Posted by Gary Abely, CFP®, AIF®, CPA
Most of us have heard that in retirement we can withdraw approximately 4 to 5% per year from our retirement accounts without too much worry about outliving these assets. One of the biggest risks a new retiree faces is sequencing of returns, or a bear market in the early retiree years. It is generally a good idea to have at least your first several years of needed withdrawals invested conservatively. While many retirees review where their funds should be invested, few spend adequate time analyzing from which accounts their withdrawals should come from and the order of those withdrawals.
The order and amount in which one withdraws from various retirement and non-retirement accounts to fund their retirement needs will play a material part in determining one’s tax bracket – the percentage of income you give back to IRS. For example, in 2016, a married couple can have taxable income of up to roughly $75,000 and remain in the 15% tax bracket. This means, for many couples, their gross income can be as high as $95,000 and remain in the 15% bracket after standard deduction and personal exemptions. Let’s say, for example, you have gross income of $50,000 and you expect to be in a higher tax bracket at some future time (perhaps after age 70 due to start of Social Security and/or Required Minimum Distributions from retirement accounts). In this case, it may make sense to withdraw an extra $45,000 from your IRA this year (whether needed to live on or not) and invest this in a brokerage account. Once the $45,000 investment is past its first birthday, it will qualify for favorable long-term capital gains treatment. Caution: You should only employ this strategy if you are certain you will be in a higher future tax bracket.
If you find that you are in the 15% or lower tax bracket, it is also a good idea to review your investments held outside of your retirement accounts. The long-term capital gains rate for those in the 15% or lower tax bracket is zero. It may make sense to sell a long-term held non-retirement security for income needs vs. pulling more money out of a taxable IRA account. This strategy is known as managing your tax bracket. By selecting where you pull needed money from, in many cases you can control the amount of taxes you owe that year.
If not complicated enough, one must also factor in the taxation on their Social Security benefits they receive as part of their withdrawal strategy. Up to 85% of one’s Social Security Benefits could be taxable. For 2016, married filing joint taxpayers with “provisional income” greater than $44,000 will have up to 85% of their Social Security benefits taxed. Provisional income is calculated different than taxable income and consists of gross income not including Social Security benefits plus any tax-free interest earned plus half of your social security benefits.
With tax rates on income ranging from 10 to 40%, managing what rate you pay is very important in retirement. Ultimately, what you can spend in retirement is not based upon what you earn, but rather on what you keep after payment of taxes. Prior to retiring, sit down with your CPA or financial advisor who is well versed in taxes to determine an appropriate long-term withdrawal strategy. Finally, remember to include in your monthly budget big ticket items such as new car purchases and home improvements so that you don’t withdraw too much in any one year for such items. Doing so, could unintentionally put you into a higher tax bracket. Finally, always ensure you withdraw at least your required minimum distribution from your retirement accounts. Failing to do so, could result in a 50% tax penalty.