During your working years, you may be very successful at saving money for retirement in an IRA, 401k, 403b, or similar plan. No taxes are paid on this money when it is put into these plans, which helps you build a larger nest egg. You will need to pay taxes on the money, however, once you take it out. Even if you don’t need the money to pay living expenses, the government will require you to begin withdrawals at age 70½. These mandatory withdrawals are called Required Minimum Distributions or RMDs.
In a way, you are climbing up the “IRA Mountain” while saving money for retirement. But once you are retired, it’s time to come down the mountain and start paying those taxes you avoided over the years. To continue the mountain metaphor, many people don’t realize that 80% of the accidents that occur climbing Mt. Everest happen on the way down. I find that people make the most and biggest IRA mistakes coming down the IRA Mountain. As a result, they end up losing more money to taxes than necessary.
Your inclination may be to leave your money in an IRA so that it will continue to grow. It will, but the money you owe in taxes on that IRA also grows. You want to be certain to take the money out of the IRA when the tax rates on the money are lowest.
Once you turn 59½, you are free to take money out of your IRA without penalty. During the years between ages 59½ and 70½, you may have the opportunity to minimize taxes by withdrawing money (even if you don’t need it then) while you are in a lower tax bracket.
(To keep things simple, I use the term “IRA” in this article, but my advice applies to 401ks, 403bs, SEP plans, and other “qualified” plans which allowed you to defer paying taxes.)
Many people don’t know how our system of tax brackets works, so here is a simple explanation:
On the first page of your tax return, you add up your income. On the second page, you get to take your deductions. This leaves you with a value called “taxable income.”
Here is a table of the tax brackets for a married couple based on the amount of taxable income they have for 2014. Federal tax brackets change every year, so for the sake of example, here is 2014’s bracket:
2014 Federal Tax Brackets
Tax Rate | Taxable Income Married Filing Jointly
10% | Up to $18,150
15% | $18,151 to $73,800
25% | $73,801 to $148,850
28% | $148,851 to $226,850
33% | $226,851 to $405,100
35% | $405,101 to $457,600
39.6% | $457,601 or more
You can see that the first $18,150 dollars of taxable income is taxed at 10%. The income between $18,151 and $73,800 is taxed at 15 percent. Income between $73,801 and $148,850 is taxed at 25 percent and so on. By looking at your tax return and finding your “taxable income” number, you can tell what your tax bracket is, i.e., at what tax rate your “next dollar” of income would be taxed. This is often called your “marginal tax bracket.”
For instance, if your taxable income were $50,000, your marginal tax bracket would be 15 percent. You could have taken $23,800 more out of an IRA and still paid only 15 percent federal tax on it ($73,800 minus $50,000).
Now that you know your current tax bracket, you can begin to predict what it will be in the future. How much income will you get from pensions, social security, etc.? Will your tax rate be higher or lower in the years to come? If you will be in a lower tax bracket in the future, you don’t want to take your IRA money out now if you don’t need to. If your bracket will be higher, you may want to take advantage of your lower tax bracket now to withdraw money from your IRA. You may want to talk to your accountant or financial advisor for help in estimating your future income.
When you turn 70½, you will be required to begin taking RMDs on your IRA (and 401k, etc.). The law requires you to withdraw about 4% of the total IRA funds and pay taxes on it. For example, if you have $500,000 in your IRA, you will have to add $20,000 to your income that year. This added income might then put you in a higher tax bracket. Be sure to include this income when calculating future tax rates.
Now that you know your current tax bracket and have estimated your future brackets, you can develop a plan for taking money out of your IRA each year. It is best to take out just enough so that you are still in your current tax bracket, but not enough to put you in a higher tax bracket. By doing this, you can minimize the taxes you pay on this money. You may want to “mock up” a tax return at the end of the year to estimate what your taxes will be that year in order to “fine tune” the amount. Your tax preparer can help you with that.
Some people don’t need to spend the funds from their IRA right now. They may plan to spend the money later in retirement, or they may want to leave it to their spouse or children. There are some smart ways to position these withdrawals to minimize taxes in the future. Consider converting the IRA money to a Roth IRA, which will then grow tax free with no Required Minimum Distributions while you are alive. Your or your spouse can use this tax free money later in retirement. You can also use the withdrawals to fund a permanent life insurance policy, which will then pass to your spouse or children tax free. Even at higher ages, the amount you leave this way may be greater than the present value of the IRA.
While you were working, you put money into the plan and let it grow. You could not take out any of that money without penalty. You may not be used to thinking about other strategies for the funds. Once you turn 59½, you have more options and need to consider them if you want to minimize your taxes.
When you delay taking money out of your IRA you are not just delaying the taxes, you are also delaying the tax calculation. Leaving money in your IRA until you are required to take it out may mean that your Required Minimum Distributions will be high enough to put you in a higher tax bracket, and you may end up paying more in taxes.
This is one feature of our tax code few people realize, or even like to think about: When one spouse dies, the surviving spouse must soon start filing as a “single” taxpayer. Let’s compare the tax brackets for a single taxpayer versus a married couple. Again, remember that these tax brackets change each year, so this table is for the below example only:
2014 Federal Tax Brackets
Tax Rate | Single Filers | Married Filing Jointly
10% | Up to $9,075 | Up to $18,150
15% | $9,076 to $36,900 | $18,151 to $73,800
25% | $36,901 to $89,350 | $73,801 to $148,850
28% | $89,351 to $186,350 | $148,851 to $226,850
33% | $186,351 to $405,100 | $226,851 to $405,100
35% | $405,101 to $406,750 | $405,101 to $457,600
39.6% | $406,751 or more | $457,601 or more
You can see how the tax brackets for single filers are half that of a married couple. For instance, for a married couple, the 25% bracket doesn’t start until $73,801, but for a single filer it starts at $36,901. Once you pass away, your spouse will have to take Required Minimum Distributions, but since they will be single, it is very likely that the money will be taxed at a higher rate.
You may think it’s good to minimize their IRA withdrawals because you want to leave as much as you can to your children, but your children may end up paying more tax on your IRA than if you withdrew it yourself. Because it is not their IRA, but an inherited IRA, they will have to take Required Minimum Distributions even if they are under 70½ years old. If they are still working and earning money, they may already be in a higher tax bracket than you are in retirement.
Also, much of our nation’s taxes are still tied up in IRAs. Congress is considering changing the law so that IRAs inherited by children must be completely withdrawn over 5 years. If that were to happen, the country could get the tax money much sooner than if the IRAs are stretched out over your children’s lifetime. This would also mean that your children would be required to take 20% of your IRA out each year and pay taxes on it, which could put them in an even higher tax bracket!
If it looks like tax rates may go up in future years, then getting money out of your IRA now, while rates are lower, makes good sense.
Many people are retiring with substantial amounts of money in their IRAs, 401ks, and other qualified funds. The natural inclination is to leave it there as long as possible, until Required Minimum Distributions force them to take some out. But this strategy often puts them in a higher tax bracket, and means they will pay more in taxes than if they had a strategy to withdraw some of it earlier. IRA funds left to your spouse and children are also likely to be taxed at a higher rate.
By taking money out now, you can minimize taxes on it. Using additional strategies like converting it to a Roth or a tax-free life insurance policy can further help you minimize your taxes in the future.
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