Investing—Taxes February 24, 2010, 9:35PM EST

Taxes: Finding the Right Fit

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Once an investor has retired, he can take the distribution on any assets within a taxable account without having to pay any further taxes.

Tax-Deferred Accounts

Tax-deferred accounts such as IRAs and 401(k) plans should be reserved for less tax-efficient assets such as actively managed mutual funds with higher turnover and more frequent capital-gains distributions, including most small-cap funds, says Brent Burns, president of Asset Dedication, a Mill Valley (Calif.) firm that provides fixed-income asset allocation strategies to independent financial advisers. Short-term capital-gains distributions currently are taxed as ordinary income, up to 35% depending on your tax bracket, and likely up to 39.6% in the future.

IRAs and 401(k)s are also best used by investors who aggressively buy and sell securities, making them subject to short-term capital gains. Securities that produce taxable income, such as preferred stocks, real estate investment trusts (REITs), and corporate bonds, can get the maximum benefit from income compounding over time by being in tax-deferred accounts, says Nersesian at Nuveen. Any gains from an asset within a tax-deferred account will be taxed as ordinary income upon withdrawal.

Until now, investors' attention has been focused on wealth accumulation for retirement. But now the baby boomers are starting to confront the issue of how to withdraw this money intelligently, experts say. Burns at Asset Dedication advises people preparing for retirement to figure out how much of their Social Security income will be subject to income tax, so they know how much more they can withdraw each year from a tax-deferred account and remain in their desired tax bracket. Anything they need beyond that has to come out of their taxable accounts. A married couple, for example, will be taxed at the 15% rate as long as their income doesn't exceed $67,900. If they need $90,000 a year to support a certain lifestyle, they know they'll have to take $22,100 out of their taxable account, Burns says.

Retirees are better off deferring withdrawal of assets from retirement accounts and using other resources, if they have them, to meet their lifestyle needs, says Nersesian. The one exception is the opportunity to convert tax-deferred accounts into Roth IRAs, on which they pay the taxes up front. "I'm not suggesting most investors should convert, but at least they should look into the benefits of conversion," he says.

Most experts recommend Roth conversions this year where it makes sense for an investor, especially since the ban on conversions for people earning more than $100,000 a year was removed as of Jan. 1, 2010.

Roth Conversion Factors

Nersesian cites some factors to bear in mind when deciding whether to convert a conventional IRA to a Roth plan. Most important, Roth distributions on income earned on principal are only tax-free if you meet a five-year holding period requirement. Next, a conversion is only beneficial if you are able to pay the conversion taxes with outside monies instead of reducing the amount in your account to do so. Third, if you want to avoid the required minimum distribution that takes effect at age 70.5, Roth plans allow you to do so. Fourth, if you have nondeductible, or after-tax, contributions in your retirement account, those become tax-free after you convert those balances to a Roth account.

Be careful, though, if you have multiple retirement accounts, some of which have nondeductible contributions and some of which don't, because you're required to aggregate all those accounts on conversion and would only get credit for nondeductible contributions on a percentage basis.

A partial conversion is another option, says Nersesian. If you have a $100,000 IRA, you can choose to convert only a certain portion that keeps you at a particular tax bracket before you get bumped to a higher bracket. Partial conversions also provide a hedge: If you're still working past retirement age, keeping half your money in a regular IRA and half in a Roth account gives you some flexibility to make withdrawals during retirement from whichever account is most advantageous, he says.

Bogoslaw is a reporter for Bloomberg BusinessWeek's Finance channel.