Death is inevitable; taxes aren't

By Barron's

Boomers, beware: You could be on the verge of blowing a big hole in your finances. Not from poor investment or budgeting moves; you probably know how to manage those financial affairs pretty well. No, we're talking about the danger of paying too much in taxes.

The tax pitfalls for baby boomers in coming years are likely to be steeper and more numerous than they were for previous generations at the same stage of life, advisers say. That's because the 75 million-plus people born between 1946 and 1964 control an unprecedented amount of money -- some $23 trillion -- and vast amounts of it will be on the move over the next decade or so.

For example, some $3 trillion is likely to be rolled out of 401(k)s over the next decade, and an estimated $4 trillion will be cashed out of retirement accounts in general. About $11 trillion is predicted to be inherited by baby boomers, and an additional $4.6 trillion will change hands between 2006 and 2014 through the sale of businesses, mostly by boomers.

By 2020, when the last of their generation has turned 55, they will own some $30 trillion in assets and be faced with the challenge of passing them to their heirs without also passing them large tax burdens. The danger: unwittingly letting more money than necessary become fair game for Uncle Sam.

"After spending years accumulating wealth, people don't realize how easily they can decimate their retirement assets simply by not understanding the tax consequences of how they manage their money," says Avon, Conn., financial planner Michael Reilly.

As this year's tax-planning season gets under way, folks in their 50s and 60s would do well to start preparing for five key financial events:

Rolling out of a 401(k)

If your 401(k) holds stock of a company you've been employed at, and you are approaching retirement, consider this little-known tax break: By transferring your company stock into a brokerage account instead of rolling it into an individual retirement account, it can get more favorable tax treatment.

Typically, money withdrawn from a tax-deferred account is subject to income tax rates as high as 35%. But under the tax break, you would owe income taxes only on the cost basis of the shares when they get transferred. The gains -- or the "net unrealized appreciation" -- will be taxed at the 15% long-term capital-gains tax rate when you ultimately sell them from your brokerage account.

Here's how it works. Assume your shares of company stock are now valued at $200,000; they were worth $20,000 when you received them; and you are in the 35% income tax bracket. Roll the money into an IRA, and your after-tax value would be $130,000. But with the brokerage account tax break, after paying income tax on the cost-basis and capital-gains taxes on the appreciation, the after-tax value would be $166,000. "The more gains you have, and the higher your tax bracket is, the more savings you can realize," says Mark Cortazzo of Macro Consulting Group in Parsippany, N.J.

You can generally use this strategy only if you have not taken any distributions from your 401(k) since turning 59½. In addition, all of your 401(k) assets must be rolled out in the same calendar year. However, you can divide your company stock by rolling some of it into an IRA and the rest into a brokerage account.

Carlo Croce, 66, of Riverdale, N.J., a retired Pfizer engineer, had about 50% of his 401(k) assets in the drug giant's stock. Most advisers recommend holding no more than 10% of company stock. To diversify without incurring an immediate, large tax burden, Croce rolled some of his Pfizer shares into an IRA, where he could sell them without triggering an immediate tax bill. The rest he transferred into a brokerage account and, on that portion alone, saved himself a six-figure tax bill.

Receiving an inheritance

One of the biggest blunders beneficiaries make: cashing out an inherited IRA rather than preserving it and taking required minimum distributions over their lifetimes. The tax consequences of liquidating are enormous, and you miss the opportunity to get tax-deferred growth on the money.

Say you inherit a $500,000 IRA at age 50. If you cash it out immediately, you would, at the 35% tax rate, net $325,000 after income taxes. In contrast, if you take annual minimum distributions based on an Internal Revenue Service formula -- starting at $14,619 and getting larger each year -- by age 84, the total amount you will have pocketed will be $2.7 million, assuming an 8% average annual return, says Alan Augulis, an estate planner in Warren Township, N.J.

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