December 6, 2023

Google “saving for retirement” and you’ll be provided with a plethora of helpful articles. They will tell you why you should save, how much you should save, how long the retirement account needs to grow to provide what you need when you retire, and how to invest those funds during your working years. All this information is invaluable; but what about how you can strategically take money out of your retirement accounts with the least amount of income tax cost?

Your retirement accounts can grow at a healthy rate because taxes are not paid while baking in the retirement oven. Once you start withdrawing, however, the bill comes due, and it can cost you significantly. The following are strategies that may help you begin to “un-save” from your retirement account in a smart manner and mitigate the income tax paid.

Ride the Income Tax Bracket

U.S. income tax law treats everything as taxable unless there is an exception. Whether you file as single, married filing joint or separate, or head of household, you are subject to one of the current seven (7) tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

There is an income range specific to each tax bracket. For tax year 2024, a single person will be in the 32% income tax bracket when their income is between $191,951 and $243,725; while a married filing joint taxpayer will be in the 32% bracket when their income is between $383,901 and $487,450. The 35% tax bracket starts when the single taxpayer’s income is greater than $243,725 and $487,450 for the married joint taxpayer.

If your income besides your retirement withdrawals consistently puts you in the 32% bracket, do you know how much wiggle room is left before you hit the 35% bracket? Ask your CPA to run this analysis. If there is a $30k gap, how about taking this much from your retirement account and putting it in an investment account? Yes, you will owe income tax on that $30k, but if you need to withdraw $50k from your retirement account for unexpected medical costs or emergency, you avoid the 35% bracket because you already have $30k that you took out the year before; leaving only $20k that you need to withdraw.

Think about riding the income tax bracket that you are in and expect to be in, to avoid getting caught in a higher tax bracket when you need that extra amount from your retirement account.

Roth IRA Can Be Your Best Friend

Is all your retirement money in an employer 401(k) plan? Meaning, you do NOT have a Traditional Individual Retirement Account (IRAs) and you do NOT have a Roth IRA. If the answer is yes, consider whether your employer will allow you to roll some of your 401(k) plan to an IRA. Say, you have $2 million in your 401(k) plan and no IRA. Consider rolling over $50k of your 401(k) to an IRA. This trustee-to-trustee rollover has no income tax consequence.  It is like moving money from your right back pocket to your left back pocket.

After this roll-over, “convert” the IRA to a Roth IRA. You cannot withdraw from your Roth IRA for five years and you have to pay income tax on the $50k. Why would you do this?  Here are some reasons:

  1. Roth IRA grows tax-free …until Congress changes the law.
  2. Roth IRA are not subject to annual required minimum distributions (RMDs). That is, traditional IRAs require minimum distributions be made each year when you reach age 73 (if you are born after 1950). By not needing to take out RMDs, it allows the Roth to continue to grow.
  3. Roth IRAs can be used to pay for long-term care and out-of-pocket medical costs, so that each $1 taken out goes 100% to the care provider and $0 to the federal and state governments, as there are no income tax implications. This is not the case if funds were coming out of a pre-tax retirement account, such as a 401(k).
  4. When you die, any amounts left in the Roth IRA will go to your beneficiaries income tax-free.

Learning to Un-save

“Un-saving” may seem counterintuitive, but it’s a financial strategy that can save you significant income tax payments when you retire. Talk to your CPA about how you can start “un-saving” from your retirement account, with the goal of managing the amount of income tax you will need to pay.

© Clark Nuber PS, 2023. All Rights Reserved.

This article contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.