Taxes on Withdrawals Matter
When you withdraw money from tax-deferred accounts, it will be taxed as ordinary income in the calendar year in which you make the withdrawal. If you need extra funds for a vacation, a new car, or to help a family member, the excess funds withdrawn may bump you into a higher tax bracket. For example, a taxpayer who files single returns can withdraw up to $10,275 in the 2022 tax year and remain in the 10% tax bracket. After that threshold, withdrawals will start being taxed at 12% until the next threshold is hit at $41,775.
Withdrawals Affect Social Security Taxation
In addition to considering how withdrawals will affect your tax bracket, you’ll also need to be aware of how withdrawals can affect how your Social Security income is taxed. Too many withdrawals may make more of your Social Security income subject to taxation. A formula determines how much of your Social Security is taxed. One of the components of this formula is the amount of “other income” you have. Additional IRA withdrawals increase the amount of other income and may cause more of your Social Security income to be taxed.
Building Diverse Tax Buckets Can Lower Your Lifetime Tax Bill
Rather than putting all your money into tax-deferred accounts, build up both after-tax and tax-deferred accounts. Work with a certified public accountant (CPA) or retirement income planner to estimate your tax bracket in retirement. If it will be about the same or higher than it is now, consider funding Roth accounts instead of tax-deductible IRAs and making Roth contributions to your 401(k) or 403(b) plan (if the plan allows this). As you near retirement, it will be important to have a balance of after-tax and pre-tax money. Even if you are foregoing some deductions now, by planning ahead, you will be creating financial flexibility that may be useful once you are retired.
Use Asset Location Strategies To Save Even More
As you build up tax-deferred and after-tax accounts, you can use asset location strategies to make your plan even more tax-friendly. Asset location is the process of strategically choosing where to place your assets for maximum efficiency. For instance, you’d place your high turnover, high income-generating assets inside tax-deferred accounts. Then you’d place low turnover investments that generate qualified dividend and long-term capital gains in your non-retirement accounts (the ones that send you a 1099 form each year). Tax-efficient holdings such as tax-managed funds, large-cap stock funds, and dividend income funds can be located in your non-retirement accounts, where you can take advantage of the lower tax rate that applies to qualified dividends and long-term capital gains. If these same holdings are owned inside your retirement accounts, the qualified dividends and long-term gains will end up being taxed at the higher ordinary income tax rate. That’s because all withdrawals from tax-deferred retirement accounts are reported as ordinary taxable income. Because of this, the withdrawal will not retain the underlying character of the income, such as dividend or capital gain, and won’t benefit from that lower tax rate.
The Bottom Line
Taxes matter. By creating a balance of tax-deferred and after-tax investment accounts, and locating investment holdings inside these accounts in a tax-efficient way, you can save multiple thousands in taxes over your investing lifetime.
