Financial Advice Blog

Let the Tax Brackets Guide Your Retirement Plan Withdrawals

by Community Manager  |  Retired, Army  |  San Antonio, TX  |  ‎03-10-2014 08:51 AM

Tax bag hand over - shutterstock_51755932.jpg

At times, I feel like a broken record:  “Save, save, save!”  That’s my mantra when it comes to preparing for retirement. But recently, I’ve received quite a few questions from those who have already crossed the retirement threshold.  They’ve done the heavy lifting, built a nice retirement fund and are now trying to figure out how and in what order to start using it.  Should they dip into their 401(k) first? What about tapping traditional IRAs, Roth IRAs or even money outside of retirement accounts? It’s a good problem to have, but a problem nonetheless.

 

The “Right” Order

Traditional wisdom would dictate using non-retirement accounts first then shifting to traditional retirement accounts and finally, tapping Roth accounts. The general idea is to hold on to the tax advantages of these retirement plans as long as possible. It’s a solid approach and in many cases, it could be the right answer for retirees. Even so, for some folks it might make more sense to modify the approach a little to avoid missing an opportunity provided by our progressive tax system. Yes, I used “opportunity” and “tax” in the same sentence, but stick with me.

 

Max the Most of Your Tax Bracket

It’s no secret that the more income you have, the higher your taxes will be. What’s often overlooked though is that in our system, everyone pays the same tax as their income moves through the tax brackets. For example, in 2014 you, me and Warren Buffet will all pay the same 15% on our 30,000th dollar of taxable income. Granted, Warren may blow right through the tax brackets to the point he’s paying 39.6% on most of his income, but that doesn’t change the fact that the 30,000th dollar will still be taxed at 15%. What’s my point? You may or may not have room within the 15% tax bracket and that could affect how and when you withdraw money from your retirement accounts.

 

In 2014, the 15% tax bracket applies to taxable income between $18,151 and $73,800 for joint filers (the range is $9,076-$36,900 for single filers). Taxable income is your income after deductions and exemptions. So, after you subtract $20,300, the standard deduction and exemptions for a couple, they could have adjusted gross income of up to $94,100 and still remain in the 15% bracket. And there lies the potential opportunity.

 

You may assess the tax landscape and your personal plan and decide that withdrawing money from your IRA or old 401(k) and paying 15% is a relatively good deal. If that’s the case, the old rule of thumb to delay touching your tax-deferred assets may not hold true … at least for the portion you could withdraw and still remain in the 15% bracket. For example, if you are on track to finish the year with $53,800 of taxable income, you could voluntarily withdraw up to $20,000 from a traditional IRA or retirement plan and still only pay 15% tax on the withdrawal. 

 

On the other hand, you might review your finances and find that you’re on target to finish the year with $72,000 of taxable income — you’re creeping towards the top of the 15% bracket — but still have a vacation, car or some other major expense that you’ll need to withdraw funds to cover. In that situation, you might choose to use non-retirement or Roth money to avoid climbing into the 25% tax bracket.

 

On a cautionary note, if you’re currently below the maximum Social Security taxation limits, adding additional income could cause a larger portion of your benefit to be taxable.

 

In any case, the key is to understand where you’re at in the tax bracket structure and recognize how it might influence your decision with respect to tapping your retirement funds.  This is something you or you and your team of advisors should be aware of and take into consideration as you map out your plan for how you’ll use your money in 2014. Good luck.

 

 

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Comments
by Paul1977 ‎05-15-2014 07:55 PM

This information on managing tax obligations for the long term -- that resulted from long term tax deferred investing -- is exactly what I've been looking for. Thanks!

by Summerman ‎06-11-2014 04:59 PM

There isn't really anything new here, but it is a good reminder. However it isn't really very helpful. What would be really helpful would be a program where you could enter your projected income, filing status and other necessary information and have the program tell you how much of your Traditional IRA you could take out and still be in the 15% bracket and how much more of your Social Security would be taxed and what would the taxable amount be.

by JNL ‎06-11-2014 05:15 PM

I agree with Paul1977...perfect article with the needed detail about tax %!  Thank you!!!

by Aristodemo1 ‎06-12-2014 07:08 PM

This is very good information about a topic that is rarely discussed.  I started taking money out of my IRA at age 59.  Today I have more money in the IRA than I did when I started six years ago even though I took out more than 10% the last two years.  This may not sound like a problem but it is.  My father passed away two years ago with money in an IRA and the taxes after death are very onerous.  Unless you plan on a stretch IRA it is often best to get the money out while you are alive at lower tax brackets.  If you don’t, your heirs may lose much of it to a much higher tax rate after you are gone.

by DCG ‎07-09-2014 02:58 PM

*Summerman & JNL-

It's pretty easy to set up a spreadsheet to tell you exactly what you want to know.  Even better, if you do your own, it is customized for your situation; not just generic.

by Swimmer333 ‎07-09-2014 03:02 PM
I agree with Summerman: an online calculator would be most helpful. If instituted on USAA site, be sure to provide for single filers.
by KayK ‎07-09-2014 05:45 PM
Very good information to know and think about. Especially you spend most of your life trying to save for retirement and not get the chance or full benefit to use it.
by BeeGee ‎07-09-2014 08:23 PM

I thought this was novel, so I ran the calculations for my own situation as a 66 year old retiree.  The near-term reduction in taxable traditional IRA withdrawals using Roth IRA's to stay in a lower bracket, is significant.  It is more difficult to rationally assess the alternative of sticking to conventional wisdom and keeping Roth IRA's intact to the very end, perhaps 30 years away.  One complication not mentioned is that Social Security is not all taxable, so you have to wrap that into your individual evaluation of which path is best for you.  If all your income is from IRA's, the Roth alternative & staying in a lower tax bracket is very attractive.  A lot depends on the relative size of your Roth accounts and your traditional IRA's, assumed growth rates, and how much of your income is actually taxable at these higher rates (e.g. inheritances, gifts, dividends, & Social Security, might all change your individual equation...). 

by Jayhawk49 ‎07-10-2014 05:01 AM

"you’re on target to finish the year with $72,000 of taxable income — you’re creeping towards the top of the 15% bracket — but still have a vacation, car or some other major expense that you’ll need to withdraw funds to cover. In that situation, you might choose to use non-retirement or Roth money to avoid climbing into the 25% tax bracket."

 

This would be a good idea except if you use "non-retirement money" that comes from the sale of stocks or mutual funds from which you have capital gains from the sale, those gains can push you over the $72,800 taxable income "limit." If someone believes I have this wrong please let me know!

 

I agree with the poster who suggested an "app" or program to make the calculation easier would be nice. Great discussion...thank you!

by Community Manager ‎07-10-2014 07:31 AM

Actually Jayhawk49, income from capital gains is not included in your income that's subject to the marginal income tax brackets. Consequently, it wouldn't bump you into a higher bracket. There are separate capital gains tax rates and as long as you're in the 15% bracket, your capital gains from the sale of "non-retirement money" like stocks and mutual funds are taxed a rate of 0%. So using this pool of funds wouldn't increase your tax liability. But as we always caution when discussing income taxes, it's usually wise to consult with a tax pro about your specific situation just to make sure these high level rules we've covered are applicable in your situation. 

 

Thanks for the follow-up!

 

Scott

by blaster12 ‎07-10-2014 09:41 AM

If you are not getting this information in a projected tax bracket for the following year from your financial and tax advisor, you are getting shortchanged. This is invaluable for retirees. Tax and health care costs are game changers for all of us.

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J.J. Montanaro

Joseph "J.J." Montanaro is a CERTIFIED FINANCIAL PLANNER™ practitioner.

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