Without proper planning, retirees who are drawing down assets to meet living expenses may end up paying unnecessary taxes, lowering their spendable income and choking their standard of living.
They do this when they fail to consider the impact their withdrawals will have on their tax bills. Due to the nature of the income-tax laws, different tax rates apply to different income levels and to the nature of that income. Planning opportunities – and the potential for making mistakes – are greater now that Congress has passed the Jobs and Growth Tax Relief Reconciliation Act of 2003. Worst-case under the new law: Someone can pay $3,500 instead of $1,000 in taxes on $10,000 of income.
Retirees usually have a number of income sources. To the extent that they can control this income, they also can control their tax bills. Here are some examples:
Social Security – Delaying the start of Social Security can increase your monthly benefit. Conversely, having income from employment can reduce your benefit, and if your overall income level (including interest, pensions, IRA distributions and half your Social Security benefit) is too high, up to 85 percent of your benefit can be subjected to federal income tax.
Pensions – Like Social Security, most pension plans offer higher benefits for those who wait. Taxed as ordinary income, at federal rates up to 35 percent. No Illinois state tax.
Taxable IRAs – Distributions, whether from contributions, capital gains or dividends, are taxed as ordinary income. Taxed as ordinary income, at federal rates up to 35 percent. No Illinois state tax. Ten percent penalty on most withdrawals before age 59 ½. Distributions must begin in the year following the year in which the taxpayer turns 70 ½.
Non-taxable (Roth) IRAs – No federal or state tax. Ten percent penalty on most withdrawals of earnings before age 59 ½.
Non-tax qualified investments – Under the new tax law, most dividends and all long-term capital gains are taxed at a maximum rate of 15 percent, regardless of the rate you are taxed on ordinary income.
Wages – To work or not to work? For some, it’s not a question, because of a need for income or a simple desire to stay active.
Using some basic principles, you can manage your taxes, keep more of your spendable income and enhance your lifestyle during retirement:
Take as much income as possible at the lowest rates. If you find yourself in the 15 percent tax bracket, take distributions from your taxable IRAs (or convert to a Roth IRA) in an amount calculated to bring your taxable income up to, but not to exceed, the 15% bracket.
Use up your non-qualified assets (those that have already been taxed) first. Keep your IRAs intact and working on a tax-deferred basis for as long as possible.
Consider placing dividend-paying investments in your taxable accounts. Dividends (and capital gains) on investments in your IRAs will be taxed at your highest marginal bracket – up to 35 percent – upon withdrawal.
As always, try to match capital gains and losses in your taxable accounts to create a zero net tax effect.