Let tax brackets guide your retirement plan
At times I feel like a broken record: “Save, save, save!” That’s my mantra when it comes to preparing for retirement. But lately I’m getting quite a few questions from those who have already crossed the retirement threshold. They’ve done the heavy lifting, built a nice retirement fund, and are now trying to figure out how and in what order to start using it. Should they dip into their 401(k)s first? What about tapping traditional IRAs, Roth IRAs or even money outside retirement accounts? It’s a good problem to have, but a problem nonetheless.
Find the “right” order. Traditional wisdom would dictate using nonretirement accounts first, then shifting to traditional retirement accounts, and tapping Roth accounts last. The general idea is to hold on to the tax advantages of these retirement plans as long as possible. It’s a solid approach and in many cases could be the right answer for retirees. Even so, for some folks it might make more sense to modify the approach to avoid missing an opportunity provided by our progressive tax system. Yes, I used “opportunity” and “tax” in the same sentence, but stick with me.
Make the most of your tax bracket. It’s no secret that the more income you have, the higher your taxes will be. But what’s often overlooked is that in our system, everyone pays the same tax as their income moves through the tax brackets. For example, in 2014, you, I and Warren Buffett will all pay the same 15 percent on our 30,000th dollar of taxable income. Granted, Buffett may blow right through the brackets to the point of paying 39.6 percent on most of his income, but the 30,000th dollar will still be taxed at 15 percent.
What’s my point? You may or may not have room within that bracket, and that could affect how and when you withdraw money from your retirement accounts. In 2014, the 15 percent bracket applies to taxable income between $18,151 and $73,800 for joint filers (the range is $9,076 to $36,900 for single filers). Taxable income is your income after deductions and exemptions. So after subtracting $20,800, the standard deduction and exemptions, a couple could have an adjusted gross income of up to $94,100 and still remain in the 15 percent bracket. And there lies the potential opportunity.
You may assess the tax landscape and your personal plan and decide that withdrawing money from your IRA or old 401(k) and paying 15 percent is a relatively good deal. If that’s the case, the old rule of thumb to delay touching your tax-deferred assets may not hold true – at least for the portion you could withdraw and still remain in the 15 percent bracket. For example, if you are on track to finish the year with $53,800 of taxable income, you could voluntarily withdraw up to $20,000 from a traditional IRA or retirement plan and still only pay 15 percent tax on the withdrawal.
On the other hand, you might review your finances and find that you’re on target to finish the year with $72,000 of taxable income – you’re now creeping toward the top of the 15 percent bracket – but still have a vacation, car or some other major expense you’ll need to withdraw funds to cover. In that situation, you might choose to use nonretirement or Roth money to avoid climbing into the 25 percent bracket.
On a cautionary note, if you’re currently below the maximum Social Security taxation limits, adding additional income could cause a larger portion of your benefit to be taxable. In any case, the key is to understand where you’re at in the tax-bracket structure and recognize how it might influence your decision with respect to tapping your retirement funds. This is something you, or you and your team of advisers, should be aware of and take into consideration as you map out your plan for how you’ll use your money in 2014. Good luck.
J.J. Montanaro is a certified financial planner for USAA, The American Legion’s preferred provider of financial services. Submit questions for him online. www.legion.org/focusonfinances
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