The 401(k) and other forms of employer retirement plans are important and useful while you are in the contribution phase of life.
When you switch direction in retirement and begin making withdrawals from your savings and investment earnings, it can be helpful to roll over your employer retirement account to an Individual Retirement Account (IRA).
If retirement account balances are in an IRA, two strategies become available that generally aren’t allowed from employer plans: They are qualified charitable distributions and Roth IRA conversions. Both improve tax efficiency and are under-utilized. If you can manage your assets in a more tax-friendly way, you may increase your investment returns without taking more risk because you will have more dollars left to spend in the after-tax world.
If you are over age 70½, have a pre-tax retirement account and make donations to nonprofit organizations via check or credit card, you may want to stop. Instead, you can send qualified charitable distributions from your IRA directly to the nonprofit organizations that you support. Rather than using your cash to make your donation with after-tax dollars, you can donate pre-tax dollars out of the IRA.
This strategy is different than transferring investments with capital gains to the nonprofit organization. That is another giving strategy for non-retirement accounts which no longer allows a tax deduction for many people. With a qualified charitable distribution (QCD), you instruct the custodian of your account to make a check payable from the IRA directly to the charity. As long as you are already 70½, you can do this with up to $100,000 per year. You won’t owe federal income tax as you would for other IRA withdrawals.
Make sure to adequately note these donations on your tax return. The tax-related document you receive from your custodian reflecting IRA withdrawals (1099-R) doesn’t code this transaction to clearly label it as an untaxed withdrawal. Some accountants even miss this if you don’t give them a heads up about your giving from the account.
You can’t use this type of donation to start or contribute to a donor-advised fund, but you can use this strategy to reduce your taxable income, which may be especially important if you are near income levels where your Medicare premiums are increased by crossing an income threshold.
Before you reach age 70½ and the introduction of annual required minimum distributions from pre-tax accounts, another way to lower the impact of future taxes and therefore increase the money you get to keep or spend is a conversion from a traditional or rollover IRA to a Roth IRA. Some 401(k) plans, but only a minority, do allow conversions to Roth 401(k). Most people interested in this option will have to do it after they have rolled over their employer retirement account to an IRA.
If you assume that today’s relatively low federal income-tax rates will eventually give way to higher taxes, accelerating the tax due into the current lower tax rate could ultimately save you money. It could also allow greater compounding of returns without the future tax drag.
Regardless of the possible benefits, many people are reluctant to turn a future tax into a current tax.
This strategy makes the most sense if you have some years between when you retire and when you begin to take Social Security and other pension income. This allows you to convert a portion of your IRA incrementally over a series of years before your required minimum distributions from the pre-tax accounts begin. If you have enough other savings available to pay the tax due, you can fill up a relatively low tax bracket with Roth conversion dollars.
By paying the tax now and changing the future character of this money to not be taxed —neither the principal or the growth, for you or a next generation heir — you may benefit from time and compounding growth to increase the longevity of your money.
After conversion, because the money is now in a tax-free growth account, this is where you should hold investments with the highest expected return — generally your most aggressive positions, primarily stocks. This may require you to re-position holdings elsewhere in your portfolio. Focus on keeping income-producing investments (bonds and real estate investment trusts, dividend-paying stocks) in the pre-tax account.
Apply these strategies and charitable organizations will thank you (you may be able to donate even more than planned if giving from pre-tax dollars), your heirs will appreciate you (for passing on tax-free investments) and you may increase your after-tax returns. Wins all around.
There are some specific scenarios where these options are not useful, so you should consult with experts about your intent and the impact on your financial situation before executing.