PORTLAND, Ore. (TheStreet) — Know that tax-deferred retirement account you've been feeding during your working years? Yeah, you can't defer that pain forever.
You need a strategy if you're going to keep that tax bite from sinking too deeply into your savings. Figuring out how and when to withdraw money from taxable, tax-deferred and tax-free accounts can save retirees a lot in taxes, says Anthony D. Criscuolo, a senior financial planner with Palisades Hudson Financial Group. That's especially true for wealthier clients, who started paying a new 3.8% Medicare surtax aimed at 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.
“A large part of their income often comes from investments, so this new tax may significantly impact them,” Crisculo says.
The first and easiest step is to withdraw funds from taxable accounts. Stocks and mutual funds that have appreciated longer than a year incur a long-term capital gains tax, which is relatively low for most taxpayers.
The second step is where it starts to get painful. Here you'll have to dip into tax-deferred accounts such as IRAs, 401(k) plans and Keogh plans that are taxed at your ordinary income tax rate. Once you reach 70.5 years of age, you have to take the annual required minimum distribution anyway to avoid a crushing excise tax, so just grit your teeth and get on with it.
The last to go should be tax-free accounts: basically, the Roth IRA.
“The longer you can keep your money in them, the better,” Criscuolo says. “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.”
If you're among the wealthier retirees, you're going to want to switch up that strategy a bit to avoid the full brunt of the Medicare surtax. That requires reducing your NII and/or MAGI, which could mean 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, or creating a charitable trust.
There's also the small matter of how your Social Security benefits will be taxed based on your other income: Your adjusted gross income, combined with nontaxable interest and half of your Social Security benefits.
“As your income rises, the proportion of your benefit that is taxable does, too,” Criscuolo says.
The result is often a Social Security “tax torpedo” that can sink the value of your benefits. Retirees who collect Social Security benefits should consider making some taxable withdrawals from an IRA or other retirement account to offset the damage. 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,” Criscuolo says. “Understanding the Social Security tax is the first step in reducing it.”
Even where you live can dip into your retirement income. There are folks who eyeball states such as Florida and Washington for their lack of state income tax, but there are other strategies that don't require a specific address.
“One option is to invest in state-specific municipal bond funds,” Criscuolo says. “But before you do anything, understand how state and local taxes will affect your retirement nest egg.”
Most importantly, you need to create a long-term plan that not only governs how much you should withdraw each year and from which accounts, but where you want to spend your retirement and how. The plan should factor in what you'll pay on your savings while you’re still working and how to minimize taxable income. What prospective retirees need to realize, however, is that their investment planning isn't a one-and-done proposition. The tax code changes, and they'll have to update annually just to stay on top of it.
“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,” Criscuolo says.
— Written by Jason Notte in Portland, Ore.
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