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Stop stashing it all in your IRA? Not so crazy

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in Small Business Tax,Small Business Tax Deduction Strategies

Conventional wisdom says to salt away as much money as you can in tax-sheltered retirement plans and IRAs. Reason: The contributions grow tax-deferred until you take withdrawals, usually when you’ve retired. But can you have too much of a good thing?

Strategy: Allocate dollars to taxable accounts as you near retirement. Do it even if it means cutting back on retirement plan contributions. That way, you won’t be clobbered on taxes when you withdraw the funds.

The IRS generally taxes distributions from qualified plans and IRAs at ordinary income tax rates reaching up to 35%. So, if you sink all your cash into those accounts, you could face major tax bills in the future.

That doesn’t mean you should ignore tax-favored retirement plans. But it does mean you may want to mix things up a bit.

Pay Uncle Sam now or later

Typically, a highly compensated exec or business owner will fall in a top tax bracket while he or she is working full time. But don’t assume you’ll be in a lower tax bracket in retirement, especially if you have assets tied up in the business.

Therefore, when you start taking large distributions from your retirement plans and IRAs, the payouts may be taxed at the 25%, 28% or 33% rate, or even the highest 35% rate.

Plus, you can’t put off the inevitable forever. Even if you don’t need the money to live on in retirement, you’re required to begin taking qualified retirement plan and IRA distributions after you turn age 70½. (Technically, distributions must begin no later than by April 1 of the following year.) Exception: If you’re still working, you can postpone the starting date until you retire, so long as you’re not a 5%-or-more owner of the company.

Frequently, investments outside a retirement plan will qualify for the maximum 15% tax on long-term capital gains. Assuming you can afford to pay the tax currently, you can come out ahead in the long run by shifting some contributions from tax-sheltered vehicles into taxable investments.

Tip: Remember that you can use capital losses from taxable investments to offset capital gains plus up to $3,000 of ordinary income. You receive no current benefit from investment losses in retirement plans and IRAs.

You can’t take it with you

Investing in taxable accounts can also make sense from an estate-planning perspective.

Here’s why: Currently, your heirs generally receive a “step-up” in basis when they inherit your taxable assets. Thus, they pay little or no capital gains tax if they sell the assets right away. On the other hand, if someone inherits a traditional IRA with nondeductible contributions, the existing basis remains with the account. So, when your heirs take distributions from the IRA, they could get hit with a whopping tax.

Under the Pension Protection Act of 2006, both a spouse and a non-spouse beneficiary can roll over plan assets into his or her own IRA. But distributions still must begin after age 70½. At that time, a separate Form 8606, Nondeductible IRAs, must be used to determine the taxable and nontaxable distribution portions. Find Form 8606 at www.irs.gov/pub/irs-pdf/f8606.pdf.

Tip: In any event, the inheritance may be subject to federal estate tax. Pending changes in the estate tax laws after 2009 have hampered long-term estate planning for such assets.

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