Considering all the components of a sound retirement income strategy and the many variables that come into play, the distribution phase of a retirement plan can be far more complex than the accumulation phase. Any mistakes made along the way can have a far more significant impact because of the diminishing value of time.
Preparing for Taxes in Retirement
Many people make the huge mistake of ignoring the impact that taxes will have on their retirement income. It’s common for retirees to have several income streams generated from pre-tax and post-tax accounts. However, it’s essential to be aware of which accounts to tap at certain points in retirement to prevent deleting retirement assets too quickly due to taxation. Retirees also must contend with required minimum distributions (RMDs) starting at age 73, which can worsen their tax problem.
When Too Much Tax Deferral is Not a Good Thing
Many retirees are caught off guard by the amount of taxes they must pay on their retirement income. In hindsight, they might have chosen a different accumulation strategy focusing less on tax-deferred accounts, such as 401(k)s or IRAs, that generate ordinary income taxes. They could lower their retirement income tax liability by spreading their retirement savings among post-tax accounts, such as investment brokerage accounts and Roth IRAs. Capital gains from investment accounts are taxed more favorably, and qualified distributions from a Roth IRA are tax-free.
If the goal is to maximize retirement cash flow, it requires a deliberate strategy that balances your income needs with the need to confine your taxable income to the lower tax brackets. Withdrawing exclusively from your pre-tax, IRA, or 401(k) accounts won’t accomplish that. And, if you delay withdrawing from those accounts too long, it will create a bigger RMD problem later, which will likely push you into a higher tax bracket.
The solution is to use a combination of sources to generate sufficient income while paying taxes at the lowest tax rate possible. It’s possible for a retiree to net $80,000 to $100,000 of income free of federal income taxes (excluding the Social Security tax).
The Tax Bucket Strategy
The key to this strategy is to consider the different tax bracket levels as tax buckets that must be filled with income. The idea is to fill the lowest tax bucket (0 percent) with as much income as possible before it spills into the next, higher tax bucket (10 percent), and so on.
If you are married and filing jointly for your 2023 taxes, your first $27,700 of income ($13,850 for single filers) is not taxed due to the standard deduction.1 Your first tax bucket is where you stuff as much of your income that is taxed as ordinary income as possible. It could be withdrawals from your IRA or 401(k), or it could be half of your Social Security benefits if you expect your combined income to exceed the Social Security tax threshold ($32,000), or a combination of the two.2 The objective is to fill this bucket sparingly to keep your tax rate on this income at zero.
The next bucket is taxed at 10 percent, allowing up to $22,000 on top of your first bucket ($11,000 for single filers).1 At this low tax rate, you could choose to add more withdrawals from a pre-tax account. For the next bucket (12 percent), you can add your income from capital gains and qualified dividends from your post-tax accounts. Under the new tax law, income from these sources is taxed at 0 percent up to $89,250 for joint filers ($44,625 for single filers).3 Between the three buckets, that’s more than $100,000 of income taxed at an effective rate of 0 percent.
Optimize the Strategy by Delaying Social Security
However, it is essential to keep in mind that too much income from any of these sources could trigger the maximum tax on your Social Security benefits. Regardless of whether you pay federal taxes on any of your income, it is still counted as provisional income for purposes of calculating your Social Security tax. That may be one of the best reasons for delaying Social Security benefits until age 70. It is better to use your pre-tax withdrawals to fill your buckets early on and leave your Social Security benefits to grow. That will alleviate some RMD pressure later, enabling you to lock in a higher Social Security payout.
Of course, much of this would be moot if most of your retirement income came from a Roth IRA, which generates tax-free income excluded from the Social Security tax calculation.
If you’d like to speak to a professional about developing a tax-efficient retirement income strategy, don’t hesitate to reach out to our team today.
Sources:
1 IRS provides tax inflation adjustments for tax year 2023
2 Income Taxes And Your Social Security Benefit
3 What is the long-term capital gains tax?
