Even Less Reason in 2010 to Withdraw From Your Tax-Deferred Accounts

During your retirement, you’re often advised to live off your taxable accounts first before using your tax-deferred accounts. That’s because withdrawing from your tax-deferred accounts will tax you more whereas keeping them untouched allows them to grow faster than your taxable accounts.

This article clarifies the assumptions in this advice and explains why there’s even less reason to tap those deferred accounts in 2010.

This advice assumes you have significant savings in both taxable accounts and tax-deferred accounts so that you can choose which type you wish to withdraw from. Otherwise, you can forget it. If you’ve got most everything in tax-deferred account, then you ought to leave the little you have in taxable accounts for emergency cash.

Tax-deferred accounts are those government-regulated retirement savings accounts that you get a deduction for contributing to (which gives them a ‘zero’ tax basis), grow tax-deferred, but have their withdrawals subject to your income tax rate – a potentially high tax bracket rate. Your IRA and 401(k) plans are examples.

Taxable accounts are really everything else. You contributed to them with after-tax money which gives them a tax basis. Those types of investments that earn interest or dividends are taxed yearly; those investments you sell (like stocks, or property) will be subject to a capital gains tax – but only in the year you sell them.

The investments you can hold in both types of accounts – taxable or tax-deferred – can generally be the same. But all types of investments are taxed the same under tax-deferred accounts while different types of investments have different taxation rates under taxable accounts.

Since taxable accounts have a basis which is never taxed when withdrawn, and the fact that tax rates on qualified dividends and long term capital gains are generally low – like 0%, 10%, 15% (depending on your income tax bracket), you’ll lose less in taxes when you withdraw money from taxable accounts.

Generally, though, you must make at least minimum required distributions (RMDs) from your tax-deferred accounts after you’ve turned 701/2. But you could choose to withdraw only the RMD and no more to maintain the conventional advice from above.

Are there any reasons to tap your tax-deferred accounts first?

One reason given for tapping your tax-deferred accounts more than the RMD for your living expense – when you have the choice to do otherwise – is for minimizing tax liabilities for your beneficiaries. Here are two reasons supporting this view.

First, your beneficiaries that receive your tax-deferred accounts will be subject to making at least RMDs for their remaining life expectancy at your death. Those RMDs or any more money withdrawn each year will be taxed at your beneficiary’s highest tax bracket rate since he’ll probably have a working income too. So, if you use much or all of your tax-deferred funds before you die, then you’re leaving less tax liability for him since your remaining taxable accounts (with their tax basis and lower taxation rates) hold less tax liability to him.

Coupled with this, is the second reason. And that’s that in the past, beneficiaries of your taxable accounts – such as your stocks and other investments like a house – have received a stepped-up basis to their fair market values at the date of your death. This often eliminated large potential capital gains -due to the deceased relatively low bases compared to fair market values – that would be taxed when the beneficiary sold such investments. So, leaving your beneficiaries a lot of taxable accounts allows the stepped-up basis to eliminate much of their tax liability for capital gains taxes when they sell them.

But now there are less reasons in 2010

Unfortunately, the stepped-up basis of a deceased’s estate investments is eliminated for those dying in 2010. That pretty much eliminates the second reason for preferentially tapping tax-deferred account first.

The first reason is a little weak too, since young beneficiaries have such small RMDs that their inherited tax-deferred account may still increase faster than RMDs can deplete them for many years. Then they’ll be taxed less when those beneficiaries start their retirement.

Hopefully, the stepped-up basis will be back for those dying in 2011 or later if federal legislators hurry up and come up a reasonable estate tax scheme for future years. Just figuring out what the basis is for many of the holdings of elderly people can be quite a challenge. Assigning them a stepped-up basis to fair market value at their death makes things a lot easier – not to mention a good tax break for their beneficiaries.

2 Basic Methods Of Accounting

When you’re working in accounting, there are two basic methods. You have your cash basis and accrual basis. Whichever methods you choose will depends on your type of business.

Cash basis is the simpler method. It is mainly use by service businesses that do not maintain inventory or startup businesses that do not offer credit. The accrual method is used by businesses that provide for credit sales or maintain an inventory.

In cash basis accounting, your record sales when cash is received and expenses when they are actually paid. Using the cash basis method is like maintaining a checkbook. Under this method, account receivable are not recorded as sales until they are collected. Account payable are not recorded as expenses until the account is paid.

Bad dept, accruals and deferrals are not appropriately recorded under cash basis because they are examples of outstanding credit or business notes. The cash basis method is not appropriate for businesses that extend credit.

In accrual basis accounting, you report income and expenses as they are earned or incurred rather than when they are collected or paid. Record credit sales as accounts receivable that have not yet been collected. The accrual basis also provides a method for recording expenditures paid in a single installment but covering more than one period. For example, interest may be paid semi-annually or annually, but it is recorded on a monthly basis.

The accrual method satisfies the matching concept, i.e., matching income with related expenditures. Consequently, it can provide a clear and accurate view of business operations for a given period.

Cash Accounting or Accrual Accounting

The tax authority require bookkeeping records to calculate the tax due. The choice for small business is basically cash accounting or accrual accounting each of which has advantages and disadvantages.

The date of the sales invoice and the date of purchase invoice are known as the tax point. The tax point does not determine the spread of that transaction over the tax period which can be different when accounts are prepared on an accruals basis as opposed to a cash basis.

For the purposes of cash accounting the effective inclusion of the transaction in the financial records is the date the cash or bank receipt or payment was made. The tax point date on the document is not the deciding factor to include the item in the accounts. The date the amount was paid out or received into cash funds or bank account is the date to be used fopr inclusion in the accounts.

There are disadvantages to maintaining accounts on a cash basis in that records must be kept of all payments received and paid out and those records supported by the actual primary accounting documents to which they relate. That entails matching the financial documents to the payments and receipts records, a feature many small businesses might find onerous as record keeping ios often regarded by samll business as an administrative burden.

Virtually all professional accountants adopt an accruals basis for clients accounting purposes as it is based upon recording all financial information whether relevant to the tax period or not and then adjusting the management accounting profit indicated to produce the net taxable profit or loss.

By operating an accruals basis all financial documents are recorded according to the tax point date. If every transaction was paid or received within the year then the cash accounting and accruals basis would produce the same tax accounts.

The main adjustment a small business or the accountant might make to accounts prepared on the accruals basis is to first prepare the set of accounts according to the tax point of the primary accounting records and then examine those transactions and adjust them according to their relevance to the financial period for which the accounts are being prepared.

A typical example of the difference would be the rent invoice for the business premises. Let us assume a quarterly rent invoice was received dated 1 December for the 3 months from December 1 to February 28 which was paid by the small business owner by cheque on December 31 and a year end date also of December 31

On a cash basis the rent would not technically be included in the accounts as it would be shown as a rent payment from the business bank account on January 2 or later if cashed by the recipient at a later date. Therefore that quarters rent would be included in the following year accounts not the current year as issuing a cheque is not a payment but actually a promise to pay.

Assuming the rent was paid in cash prior to the 31 December then the whole 3 months rent would be included in the current financial year. That treatment may have distorted the accounts as more or less than 12 months rent might have been included in the tax calculations.

On an accruals basis the rent invoice would have been entered in the accounting records with an effective date of December 1. The accountant or small business owner preparing the accounts would deduct 2 months from the qaurterly amount leaving one months rent in the current year accounts with the other 2 months being included the following year.

That is more accurate as the other side of the accounting would be for that same accountant or bookkeeper to further include the 2 months rent not already claimed to be included in the tax calculation for the next financial year. Mvoing the prepayment not specific to the accounting period is how business treats a prepayment under accrual accounting.

When operating cash accounting only transactions actually paid for or received are valid. On an accruals basis provisions can be made for costs incurred by the business whicvh have not yet been invoiced.

Cash accounting might appear easier but has the disadvantage of maintaining receipts and payments records in addition to the primary documents which should also be matched to the financial transactions to support the accounts.

Accrual accounting is based upon recording all financial transactions and then adjusting the end result to determine the most accurate net taxable profit. The accruals basis is favoured by accountants as it reaches an accurate tax liability as opposed to more or less tax being payable on the cash basis according to the credit control policies and practises of the business its suppliers and clients.

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