From the time we've entered the workforce, we've learned how important it is to save for retirement.
In fact, if we put $1,000 away for someone graduating from college today, it would be worth over $72,000 by the time they start collecting social security. (This assumes graduation at age 22, social security at age 67, and a 10% rate of return.)
Albert Einstein called the power of compounding the eighth wonder of the world.
Today's workers can do this retirement savings with pre-tax dollars in their 401(K) or IRA.
But, what happens when the time comes and you withdraw the money?
The entire withdrawal is subject to income tax. If you die and leave your 401(K) or IRA to your children or other beneficiaries, it is taxable upon withdrawal by them.
Further, if you die with more than $2 million, including your retirement assets, the balance of the retirement plan before the impact of income tax will be included in determining your estate taxation.
The combined affect of estate and income taxation could result in the majority of the assets going to pay taxes.
For example, assets over $2 million are estate taxed at 45 percent. If some of the assets are withdrawn to pay the estate tax, the withdrawal would incur federal and state income tax of as much as 35 or 40 percent. So, you could easily have 2/3 of the assets going to taxes.
There are a few strategies to help soften the blow of the tax bite on retirement plans. First, you can defer the income taxes as long as possible. After you reach age 70, you must start taking distributions based on the "Uniform Lifetime Table."
Based on this table, you would take approximately 1/27 the first year, and slowly increasing percentages each subsequent year.
For example, at age 85, you would be required to withdraw approximately 1/15 that year.
After your death, you can get the maximum stretch for the income taxation deferral by naming younger beneficiaries who can stretch it out over their longer life expectancies.
However, often you want to keep younger beneficiaries from having control of assets. In that situation, you can use a Family Retirement Preservation Trust to get the maximum stretch for distributions after your death.
Such a trust allows you to keep the assets in trust but still look through the trust to the ages of the individual beneficiaries.
You can also start taking withdrawals from your retirement plan and use those distributions to pay for premiums on a life insurance policy.
While you need not take withdrawals until after you reach 70, you may start taking withdrawals from retirement plans beginning at age 59 without penalty.
The life insurance policy can be owned by an irrevocable trust you set up. If done properly, the life insurance can be outside your taxable estate.
This can help avoid estate taxation and converts an asset that is subject to income and estate taxation into an asset that is subject to neither.
Saving for retirement is important. However, it is also important to consider how to avoid the unexpected tax trap retirement assets can put you in.
A qualified estate and retirement planning attorney can help you enjoy the trappings of retirement without the tax traps.
Robert J. Kulas is a member of the American Academy of Estate Planning Attorneys and the National Academy of Elder Law Attorneys. He has been engaged in the practice of law in Florida for the last 23 years. For more information or to attend an upcoming seminar, call 398-0720.