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It’s time for boomer clients to spend — and pay taxes on — their 401(k)

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(Bloomberg) --What the IRS giveth, the IRS taketh away.

At age 70½, the bill comes due on all those tax-deferred savings accounts your clients have been building, and this week the oldest baby boomers will begin to reach that finish line—with many millions more to follow. Those waves of retirees will be required to start pulling money from their IRAs and 401(k)s. Following an IRS formula, these annual withdrawals can push clients into a higher tax bracket, so advisers put a lot of energy into building strategies to minimize the tax bite. To be most effective, you need to help clients plan far in advance of the magic age. So get familiar with how these required minimum distributions work—and the options for handling them—well before they have to crack open the nest egg. To get a jump-start on what's involved, here are some quick rules of the road.

While clients have the option of tapping tax-deferred retirement savings accounts without penalty starting at age 59½, they are required by law to start taking distributions from their IRA, 401(k) and other kinds of tax-deferred accounts by April 1 of the year after they turn 70½.

From then on, they have to take money out before Dec. 31 every year. If they are still working at that age and participating in their employer's 401(k) plan, they may be able to defer RMDs from that account. The amount they must withdraw is tied to an IRS formula based on life expectancy. Say they just turned 70½ and have one $600,000 IRA. An IRS table (PDF) sets their distribution period at 27.4 years. Their $600,000 divided by 27.4 equals, about $22,000. Whether they want it now or not, that's what they have to take out. The penalties for noncompliance are steep. If they forget to take an RMD, or don't withdraw the full amount, the IRS wants 50% of the amount not withdrawn. This can avoid this by having IRA custodian calculate the RMD and automatically transfer the money to an account with them or a bank, a service many offer.

Things become trickier with tax strategies. Clients must have sizable amounts saved in both tax-deferred and taxable accounts. If they already have a Roth IRA in place, all the better. By shifting money between these accounts, and paying tax on some at opportune times, the tax damage can be decreased years of retirement income added. A few caveats: Everyone's situation is different, and no one can predict future tax policy. One bit of advice that applies to all: Any financial adviser you use should be a fiduciary, required to act in your best interests.


One of the main ways planners help clients facing big RMDs is strategically converting money from a traditional IRA into a Roth IRA, which is funded with after-tax money. That's because those required distributions can push clients into a higher tax bracket, said Kevin Reardon of Shakespeare Wealth Management in Pewaukee, Wis.

At some point after 59½, when a client can tap tax-deferred accounts without penalty, but before 70½, when they must, Reardon has them convert chunks of a regular IRA into a Roth before they retire. The point is to take advantage of a period when they're in a low tax bracket. Without income yet from RMDs, a pension, or Social Security, there may be a gap between current income and the limit for remaining in the 15% tax bracket, for example.

The point is to fill that gap with money withdrawn from your traditional IRA, pay tax on it, and put it in a Roth. How much you convert depends on a lot of things, including how much you have in taxable accounts both to live on and to cover the tax, and how close your income is to the next tax bracket. And of course, there are big benefits to having money compound tax-free in an IRA. Planners have to weigh these considerations against the chance of a higher tax bracket when you start taking distributions and other income streams kick in. Reardon's clients typically delay taking Social Security until age 70. That gets them a much higher monthly benefit than if they'd taken it earlier. It also means Social
Security benefits—which are taxed to a degree—don't add to income while clients are trying to fill their 15% “tax bucket.”


Here's an example of how the strategy could work, courtesy of certified financial planner John Shanley of Pinnacle Investment Management in Simsbury, Conn. His firm worked with a married couple, 67 and 59 years old, who are retiring later this year. The older client is deferring Social Security until 70, and the couple will have $17,000 in income coming from a pension starting in 2017. The couple's spending needs in 2017 and 2018 will come from taxable accounts. Since they have low income for two years, they'll convert $75,000 of a traditional IRA to a Roth in both years. A small part of that conversion falls in the 10% bracket and the rest in the 15% bracket. By lessening future RMDs, the client won't be bumped into the 25% tax bracket in 2019 or the 28% bracket they might have hit in later years, said Shanley.

A helpful way to look at the savings is to compare the tax bill generated by a conversion today with what it would likely cost down the line, he said. For instance, a $75,000 move from an IRA to a Roth now at a 15% rate costs $11,250 in tax. The same transfer later, while in a 25% tax bracket, would cost $18,750.

The conversion’s tax benefit in later years may be diminished if new income streams start, say from another pension or more RMD income, but it’s still a way to take advantage of a few years at a lower rate, Shanley said.

And finally, if you’ve done so well that the RMDs aren’t needed, you can make "qualified charitable distributions" of up to $100,000 a year. That way, RMDs won't be included in gross income. You have to be careful, though—the company holding your tax-deferred account must send the money directly to a qualified charity.

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