Three moves to save your retirement fund

(Fortune Magazine) -- When it comes to saving for retirement, it's natural to think you can never have too much of a good thing: The more you sock away in tax-deferred IRAs and 401(k)s the better, right? Not so fast.

If you're not careful about the way you save - and how you start withdrawing money as retirement nears - you or your heirs may watch your hard-earned savings disappear into the hungry maw of the Internal Revenue Service.

Tax-deferred accounts such as IRAs and 401(k)s are among the best vehicles for retirement-wealth accumulation known to man (and given the demise of the traditional pension, they're increasingly the only vehicle for many people).

As a result, such accounts are ubiquitous. But tax-deferred accounts have been around for just three decades, so it's only recently that many people have accumulated large balances in them. That makes smart tax strategy more critical than ever for all holders of traditional IRAs and 401(k)s, especially those who've squirreled away a lot of acorns in their tax-sheltered nests.

Many people amass large traditional IRAs when their 401(k) or pension plan is transferred into an IRA upon retirement. In 2005, 22% of traditional IRAs held more than $100,000, according to the Investment Company Institute. Some 16% of 401(k) accounts boast similarly big balances, according to a 2005 survey by the ICI and the Employee Benefit Research Institute.

Having large, tax-deferred balances can pose problems when you retire, as various investments are suddenly exposed to taxes. Granted, it's a nice problem to have: Most people don't save enough, period. But being careful about how you save and not just how much can mean the difference between spending your retirement winters in your snowbound home or in a beach condo funded by the dollars you would otherwise have forked over to Uncle Sam. IRA tax traps are surprisingly dangerous - and avoidable. Here's how you can sidestep some common perils.

Many people allocate investments to the wrong accounts, says Joan Crain, senior VP at Mellon Financial: They jam their IRA full of growth stocks and funds "because it's tax-deferred and you want to grow this thing as large as you can."

Meanwhile they park nonprotected assets in safe vehicles such as tax-free municipal bonds or deploy "play money" on risky small-cap or emerging-market picks in hopes of turbocharging their returns. "This," says Crain, "gets it exactly backwards."

Why? First, the distributions - both the principal and the gain - from traditional IRAs are taxed as ordinary income, with rates as high as 35%, not including state taxes. Long-term capital gains, by contrast, top out at 15%. Since most investors keep the bulk of retirement savings in large-cap stocks, many will see much of their portfolio exposed to those high income taxes.

The other reason not to cram your IRA with giant-company stock funds: Most large-cap and index funds have low turnover (i.e., they don't trade very often) and throw off little income - as financial advisors say, they are tax-efficient. So stashing them in a tax-deferred account saves you little.

At the same time the investments people often keep in a taxable account - small-cap and emerging-markets funds and income producers like REITs and bond funds - tend to be highly inefficient, with high turnover rates and lots of dividend income or cash distributions. That means the taxman takes a nibble each year.

Solution: Put the least-tax-efficient assets in your IRA

This example, provided by Mellon, shows why: A 50-year-old marketing vice president has a $2 million portfolio, 60% in stock funds and the remainder in bonds. Assume she splits her portfolio between a traditional IRA and a taxable account, holding $1 million in each, with both accounts having the same 60-40 stock-to-bond mix.

In 20 years she'll have $4.6 million in her IRA and $3.8 million in her brokerage account, for a total of $8.4 million. (For those yearning for the fine print, this assumes a 9.5% blended return for stocks, 6% for corporate bonds, and 4.5% for municipal bonds. It also assumes 5% annual turnover in the large-cap stocks and 10% turnover in the other stocks.)

If she had allocated her investments with tax efficiency in mind, all her fixed-income holdings - $ 800,000 - as well as $200,000 in small caps and emerging-market funds would be deposited in her IRA. Her brokerage account would consist of $1 million in stocks, mostly large caps, with some other mid-cap and international stocks. Using the assumptions above, she'd now have $3.75 million in her IRA after 20 years and $4.85 million in her brokerage account, for a total of $8.6 million.

That's $200,000 more than she generated when she ignored tax efficiency - and it gets better when she cashes out. Taxes whittle her evenly divided portfolio from $8.4 million to $6.6 million. But in the tax-efficient portfolio, she ends up with $7.1 million. That's $500,000 better - enough for that beach condo.

What if you've already larded your IRA with large-cap stocks? It's usually fairly easy to switch to bonds. But altering the asset mix in a taxable account can be prohibitive because of capital gains taxes. Also, many 401(k)s don't offer exotica like emerging-market funds that really benefit by being tax-deferred. If your plan allows it, says Chris Cordaro, a financial planner at Regent Atlantic Capital in Chatham, N.J., explore transferring your 401(k) into an IRA before retirement - so that you can choose among a broader variety of investments.

The IRS forces you to start withdrawing from your IRAs at age 70 1/2. These required minimum distributions, which are set according to life expectancy tables, can be substantial if your account balance is big and bump you into a higher tax bracket, soaking your distributions - and other income - with extra-high taxes. "A lot of people get this backwards too," Crain says. "When you retire, you should aim to be at a lower tax rate than when you are working."

Solution: Start taking distributions before you have to

The law permits IRA withdrawals without penalty or minimum between ages 59 1/2 and 70 1/2. You can often make withdrawals without jumping into a higher tax bracket and can reinvest the money in a way that shelters it from the IRS. For instance, if household income is under $100,000 (a cap set to be eliminated in 2010), you can shift money from your traditional IRA into a Roth IRA, where it can grow tax-free. Should you make too much to qualify for a Roth, you can employ tax-sheltered annuity trusts.

You no doubt have better reasons to go on living than to avoid taxes, but add this to the list: If you expire while holding a large IRA balance, you may give your heirs extra reason to grieve. A spouse can usually inherit an IRA without income tax effects. Other heirs aren't so lucky.

If you die before age 70 1/2 and your IRA passes to someone not named as the IRA's beneficiary, that person must start taking distributions within a year of your demise and empty the IRA within five years. Not only does that mean that much of your savings will end up in IRS coffers, but those distributions can push your heirs into a higher tax bracket. If the inheritor is named as the IRA's beneficiary, that person still has to start taking payouts within a year but may stretch them over his life.

If you've already hit 70 1/2 when you buy the farm, your heirs must take distributions based on the number of years remaining in your assumed life expectancy. Plus, if your estate is large enough - above $2 million, currently - they may have to pay as much as 55% in estate tax.

Solution: Reinvest IRA payouts to avoid taxes

Shift your distributions to a Roth if possible. Set up a trust for your heirs. And be sure to name beneficiaries for your IRA. Another benefit of concentrating more of your portfolio outside your IRA: If your heirs inherit stocks or bonds from a taxable account, they'll owe capital gains tax only on the increase in value from the time they inherit the investments as opposed to the time you bought them. The impact can be dramatic: This strategy would save $125,000 in taxes for the heirs of the marketing VP cited by Mellon.

If you qualify for a Roth, you benefit from tax-free distributions. If you don't qualify, consider moving your assets into an annuity product or a trust that can shelter the money from the IRS.

The trick - and we're not saying it's easy - is to avoid holding more in your IRA than you'll need in your lifetime. "It's always a bit of a balancing act," says tax lawyer Jonathan Forster of Greenberg Traurig, "since no one wants to run out early."

But seek help from a financial advisor or tax expert; the rules are complicated and the pitfalls many. It's possible to retire in style while giving your heirs - not the taxman - a nice boost. Just remember, when it comes to a traditional IRA, bigger isn't always better.

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