Arden Dale for the Wall St Journal writes: A big IRA or 401(k) account can be a burden, not a blessing--at least when it comes to taxes.
Many boomers in or near retirement have a big share of their wealth tied up in tax-deferred accounts that will cost them extra in taxes if they fail to plan carefully.
Advisers see a golden opportunity for older clients to save taxes and build wealth by tapping their tax-deferred accounts instead of letting the money sit. They may have to sell the idea, however, because a lot of people firmly believe it's best to leave their IRAs or 401(k) accounts untouched until the government requires them to start making withdrawals at age 70 1/2.
At 59 1/2 years, account owners can start taking out money with no tax penalty. At 70 1/2, they must withdraw a minimum amount each year. But in the years between these milestones, many are in a low tax bracket that allows them to take money from a tax-deferred account relatively painlessly. The goal of creative planning is to keep the account from getting so big that it becomes a tax burden later on, and to build wealth outside of it.
"I call it the sweet spot for tax planning," said Ed Slott, an expert on IRAs and other retirement savings accounts. Tax-deferred accounts, he added, are "infested with taxes," and long-term planning is a must to minimize them.
California adviser Stefan Prvanov says some of his retired clients come in feeling confident because they know they will be in a low tax bracket over the short term. They may be living off a taxable account and have a large 401(k) or IRA they don't plan to tap until 70 1/2. A 62-year-old, for example, may know he will owe little or nothing in taxes at least until he's 65. That's not looking far enough ahead, the adviser cautioned.
Mr. Prvanov helped one client in this category turn around a scenario that would have put him into a higher tax bracket when he turned 70 this year. The man, who had been in management at a large U.S. corporation, came for advice when he was in his early 60s. He had retired early to spend time traveling with his wife, and most of his savings were in an IRA that held around $800,000. He was in the 15% tax bracket and pleased because he expected to stay there for the next few years. Mr. Prvanov guided him to convert a portion of the account to a Roth annually, in chunks of $30,000 and $40,000. The Roth account now holds around $500,000. The IRA, which has continued to grow through investment returns, still holds around $800,000.
The client will be in a higher tax bracket once he starts taking required minimum distributions, but not as high as if the IRA had ballooned in size. And, the man now has a pool of money he can tap tax-free.
Clients in certain professions, such as doctors, seem more prone to tunnel vision on this issue, said Mr. Prvanov.
"It's much better to plan ahead to have flexibility, and better control of your taxes," said Mr. Prvanov, president of Blankinship & Foster in Solana Beach, Calif., which manages around $400 million.
The Internal Revenue Service has loosened restrictions on moving money from a traditional tax-deferred account to a Roth account, a tactic that now is hugely popular with advisers as a tool to help clients in or near retirement. Mr. Prvanov said his firm averages between 30 and 40 Roth conversions a year. Roth owners pay the taxes upfront on money going on these accounts, which can grow tax-free and face no taxes on withdrawals later.
Amy Weldele, a senior wealth manager at Budros, Ruhlin & Roe, Inc. in Columbus, Ohio, said one husband and wife she works with, retired executives in their mid-60s with about $2 million in IRA assets, have converted about $73,000 from the account each year for the past five years to a Roth. The clients now have about $1 million in Roth assets and about $1 million in taxable brokerage accounts.
Without the Roth conversions, the couple's taxable income would be zero because itemized deductions of $100,000 for medical expenses, state income taxes, real estate tax and charitable contributions offset $100,000 of taxable income, Social Security income, dividends and capital gains.
The conversions bump the pair into a 15% tax bracket, a price well worth paying to keep the IRA from getting too large. Ms. Weldele projects that the strategy will keep the pair in the 15% bracket when they reach 70 1/2. Without the conversions, they would have been bumped into the 25% bracket once required to take minimum distributions.
This approach works best when the client has a taxable account from the outset to cover the upfront tax costs of a Roth conversion, according to Ms. Weldele, whose firm manages around $2 billion.
"If they retire with just a large IRA, you can't really do it," she said.
Indeed, that was the situation for a client of adviser Adam Leone. The retired man, who had just turned 62, had everything in a $900,000 IRA. He wanted to start collecting Social Security and leave the IRA untouched. But Mr. Leone saw that the man needed another form of savings. He advised holding off on Social Security, and had the man take chunks from the IRA each year for the past few years. The man didn't have the money to pay taxes on a Roth conversion, so Mr. Leone used the withdrawals to simply build up savings in a brokerage account. That eased life for the man and his wife, who together planned to move once she retired.
"Their hands would have been forced financially once she retires, and we wanted to smooth that," said Mr. Leone, a principal at Modera Wealth Management, a Westwood, N.J. firm that manages around $1.3 billion.
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