A smart strategy for withdrawing money from taxable, tax-deferred, and tax-free accounts can save retirees a lot of money. Tax planning is crucial for every retiree, particularly the affluent because of the new Medicare surtax.
Withdrawing funds from your taxable accounts first is the general rule. When you sell stocks and mutual funds that have appreciated longer than a year, you’ll pay a long-term capital gains tax. The rate is relatively low for most taxpayers.
Look next to tax-deferred accounts. Withdrawals are taxed at your ordinary income tax rate, so they’re a less attractive source of funds. Tax-deferred accounts include traditional IRAs, 401(k) plans, and Keogh plans. Once you reach age 70-and-a-half, you must take the annual required minimum distribution (RMD) or pay a hefty excise tax.
Tax-free accounts—the Roth IRA—are generally last in line.
The longer you can keep your money in them, the better. However, it could be wise to use assets in your Roth IRA for large emergency expenses, like major home repairs or medical bills. If you withdraw a lot of money from a tax-deferred account, it might push you into a higher tax bracket. But pulling a large amount from a Roth IRA will not impact your overall tax rate.
There are exceptions.
If you have a low-income year, you may want to pull some money from a tax-deferred account to benefit from that year’s low tax bracket. If you have a high-income year and investments in a taxable account have a lot of appreciation, it may make sense to instead withdraw from a Roth IRA.
If you own securities that have lost ground in a taxable account, selling some could be a good move in a high-income year to help offset your other income.
Social Security benefits are taxed based on your other income, which is generally the sum of your adjusted gross income, nontaxable interest, and half of your Social Security benefits. As your income rises, the proportion of your benefit that is taxable does, too.
This can result in the Social Security tax torpedo.
Retirees who collect Social Security benefits early often need to supplement them with taxable withdrawals from an IRA or other retirement account. But when income in early retirement exceeds relatively modest levels, your marginal tax rates could increase.
If you take your Social Security benefit relatively early, allow for the ripple effect that taxation of your benefits could have on your overall tax rate. Understanding the Social Security tax is the first step in reducing it.
Starting with the 2013 tax year, a new 3.8% Medicare surtax applies to taxpayers who have net investment income (NII) and whose modified adjusted gross income (MAGI) exceeds $250,000 for married taxpayers and $200,000 for singles.
This surtax effectively raises the marginal income tax rate for wealthy retirees. A large part of their income often comes from investments, so this new tax may significantly impact them.
To minimize the tax, you can reduce your NII and/or your MAGI. Tactics that can accomplish this include: investing more heavily in municipal bonds and/or tax-deferred annuities; buying cash-value life insurance; carefully planning the timing of estate or trust distributions; converting a traditional IRA to a Roth IRA; and creating a charitable remainder trust and/or charitable lead trust.
The law defines NII, specifically. Understand what sorts of income count toward the threshold and try to structure your portfolio to minimize the NII tax.
While stock dividends are taxed at a lower rate than bond or bank interest, they’re given no such break from the NII tax.
State income taxes also can take a substantial chunk of your retirement income.
Some people move to a state with low or no income taxes when they retire. This strategy can work, but it isn’t the only solution. One option is to invest in state-specific municipal bond funds. But before you do anything, understand how state and local taxes will affect your retirement nest egg.
Long-term and yearly tax planning both vital
Create a long-term plan that governs how much you should withdraw each year and from which accounts. The plan should consider what you might pay on your savings while you’re still working and how best to allocate your investments in order to minimize your taxable income.
At the same time, annual tax-bracket planning lets you uncover opportunities arising from changing circumstances. Such planning will allow you to strategically realize capital losses and take advantage of itemized deductions, while keeping an eye on tax changes that could affect your plans.
Tax planning is complex for everyone, and the surtax has made it even more complex for the wealthy. Consider getting qualified help from a tax expert or financial planner. It can save you more than it costs.
Anthony D. Criscuolo, CFP, is a financial planner and portfolio manager with Palisades Hudson Financial Group’s Fort Lauderdale office. He can be reached at firstname.lastname@example.org. Palisades Hudson is a fee-only financial planning firm and investment adviser based in Scarsdale, N.Y., with $1.3 billion under management. It offers investment management, estate planning, insurance consulting, retirement planning, cross-border planning, business valuation and appraisal, family office and business management, tax preparation, and executive financial planning. Branch offices are in Atlanta, Fort Lauderdale, Fla., and Portland, Oregon. Read the firm’s daily column on personal finance, economics and other topics at http:// palisadeshudson.com/current-commentary. Twitter: @palisadeshudson.