Retirement Income Planning – How to maximize your after tax income – Part One of a Three part series.

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Part One – The Problem

You have worked hard.  You have contributed religiously to your 401(k)’s and other qualified retirement accounts over the years.  You have significant assets in your 401(k)’s, 403(b)’s rollover IRA’s and other qualified plans.  You are inching closer to retirement and wondering how you are going to generate retirement income without getting hammered by federal income taxes.  Well, frankly, now that the Secure Act has eliminated Stretch IRA’s you may even be questioning why you socked so much away in tax-deferred accounts to begin with – more on that in Part Three.

The problem with the high balances of retirement plans is that when the money is paid out to you to generate income it is taxed at ordinary tax rates – the same income tax rates as when you were working.  The money that you have accumulated has never been taxed and therefore the government wants to receive their tax revenue off the money that was removed from your paycheck while working as well as the growth that has occurred while it was building in value.  You are able to defer the income tax until age 72 when you must begin taking required minimum distributions.  But, if you retire at age 62, you’ve got to have income coming in from somewhere.  Perhaps you have a pension, rental income, or a lot of money in non-retirement accounts that you can draw on until social security and RMD’s begin.  Or, perhaps you don’t!  Which means that you may need to begin to tap your IRA accounts sooner and therefore pay taxes on amounts withdrawn as if they were earnings.  So, you could see tax rates as high as 37% if your standard of living requires substantial distributions.

For those who have significant non-retirement accounts in place, you may be able to lean on those assets to generate some or all of your living expense needs as well.  Depending on what you have invested in inside these accounts, they will often pay dividends, both the ordinary type which are taxed at ordinary tax rates and qualified dividends that are taxed at lower rates.  In addition, pensions, deferred compensation plans, ESOP’s and other income sources may help bridge the gap before social security and RMD’s must begin.  If you don’t have substantial assets in these types of plans, you may well find yourself with an unexpected window of opportunity – a tax vacation window of sorts between the time earnings stop and social security begins (as late as age 70) and required minimum distributions must begin at age 72.  So, back to the “retire at age 62” example, you just might find yourself with an eight to ten year window where you are not paying much in the way of taxes which is illustrated in the chart below:

 

How you take advantage of being in this window is the subject of Part Two of this blog.

Now if you don’t happen to have much accumulated in retirement accounts because it is in non-retirement accounts instead, you might have a completely different income tax outlook than what is shown above because you will not see RMD’s kick in at age 72, if one were to wait that long.  Non-retirement accounts generate both ordinary and qualified dividends which you pay tax on annually.  Ordinary dividends are taxed at ordinary tax rates and qualified dividends are taxed at preferred rates from 0% for joint filers with income up to 80K to 15% for those with income between 80K and 496K.  Those over that are taxed at 20% – still lower than ordinary income rates!  And, if you sell the investment you made money on and a capital gain is realized, capital gains rates follow the same tax consequences as qualified dividends.  And you can offset capital gains with any losses that you may have realized in years prior.  You can maybe begin to see why retirement accounts (after-tax) may not be all they are cracked up to be!

This is a good place to mention the importance of good tax location planning.  Consider placing the asset classes that generate ordinary dividend inside your retirement accounts and those that pay qualified dividends and can be sold for favorable capital gains rates in the non-retirement accounts.

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