03-24-2014 09:00 AM
Content provided courtesy of USAA.
By JJ Montanaro, CERTIFIED FINANCIAL PLANNERTM
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 nonretirement 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, you 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 toward 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 nonretirement 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.