Retired people have an interest in preserving their capital as long as possible and this means you need to save tax. But because different investments are subject to income taxes in a different ways and at different income tax rates - and yearly where required - the sequence in which you withdraw from your assets may significantly effect on how quick you will consume your wealth and pay tax--or save tax. So in what order should you withdraw from your various investments?
The assets you have for your retirement can generally be broken down as:
• pension revenue,
• Social Security income,
• financial savings and investments - made up of
o tax free and tax-deferred investments associated with IRAs, 401(k)s, etc,
• home equity
To preserve your wealth as long as possible and save tax, the general rule is that
- you will use the funds FIRST that have the lowest tax rate to use
- you will use the funds last that compound the fastest
These investment accounts which are tax-deferred (IRAs, 401ks, annuities) - under an equal investment growth situation - will compound quicker than taxed investments which forfeit some of their yearly earnings to taxes (bank accounts, bonds). Therefore, you want to use IRAs, 401ks and annuities LAST. Not only do they grow faster because they are unencumbered by taxes, any withdrawals are subject to taxes at your marginal income tax rate (your highest rate).
Long term capital gain investments like your home or stocks may present small or no taxation to you.As an example, on your home, the first $250,000 of qualifying gain ($500,000 if married), is free of tax. Or consider stocks held for at least one year--the gain is taxed at the low rate of just 15% (and possibly lower depending on your tax bracket).
Based on the different ways and rates at which assets are taxed, we recommend that you use assets in the last category earliest. Of course, there are assets that cost no tax to use and those are assets you have in savings such as money market, CDs, savings account. Not only do you pay taxes on those assets whether you use them or not, they tend to pay very little interest.
Your pension revenue would be taxable as your regular tax rates and will be taxable to you whether you spend it or not. So that income must be taken as it comes and there is nothing you may do about it.
Another supply of income is your Social Security benefits. This is usually tax free for those whose income remains under threshold amounts depending on your filing status; beyond that, approximately 85% of social security income could be taxed. But make an effort to hold off getting your benefits until your full retirement age - probably 66 for many of you. You lose some 30% of benefits at 62. Holding off 'til your 70 will credit you about 30% more income.
Take benefits of any capital losses to save tax also (that means you need to sell your losing stocks by December 31 of each year since you can buy them back again 31 days later anyway).
Your IRAs and comparable investment strategies accumulate tax-deferred. This improves their yearly compounding capability. Everything you withdraw from them is taxed at ordinary income prices. So to save tax, allow them ride and pull out just the minimum required distribution (MRD) amounts beginning at age 70½.
Even better, Roth IRAs and Roth 401ks compound tax free, don't have any MRD prerequisites, and you can withdraw from them tax free. Consequently, you want to leave them alone as long as possible. Do not touch them 'til last. They're also the best type of IRA to pass to a beneficiary. Similarly, if you have tax free bonds, you will of course receive income from them which is tax free.
Here's your summary on ways to save tax by using your assets in the right order.
|When To Withdraw From An Asset To Preserve Wealth|
|Asset||Taxation Status||When to Withdraw as source of income|
|Pension income||Taxable||Receive as distributed|
|Social Security||Not taxable below threshold (single.., married….||Wait 'til full retirement age or hold off for higher benefits|
|IRAs, 401(k)s, etc||Taxable when distributed||Hold off 'till deplete taxable investments - just take MRD or convert to Roth IRA|
|Roth IRAs||Tax free growth and withdrawal||Hold off 'til last - best way to leave beneficiaries your IRA money|
|Taxable investments||Taxable yearly as dividends/interest or capital gain as sold||Distribute as needed before depleting IRA-type money|
|Home Equity||Capital gain/big exclusion when sold||Buy down for access to tax free or minor taxed equity|
You Pay More Taxes Than NecessaryAnd we guarantee your CPA has never told you The problem with paying taxes is that most people overpay. So if you are concerned about having enough in retirement, you must stop overpaying taxes. I know you think your CPA takes care of this for you. WRONG. I AM a CPA (retired) and I can tell you that 90% of CPAs do nothing more than enter your information into the little boxes on the tax return but NEVER tell you how to pay less next year. Why? Many of them simply do not know what we can show you. In ten minutes.
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