to this penalty regardless of the age at which the withdrawal is made.
• Payments are made to a beneficiary or estate.
• Payments are made to a totally and permanently disabled owner.
• Payments are part of substantially equal periodic payments over the life expectancy of the owner or life expectancies of owner and beneficiary.
• Payments are equal to or less than any deductible medical expenses.

There are also exceptions from the early distribution penalty tax for distributions from qualified retirement plans:

• Distributions made after you separated from service with your employer, if separation was during or after the year you reached age 55
• Distributions made under a qualified domestic relations order
• Distributions as dividends from employee stock ownership plans

The exceptions from this penalty tax for IRA distributions include those for the following purposes:

• For qualified higher education expenses
• For a first-time home purchase
• To pay health insurance while you are unemployed

Waiting too long

There are also tax penalties if you wait too long before beginning distributions from tax-advantaged retirement accounts.

If you don’t take the required minimum distribution after age 70½, you will pay a 50 percent penalty on withdrawal shortfalls, determined by an IRS formula.

Withholding and Estimated Income Taxes

Most of your retirement account withdrawals will probably be subject to 20 percent mandatory federal tax withholding. However, as with most tax matters, there are exceptions to this rule.

While you can decide not to have taxes withheld from IRA accounts, you still have to make sure that the taxes are prepaid. You can do this by paying an estimated tax on income that is not subject to withholding. Taxes that will be due may be more or less than the amount that is, or is not, withheld.

If you have taxable income from sources that are not subject to withholding (including some retirement accounts), and if you had a tax liability for the prior year, you may be required by law to pay an estimated tax for the current year.

Consult with your tax professional to calculate your estimated taxes. You can also find more information on estimated taxes in IRS publications 590 and 554 or online at www.irs.gov.

Selling Your House as a Tax Break

If you decide to sell your primary residence, you may be pleasantly surprised: profits of as much as $250,000 (single owner) and $500,000 (joint ownership) may be exempt from taxes.

To take advantage of this tax benefit, there are several requirements, including these:

• You owned the house and it was your primary residence for two of the last five years.
• You haven’t used the exclusion within the last two years.

For complete details, consult IRS publication 523 (www.irs.gov) or your tax advisor.

Paying Off Your Mortgage

Although your mortgage is debt, it is unique because it may have tax advantages if your payments are made mostly to cover the interest, which is deductible. However, if your payments are mainly toward the principal, you might not have any tax benefits.

Even if the balance remains high enough to generate a tax break, you may want to consider paying off your mortgage if your situation meets these conditions:

• You are already maximizing retirement savings.
• You have paid off other higher-interest, non-tax-deductible debt.
• You have an adequate emergency fund.

You may find that the financial freedom from being entirely debt-free is worth foregoing the interest tax deduction. Consult with your tax advisor to see if paying off your mortgage makes financial sense for you.