We spend many years saving and investing in our retirement portfolios. And when we retire, there is still more work to be done. You probably have many accounts in your retirement portfolio including a 401(k), traditional IRA, Roth IRA, after-tax brokerage account, annuity, Social Security benefits, and perhaps even a traditional pension. You will need to use all of these sources of income efficiently to best replace the paychecks you used to get from your job.
One of the most important strategies is to keep tax to a minimum. Due to tax-deferred retirement accounts, many of us have delayed paying taxes on much of our retirement income. And that tax bill becomes due when we withdraw the money in retirement. Aiming to stay in a low tax bracket can help retirees to minimize the tax they pay on their retirement savings. Here’s a look at the current tax brackets:
Tax Brackets 2012
Married Filing Jointly
Head of Household
10 percent bracket
15 percent bracket
25 percent bracket
28 percent bracket
33 percent bracket
35 percent bracket
In retirement, we should strive to avoid the 25 percent tax rate (or higher) as much as possible. To stay in the 15 percent bracket, we will have to make sure our adjusted gross income stays under $35,000. There are several things we can do to accomplish this.
Let’s say a single retiree needs $3,000 per month after taxes to cover expenses. Can a retiree bring in this income, but still avoid the 25 percent tax rate? It depends on where the income comes from.
Annuity, pension, and Social Security income are each taxed differently than regular earned income. In this example, let’s assume the taxable portion of these types of income is around $15,000 per year.
Then we could withdraw $20,000 from a 401(k) or traditional IRA and still stay in a low tax bracket. These are both pre-tax accounts and any withdrawals are taxed at the earned income rate.
So far this retiree has an adjusted gross income of $35,000, which allows him to avoid the 25 percent tax bracket, and instead pay an effective tax rate of around 13.75 percent. This is about $2,500 per month in after-tax income. But we are still $500 short of $3,000 per month for expenses.
We can then tap an after-tax account for this shortfall. The current long-term capital gains tax rate is 0 percent for people in the 10 or 15 percent tax bracket. You could also withdraw the money from a Roth IRA or Roth 401(k). No income tax is due on these withdrawals because you already pre-paid the income tax up front.
If you want to remain in a low tax bracket in retirement, generate $35,000 or less from taxable income sources including a 401(k), IRA, Social Security, annuity, and pension. Once you hit $35,000 worth of taxable income, switch to after-tax accounts like the Roth IRA to generate the rest of your target income.
This flexibility is why it is important to invest in a Roth IRA and after-tax accounts. While you don’t get an immediate tax break, these accounts add tax diversification to your portfolio that can be extremely useful when it’s time to withdraw the money. While employers often encourage us to contribute to traditional 401(k) accounts, don’t ignore the future tax benefit of the Roth IRA. It’s best to contribute to both a traditional and Roth 401(k) or IRA, and an after-tax brokerage account.
Joe Udo is planning an exit strategy from his corporate job by reducing expenses and increasing passive income. He blogs about his journey to early retirement at Retire by 40.