We spend a lot of time and effort accumulating a retirement fund. But at a time when retirement can last for over 20 years, we also need a tax-efficient withdrawal strategy to help our nest egg last longer.
Various types of retirement income are taxed at different rates. Here's a look at the different types of income and their respective tax rates in retirement:
Ordinary income tax rate. Once you retire, you won't have a regular paycheck anymore and your ordinary income tax will decrease significantly. But you'll still probably have to pay tax on these sources of income:
--Tax-deferred account withdrawals from traditional IRAs and 401(k)s
--Short term capital gains (gain from sales of assets held under 1 year)
--Annuity payouts may be taxable
--A portion of your Social Security benefit may be taxed federally depending on your income
--Your traditional pension benefit might be taxable
Long-term capital gains tax rate. Income from these investments is taxed at the 0 to 15 percent rate depending on your ordinary income tax rate.
--Qualified dividend income
--Sales of assets held over 1 year in a taxable brokerage account
Tax-free accounts. There is no tax due on withdrawals from these accounts if you are at least age 59 1/2 and the account is at least 5 years old:
Make a withdrawal strategy. The first thing you need to do is figure out how much income you will get in the form of monthly payments from a pension and Social Security. This will give you an idea of your marginal tax bracket. Next, figure out your deductions because this will offset your ordinary income. The overall goal is to avoid the top marginal tax rates of 28 percent, 33 percent, and 35 percent.
Once you know your marginal tax bracket, then you can estimate how much of a withdrawal you can take from your tax-deferred accounts before you will hit the next tax bracket. If you need more income, then look to dividends and long-term capital gains first. After that, you can tap tax-free Roth accounts.
Let's look at an example. John is 67 years old and single. He receives a Social Security benefit and a small pension from his job totaling $30,000 per year. He takes the standard deduction for a single person (around $6,000). This means his adjusted gross income (AGI) is $24,000. He needs $50,000 to comfortably fund his retirement, so he makes an $11,000 withdrawal from his IRA (tax-deferred account). This pushes his AGI to $35,000 and he is still in the 15 percent tax bracket. From here he can generate $15,000 from dividend income, long-term capital gains, and withdrawals from the IRA. Since he is in the 15 percent ordinary income tax bracket, he won't have to pay any tax on the dividend and long-term capital gains.
Of course, it all depends on your situation. If your tax-deferred account is really large, then it will probably be better to withdraw from the tax-deferred account first to reduce the required minimum distributions (RMD) that will be due when you hit age 70 1/2. In John's case, if he has a million dollars in his traditional IRA, then he'll have to withdraw about $36,500 in the year after he turns 70 1/2. This will push him into the next marginal tax bracket of 25 percent. This is not bad since John is already living a comfortable life and he still avoids the highest tax rates. However, if John has 3 million dollars in his IRA, then he will have to take $110,000 RMDs and he will be pushed up to the 28 percent bracket. In this case, John probably should withdraw more from his traditional IRA earlier to reduce his RMDs later.
If you are younger than 60, this underscores the importance of diversifying your investments with different retirement accounts. We need to invest our income in all these tax buckets so we'll have more choices when it's time to withdraw. The tax-free bucket will give you the most flexibility in retirement.
Joe Udo is planning an exit strategy from his corporate job by reducing expenses and increasing passive income. He blogs about his journey to early retirement at Retire by 40.