As you approach retirement, it’s important to keep in mind the complexity that comes along with planning to distribute your retirement savings.
Leading up to retirement, financial decisions are relatively simple. You decide how much you can save, what type of account to save it in, and how to invest within that account. Retirement savings tax decisions are also fairly simple – will you save in an account that provides a tax deduction (like a 401k) or one that does not?
Once you actually retire and need to use your savings, things get much more complex. You’ll now have to make decisions about which type of account you want to withdraw from; which assets within each account to sell or use for your spending; how each withdrawal decision will impact your taxes; and how withdrawal decisions in retirement can impact other areas of your financial picture.
If you have multiple types of retirement savings accounts, such as a 401k or IRA, a Roth IRA and brokerage or bank accounts, you’ll need to understand the tax implications of taking withdrawals from each type of account.
The most common retirement savings accounts are pre-tax accounts, like 401ks and Traditional IRA’s. These accounts allowed you to save for retirement and deduct the amount of your contributions to the account from your taxable income in the year you made the contribution.
You saved on taxes then, but with the caveat that you’ll pay ordinary income taxes on the full amount of withdrawals from these accounts in retirement. In effect, your withdrawals from your pre-tax accounts are counted in your taxable income for the year you take the withdrawals.
You’ll also need to be careful – if you withdraw from pre-tax accounts before you reach age 55, or from Traditional IRAs before age 59.5, you may also owe a 10% early withdrawal penalty.
By using your pre-tax accounts for retirement withdrawals, you can potentially increase your tax bill beyond just the tax on the withdrawal itself. The portion of your Social Security benefits that are taxable can range from 0% to 85%, depending on the amount of your non-Social Security income each year.
If you also have income from long-term capital gains in your brokerage accounts or qualified dividend income, the tax rate you pay on those sources of income can vary depending on the level of your total taxable income each year. In fact, if you’re qualified income is below $83,350 if married filing jointly ($41,675 for single) for 2022, you can pay 0% tax on long term capital gains and qualified dividend income.
So, the decision to withdraw from pre-tax accounts can potentially increase your tax bill on the withdrawal and other sources of income.
However, at the same time, building up larger balances in your pre-tax accounts early in retirement could potentially result in higher taxes in the future.
Under current law, at age 72, owners of pre-tax retirement accounts like 401ks and Traditional IRA’s must take a Required Minimum Distribution from these accounts. The amount of the withdrawal is set by actuarial rates, but typically results in a withdrawal between 3.5%-4% of the balances held in those accounts. Social security income will be in effect by this point, and potentially other sources of income, such as pensions, annuity distributions or investment income from brokerage accounts or real estate. If the combination of income is large enough, this could push you into higher tax brackets.
Total income above $228,000 for MFJ ($114,000 single) in 2022 can result in an increase for the cost of Medicare premiums for someone in at this stage. This “income-related monthly adjustment amount (IRMAA)” raises the monthly premium cost for Medicare, and the increased premium cost can range from $68-408.10 per month, depending on the level of income above the thresholds.
The IRS looks back at your income from 2 years ago for the current year IRMMA and updates the calculation each year. So, some advance planning and keeping regular track of all of your income sources can help you plan to effectively address these surcharges. With the 2-year look back and some unavoidable required income (such as SS and your RMD) it can be complex to manage all the factors that could impact your total taxes and surcharges once you are above RMD age.
Choosing which and what type of asset to use for retirement spending can also be a complex matter. For example, if you are withdrawing funds for retirement spending, your ultimate tax result will depend on the type of account and the type of asset you are using for withdrawals.
Let’s look at a couple of examples. Let’s assume you needed a withdrawal of $40,0000 for your annual spending.
If you withdraw from cash savings in a bank, you typically have very little tax impact. You would have no capital gain or loss and your investment income would be limited to the interest you received in the bank account that year.
If you withdrew the funds from a pre-tax account such as an IRA, you’d have ordinary income tax at your current tax rate on the entire $40,000.
If you withdrew $40,000 from a taxable brokerage account, it would depend on the asset’s type and disposition when you made the withdrawal. If you sold stock at a gain that was held for more than 1 year, you’d owe long term capital gains taxes on the difference between your purchase price and your sales price. But if you sold the same stock at a loss, you wouldn’t own any taxes, and if your loss was larger than any other capital gains for the year, you’d actually be able to carry forward that tax loss to offset future gains.
Of course, this assumes you did not also purchase the same or an effectively similar security within 31 days of the date of the sale, in which case the capital loss would be disallowed.
If you sold the same security at a gain, but had not held it for at least one year, you’d pay ordinary income tax on the gain, rather than long terms capital gains rates, which are typically lower.
If you withdrew the $40,000 from a Roth IRA that you’ve held for at least 5 years and are over 59.5, you’d owe no taxes on the withdrawal.
You can see that a withdrawal decision in retirement can have a variety of tax outcomes, depending on what is withdrawn and from where.
Additional complexity can be introduced as one also considers the impact of future taxes on withdrawal decisions. For example, if you have large balances in pre-tax accounts, but retire early and have much lower income for a few years, it might make sense to consider withdrawing funds from a pre-tax account for spending or converting those funds to a Roth IRA.
If you believe your income tax bracket may be higher at age 72 due to RMD’s and other income, it may be more advantageous over your lifetime to go ahead and take funds out of a pre-tax account and pay taxes now. Since your withdrawal is lowering your pre-tax account balance, theoretically you’ll have a lower RMD amount at age 72. If this reduction can keep you in a lower tax bracket at age 72, you may be saving significant dollars in future taxes.
Converting those funds to a Roth IRA can allow them to grow for the future in a tax-free manner, and also provide you with a tax-free bucket from which to take future withdrawals. While you still pay current taxes on the withdrawal amount, if you execute a Roth conversion correctly, all of the earnings and growth on the converted amount can be tax-free for the remainder of your lifetime.
You will also want to consider the future tax disposition of the types of assets you hold in to determine which type of account provides the best tax result when those assets are used in the future.
For example, when you earn interest from bonds in a brokerage account, you owe ordinary income tax on the amount of the interest you receive. You also owe ordinary income tax if you withdraw bond interest from a pre-tax retirement account like an IRA. So, no matter which account you hold the bond in, you will owe ordinary income tax on the interest.
But for stocks, the same is not true. If you sell an appreciated stock in an IRA and then withdraw the proceeds, you owe ordinary income tax on the full amount of the withdrawal. But if you sell a stock in a brokerage account, your tax liability is based on whether the stock was sold at a gain or a loss; the amount of the gain, offset by any net realized losses for the year; and whether that gains were long term or short term.
So, there is potential to have more control over the ultimate tax liability of a stock sold in a brokerage account, and potentially a lower or even no tax liability, depending on other losses and total income for the year.
With these ideas in mind, it can make sense to plan for optimal asset location in retirement.
Using the simple examples we just explored, it could make sense to hold more bonds in an IRA for example, and more stocks in a brokerage account. Since bonds interest is taxed as ordinary income in either account, there is no change by holding more bonds in the IRA. More stocks in the brokerage accounts allows for many more opportunities to review and make adjustments on the capital gains impact on any stock sale.
In either case, we assume the investor is holding the same overall portfolio allocation to meet their goals and risk tolerance in retirement. But the complexity comes in taking time to plan for the location of each type of asset for the best tax results, now and in the future.
As you can see, retirement distribution planning can be much more complex than saving for retirement.
In addition to the above examples, there are several areas of retirement distribution planning that include even more complexity – including annuity distributions, inheritances, real estate income and sales, reverse mortgages, etc. While many people can handle the savings and investing strategies needed to get to retirement, it is a much more complex process to live off your retirement savings.
We help people everyday retirement confidently and help them plan for all these factors.
If you need help with your retirement distribution strategy, schedule a call for a complimentary assessment with us.
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About the Author:
David Edmisten, CFP®, is the Founder of Next Phase Financial Planning, LLC, a financial advisor in Prescott, AZ. Next Phase Financial Planning provides retirement, investment and tax planning that helps corporate employees retire with both financial and lifestyle security.