There are one set of challenges for those who have the bulk of their money inside qualified retirement plans such as 401(k)’s and IRA’s and there is a whole different set of challenges for those that have non-retirement accounts. And, sometimes people have a combination of the two which can help with tax location management – where you place different investment styles to get the best tax treatment – the best of both worlds. The two things to remember is:
- Withdrawals from retirement accounts are taxed at ordinary tax rates – treated just like earnings – from 0% to 37%.
- Investments held in non-retirement accounts distribute dividends and capital gains. Dividends produce either ordinary dividends (taxed like earnings) or qualified dividends (taxed at lower capital gains rates 0%, 15%, or 20% for those making over 500K/year.
Now before we move on, we’ve got to determine if you will have a window of opportunity after you retire and before social security (age 70 at the latest) and mandatory required minimum distributions begin from your retirement accounts at age 72 (used to the 70 1/2 ).
If you have other sources of income such as a spouse who continues to work, a pension, or other business income you may not have such a pronounced tax vacation window if any at all. What can you do to maximize after tax income?
#1 – Consider deferring social security to age 70. You receive more benefits by waiting anyway. This can be best for those who think they will live well into their 80’s and even 90’s. Remember 85% of social security benefits are taxable. There are certainly more nuances to social security than this and we will look to cover those in an upcoming blog post.
#2 – If you have the bulk of your assets in retirement accounts consider taking distributions from retirement accounts for income to a level where the income tax rate is lower than what it will be later on. For married couples 12% up to $78,950 of taxable income and 22% from there up to $168,400. Higher rates to a maximum of 37% beyond.
#3 – If you don’t need the income from retirement accounts because say you are living off cash savings and other non-retirement accounts, you might use the tax vacation window to convert some of your IRA accounts to Roth IRA’s. Remember you pay the tax upon conversion at a hopefully lower tax rate and the money grows tax free, and is paid out to you tax-free as long as you wait at least five years before tapping.
#4 – If on the other hand you have most of your money in non-retirement accounts that pay dividends, structure things so that qualified dividends (which are tax-free up to 80K of taxable income for couples (half of that for single filers). Anything over 80K is taxed at 15% up to $496,600 of taxable income after which the qualified tax rate goes to 20% plus. Ordinary dividends are taxed at ordinary tax rates.
The tax vacation window got a little larger recently after passage of the Secure Act in which required minimum distributions don’t have to begin until age 72 from what was age 70 ½ previously. But, with the Secure Act also changes how IRA’s pass to your heirs – dramatically!