Manage your tax brackets in retirement
A mix of taxable and nontaxable income sources may help boost retirement income.
- FIDELITY VIEWPOINTS
- – 01/15/2015
When planning for retirement, many people make the mistake of thinking that what they see in their retirement accounts is what they will have to spend in retirement. What they sometimes forget: the taxes they will need to pay on certain withdrawals, like those from traditional 401(k)s and IRAs.
“It’s not what you earn that counts, but how much you get to keep after tax,” says Matthew Kenigsberg, vice president in Fidelity’s Strategic Advisers. “In addition, managing your tax brackets in retirement can help preserve more of your assets for the next generation.”
To do so effectively, you’ll want to build a suite of taxable and nontaxable income sources, ideally at least five to 10 years before you retire. That way, you will have the flexibility to pull withdrawals from different sources in order to help reduce your taxes overall.
To do that you will want to keep your ordinary income, which is taxed at the highest rates, in the lowest possible tax bracket. The biggest benefit comes for those who can remain in the 15% bracket.
For 2015, the 15% bracket tops out at $74,900 for joint filers ($37,450 for single filers). The next bracket is 25%, so bumping up a bracket costs you 10% more on your next taxable dollar. See IRS tax brackets
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What to do if your taxable income is about to push you into a higher tax bracket? The easy answer is to substitute available income sources that are not taxed as ordinary income to help you stay within the lower income tax bracket.
Here are six nontaxable income sources to consider setting up before you retire—so you’ll have tax-smart choices afterward:
1. Qualified Roth distributions
Qualified withdrawals from Roth accounts won’t be subject to federal income tax, making them a useful vehicle to help manage tax brackets in retirement. For example, if you need money to pay for unanticipated expenses, you can withdraw money from the Roth account without triggering a federal tax liability as long as you meet the qualifying criteria. Moreover, Roth accounts can be effective estate-planning vehicles, because currently any heirs who inherit them generally won’t owe federal income taxes on their distributions.
2. Liquidation of taxable assets at or below cost basis
Even if the assets in your taxable account are at an overall gain, there may be tax lots that are at or below your cost basis. If you sell those, you won’t pay taxes. And if they represent losses, you can use them to offset capital gains, and up to $3,000 a year in ordinary income. Consult with your accountant or financial representative.
3. Tapping home equity
There are several ways investors can access the equity locked up in their homes, including HELOCs (home equity lines of credit) and reverse mortgages. All come with various downsides and costs, so caution and careful consideration are important, but in some instances using one of these techniques may be a reasonable way to generate supplemental income. Reverse mortgages, for example, are home loans that provide cash payments based on the equity in your home. In a reverse mortgage, distributions are technically considered borrowing rather than income, so they typically are not taxable.
Reverse mortgages are complex, however, and involve taking on debt. So, investors should study the pros and cons carefully before using them. Homeowners typically defer payment of the loan until their death. Upon their death, the heirs either give up ownership of the home or must repay the loan from the reverse mortgage company. Rules can vary from state to state.
4. Cash-value life insurance
Cash-value life insurance—sometimes known as permanent life insurance--is a form of whole life or universal life that pays out upon the policyholder’s death, but that also accumulates value during the policyholder’s lifetime. Many life insurance policies include cash value that can be borrowed against without incurring taxes. Be careful when using cash values; if the policy lapses, this could cause some unintended consequences, such as losing the death benefit coverage and causing any gains to become immediately taxable.
5. Health Savings Accounts (HSAs)
HSAs are individual accounts typically offered by employers in conjunction with a high-deductible health care plan to cover qualified medical expenses. However, contributions to HSAs can accumulate tax free and can be withdrawn tax free to pay for qualified medical expenses, including those in retirement.
Note that the medical expenses need not be from the current year. It’s important to keep good records of past expenses so that they can be applied to future HSA withdrawals if needed.
6. Annuity income
Annuitized income (i.e., annuities purchased with taxable assets) consists of both taxable income and nontaxable return of principal. The amount of taxable income generated depends on your life expectancy. For those who purchase an immediate income annuity at a relatively late age, the cash flows may be mostly nontaxable return of principal.
Managing brackets in practice
Now, let’s look at how managing tax brackets might work in practice. Consider the Smiths, a hypothetical married couple who have their assets in a variety of different account types and whose annual expenses total $100,000. They expect $42,000 in gross income (all taxable) before tapping their retirement accounts, so their gross income gap (i.e., before considering taxes) is $58,000. They also anticipate $20,000 in deductions and exemptions, so their expected taxable income before withdrawals is $22,000.
If they withdraw $52,900 from their traditional IRAs, it would bring their taxable income to $74,900—the top of the 15% bracket for 2015. They could then withdraw the remaining $5,100 that they need to cover their income gap plus $10,313 to cover their tax bill, for a total of $15,413, from a Roth IRA, which does not generate taxable income as long as the withdrawal is qualified. If the Smiths could get some or all of the $15,413 from a taxable account without generating capital gains taxes – for example, from a bank account – that would work as well.
As the chart below shows, this strategy saves the Smiths $5,137 in taxes this year compared with just withdrawing everything they’ll need from the traditional IRA, thus preserving their ability to withdraw the traditional IRA money in a future year when their tax bracket may be lower. The picture would be similar with any of the other tax-free income sources listed above. If, for example, they had cash-value life insurance, they might have been able to use a policy loan instead of a withdrawal from a Roth IRA (assuming that wouldn’t cause a lapse in their policy, or other problems).
Please note that the diagram illustrates only the current year, but a tax bracket management strategy should consider the preceding and following years as well. Sometimes the impact of events in those years can meaningfully affect the strategy and its results. Also, the use of a tax bracket management strategy is not appropriate for all investors, so be sure to consult with a tax professional before implementing one.
Finally, be sure to keep abreast of your state’s tax laws. Some states offer favorable tax treatment for certain sources of retirement income, such as some 401(k) plans and pensions (and several states have no state income tax at all). So you will want to make the most of state tax law as well.
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