Managing your Retirement Income and Withdrawals
Most people know that the sooner you begin saving for retirement the better, but not many people have thought ahead and prepared for the impact of taxes in retirement. To start, you need to understand the tax treatment of your different income sources in retirement. This article dives into understanding the tax impacts on withdrawals, how to handle withdrawals under the CARES Act, and the benefits of tax diversification.
How to plan a withdrawal
Depending on the size of your withdrawal and your account type, the withdrawal can put you into a higher tax bracket.
Let’s start with traditional accounts – these are typically your traditional IRA and 401(k) accounts which are funded with pretax dollars. This means you are deferring paying taxes on the income you contribute to them until a later date. When you begin to make withdrawals, those amounts must be included in your taxable income for the year, when you add this to your other retirement income, this may push you into a higher marginal tax bracket. Roth accounts are different (which likely include Roth IRA accounts) and are funded with after-tax dollars. While you can withdraw your contributions from a Roth-type account at any time, with no tax implications, your investment earnings will only be tax-free if you are at least 59½ years old and have held the account for at least five years before your first withdrawal. Otherwise, any investment earnings you withdraw will be added to your income for the year and taxed at your normal income tax rate. You may also incur an additional 10% penalty.
If you have both traditional and Roth accounts and don’t want to pay any more tax than you have to, consider limiting your traditional account withdrawals so that they won't be taxed at a higher marginal rate, then supplement that income as needed with tax-free withdrawals from your Roth accounts. However, don’t forget that you may not have total control once you reach the age when your traditional accounts are subject to RMDs.
Withdrawals Under the CARES Act
Throughout 2020, millions of Americans tapped their 401(k) and IRA accounts to access emergency money during the Covid pandemic (which was allowed under the federal CARES Act). If you did withdraw money for this purpose, it is time to make a few decisions with the tax deadline approaching. First, you need to determine if your withdrawal was eligible under the CARES Act. Next, it is time to make a plan to pay it back – under the CARES Act rules for 2020, you have three years to pay the withdrawal back to the plan without any tax consequences compared to the usual 60 days. Additionally, you should consider paying taxes on at least one-third of the distribution this year. This is because you will be liable for taxes on the withdrawal on a ratable three-year basis.
The Benefits of Tax Diversification
Tax diversification helps control how much you pay in taxes and when those taxes are paid. The concept is similar to the diversification across different asset classes. It is important to understand the difference between tax-deferred, tax-free, and taxable accounts. Tax-deferred vehicles allow you to delay paying taxes on investment gains, and potentially accumulate more over time through tax-deferred compounded growth. Tax-free vehicles are funded with after-tax dollars. Finally, Taxable accounts include brokerage accounts and if you sell your investments, you will pay taxes on the gains and having a strategy for this vehicle is critical to ensure you are balancing your short-term and long-term gains. Typically, tax-efficient investments, such as index funds, ETFs, and stocks that you plan on holding should be placed into taxable accounts. While taxable accounts don’t offer tax benefits, they give you flexibility in terms of uses and withdrawals. This type of account also works well if you have maxed out contributions to your retirement account and want to keep investing for retirement. While fixed income, commodities, liquid alternatives, and REITS should be placed into tax-free accounts. Understanding when and how to choose the right investment for your situation can help you minimize your tax bill and maximize your savings in the long run.
One of our priorities at Client First Capital is coming up with a plan that supports your goals. We specifically look at your short-term and long-term goals and make sure your financial plan aligns with them and then layer in how to maximize savings and minimize taxes. Please feel free to connect with us by sending an email or filling out our contact form.
