Hey guys, Mike Frontera here back with another Retirement Theory video! You know, one of the most critical factors in planning a successful retirement is being smart about taxes. And today I’m going to talk to you about being tax-wise when it comes to drawing from your investments. I’m seriously still floored at how much money you can keep in your own pocket, just by changing which account you’re pulling from and when. So I want to show you a couple cool examples of that, and give you some things to think about when you’re ready to start turning on an income stream in retirement.
Now, if you’ve ever thought about this, or maybe you Googled it before…maybe you looked up “what account should I draw from first in retirement?” you’d probably find that there is a conventional wisdom kind of strategy out there. But I think it stinks.
So, the conventional wisdom you’ll see most often is that you draw from:
- Taxable investments
- Tax-deferred retirement accounts
- Your Roth accounts
And, to be honest the rationale behind it isn’t bad. We get the least bang for our buck tax-wise from those taxable accounts since we pay taxes on them every year. No tax-deferral like our 401(k)s, IRAs, and Roths. So get those out of the way and then move on to the traditional tax-deferred accounts. We of course leave the Roth accounts for last since we’re not only deferring taxes, but we get our withdrawals tax-free. So the theory is to leave those Roth alone as long as possible so get the most tax-free benefit. It seems to make sense. But for a lot of people actually, it just doesn’t.
So why doesn’t the conventional wisdom make sense for so many of us? Well the biggest reason is that it is completely blind to your situation and goals.
One of the most important things to pay attention to when you’re drawing retirement income is where you fall within the income tax spectrum. Your current and expected future income picture can provide you with much better information versus the conventional wisdom method.
From a general strategy standpoint what we’re trying to do is draw from the accounts that will be taxed the harshest while you’re at those lower tax rates and then drawing from accounts that will be taxed the least when you’re at those higher tax rates. And to do this requires awareness not just of where you fall now in that spectrum, but where you’re likely to be in the future.
Take a look at these two tax bracket charts. This first one is our Federal Income Tax Rates. Look right here. For married couples filing joint returns, if your taxable income, that’s after all your deductions, is $80,250 you’re in the 12% tax rate. Once you get that next dollar though, your tax almost doubles to 22%!
Here’s this next chart on capital gains. You pay those on a handful of items, including most gains on investments held more than a year in those taxable investment accounts. And look at this – look how crazy this is. If your taxable income as a couple is under $80,000, your capital gains rate is 0%! The next rate jumps to 15%!
With those rates in mind, let’s look at how this might play out in a hypothetical scenario. Let’s say that you’re retired and 63 years old. Your spouse has a bit of part-time income and you’re taking some supplemental withdrawals off your investments. For the moment it doesn’t matter from which account. And let’s say with all that is coming in the door you’re doing great. You’re comfortable.
Now, you take a look at where you sit along the income tax spectrum and notice that you’re in that 12% tax bracket and still about $15,000 shy of that next big tax jump. When taking a look at where you fall along the tax spectrum down the road things look a bit different. You and your spouse both have fairly large IRA balances which at some point will have these big required minimum distributions. You also haven’t claimed your Social Security benefits yet. So between those income sources, your income is likely in the future to be well into that higher 22% tax rate. And that’s IF tax rates stay as low as they are right now.
So…Instead of doing nothing, might it may make sense to take advantage of your current position along the income spectrum and accelerate some income in this tax year? Maybe you have investments with large capital gains. You could sell and realize $15,000 in gains without paying any Federal income taxes! Sell them once you are in that higher income situation and you’ll be paying 15% or more.
Or maybe it makes sense to convert $15,000 from your Traditional Retirement Account over to a Roth. That would allow all of the future growth to be tax-free! By doing nothing you’re allowing all that growth to be taxed in the future when you’re likely to be at a rate that’s nearly double what it is now.
How about a different example? Let’s say you have children that you want to leave assets to. You have IRA accounts and taxable investments with large capital gains embedded in them. Between Social Security and your minimum IRA withdrawals, maybe you’re in the 22% tax rate or 15% for capital gains. And let’s say your children are fairly high income earners as well.
Well, under current tax law, you receive a step-up in the basis on taxable investment accounts at your death. That effectively can wipe all those gains away and now nobody ever pays taxes on all those investment gains.
Not to mention that since the recent passage of the SECURE Act, the IRAs that are inherited by children have to be fully withdrawn within 10 years. Meaning that your children are likely to pay a much higher tax rate on your IRA funds that you will. But you’re most likely to pay a higher tax rate on the taxable assets than they will.
I’ll say that again!
Yes, it’s possible that by drawing your IRA funds first, you could pay a lower tax rate than your children would, and at the same time avoiding a higher tax rate than your children would by leaving the taxable funds alone.
This type of income planning doesn’t just affect ordinary income and capital gains rates either.
How about state income tax rates and exemptions? New York state for example. If you’re 59 ½ or older, the first $20,000 you draw from your IRA is exempt from New York State income taxes. Let’s say you didn’t take any money out of your IRA plan this year but you need to pull $40,000 next year. All else being the same wouldn’t it make more sense to take $20,000 in December and another $20,000 in January? At a 6.45% rate that one slight change moves $1290 from NYS tax department’s account to yours.
Where you fall along the income tax spectrum affects the taxes you pay on Social Security benefits, Medicare surcharges, subsidies for health insurance premiums and property taxes, affects phaseouts on deductions, and so much more. These are all opportunities for you to keep more dollars in your balance sheet if planned properly.
I tell you, income planning is some of the most exciting stuff out there! There really is so much that you can do to positively affect what you and your family keep versus what you pay in taxes.
Who can help you with this stuff? I can! Come visit me at www.retirementtheory.com or send me an email at firstname.lastname@example.org. Did you click subscribe on this video or follow me on Facebook? I think that you should. You’ll continue to see videos like these on everything retirement planning.
Examples are hypothetical and for illustrative purposes only and should not be considered as individualized investment advice. Please consult with a financial professional regarding your unique situation. Cambridge does not provide tax advice
Once again, thank you for joining me, take care of yourselves, and we’ll see you next time!