Retirement Withdrawals That Work for You

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By Zack Gutches, CFP®, CPA

From the time you received your first real paycheck (and maybe even before), your parents and other trusted mentors stressed the importance of putting money away for a comfortable retirement. But while we spend a significant amount of time in our 30s, 40s, and 50s tracking our progress toward our savings target, most of us spend less time thinking about the tax consequences of retirement withdrawals.

The impact of the IRS on your nest egg will vary depending on whether you have an after-tax savings account, Roth IRA, or pre-tax 401(k). Strategically considering the tax treatment of tax-free, tax-deferred, and taxable accounts can help you make smart moves as you invest your funds as well as when you withdraw them for retirement.

Defining the Categories of Tax Treatment

For sustainable retirement income, you need a healthy mix of investments from each of the three tax treatment categories. Start with a clear understanding of how the IRS taxes different types of retirement accounts.

Tax-free accounts

Because you paid tax on the money before investing, tax-free accounts do not require you to pay tax when you withdraw your funds. Examples include Roth IRA, Roth 401(k), and Roth 403(b) investment accounts.

Tax-deferred accounts

With a tax-deferred account, you receive a tax deduction when you invest, typically through an employer-sponsored pre-tax 401(k) or 403(b). Other accounts in this category include a traditional IRA and a deferred compensation plan.

When you withdraw funds from a tax-deferred account, you must pay income taxes on that amount based on your tax rate that year. However, you will not owe federal tax if your total income for the year falls below the standard deduction ($12,400 for an individual and $24,800 for a married couple filing jointly in 2020).

2020 Federal Income Tax Rates

Tax Rate Income (Single) Income (Married Couple Filing Jointly)
10% Less than $9875 Less than $19,750
12% $9875 to $40,124 $19,750 to $80,249
22% $40,125 to $85,524 $80,250 to $171,049
24% $85,525 to $163,299 $171,050 to $326,599
32% $163,300 to $207,349 $326,600 to $414,699
35% $207,350 to $518,399 $414,700 to $622,049
37% $518,400 and above $622,050 and above

Source: IRS

Taxable accounts

Taxable accounts entail income saved outside of a tax-advantaged retirement plan. Examples include salary and bonus income as well as restricted stock units. When you hold investments such as stocks and bonds in taxable accounts for longer than a year, the funds are subject to capital gains tax upon withdrawal at these 2020 rates:

2020 Capital Gains Tax Rates

Tax Rate Income (Single) Income (Married Couple Filing Jointly)
0% Up to $40,000 Up to $80,000
15% $40,000 to $441,450 $80,000 to $496,600
20% $441,450 and above $496,600 and above

Source: IRS

Reviewing a Real-World Example

Relying too much on a single type of investment account for your retirement savings can result in unexpected tax consequences that diminish the size of your nest egg. Let’s look at common scenarios that can result from failure to plan for the cost of withdrawing retirement funds.

Tom and Denise Walker, a 65-year-old married couple, have met their goal of saving enough money to have $150,000 annual income in retirement. However, because they only invested through a pre-tax IRA, they actually need $177,042 per year to account for the 18 percent tax upon withdrawal.

The Walkers live across the street from the Garcias, another couple the same age. Jorge and Veronica Garcia also plan to live on $150,000 per year in retirement but invested their savings in a combination of tax-free, tax-deferred, and taxable accounts. With this strategy, the Garcias completely eliminated their withdrawal tax burden by living on:

  • $45,200 from a Roth IRA
  • $24,800 from a pre-tax traditional IRA
  • $80,000 from stocks and bonds held in a taxable brokerage account

While we’ve dramatically simplified the numbers here, it’s clear that diversifying your retirement accounts can make a big difference in the lifestyle you’ll enjoy in your later years.

Making It Work For You

You can apply the Garcias’ wins to your own retirement withdrawal strategy. Using a tiered approach to retirement income, they withdraw funds from their pre-tax IRA up to the annual standard deduction, which allows them to completely avoid federal tax on those funds. Next, they take advantage of the graduated capital gains tax structure, which allows up to $80,000 in tax-free withdrawals for 2020. Finally, they reach their $150,000 annual income goal by withdrawing the remainder from tax-free Roth accounts.

Unless Congress repeals the Tax Cuts and Jobs Act, its tax rates will remain in effect until 2025 before reverting to 2017 rates. Having a mix of tax treatments in your retirement portfolio provides the flexibility you need to weather changing economic conditions. Although retiring without an income tax burden like the Garcias would be incredibly rare, you can reduce your liability with careful planning that also accounts for health care costs, Social Security benefits, unearned income such as dividends and interest, and personal priorities such as charitable giving.

Partnering with a fee-only fiduciary advisor can help you balance these elements of your retirement plan as you accumulate wealth to help ensure you can use it as you intend. When you work with Brighton Jones, our advisors will craft a plan that considers and clarifies your life objectives and goals.

Zack Gutches, CFP®, CPA is an advisor at Brighton Jones.

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