Retirement Basics: Understanding Tax Efficiency

Retirement Basics: Understanding Tax Efficiency

Managing your taxable income during retirement can be complicated. Social Security Retirement benefits, retirement plan distributions and supplemental income can quickly impact the amount of tax you must pay. Here is something to consider.

One of the basics in retirement is to be as tax efficient with your income as possible. In 2016, income tax rates range from 0 – 39.6% plus a potential 3.8% net investment tax. Understanding how these progressive tax rates apply to ordinary income creates a tremendous retirement planning opportunity.

Many retirees can control their taxable income each year by the amount they work and how much they withdraw from retirement savings accounts like IRAs and 401(k)s. When your income drives you into a higher income tax rate, you will need to decide if you want to maximize the tax rate applied to this range of income.

Example: Assume you are a single taxpayer with $10,000 in retirement income from a part-time job. You also have $150,000 savings in a 401(k) retirement account. Also assume you are old enough to not have taxable Social Security Retirement benefits. The income range and applicable tax rate for a single taxpayer in 2016 is…

TAX RATE TAXABLE INCOME*
10% $1 – 9,275
15% 9,276 – 37,650
25% 37,651 – 91,150
28% 91,151 – 190,150
33% 190,151 – 413,350
35% 413,351 – 415,050
39.6% Over $415,050

In this example, excluding other variables, you have the opportunity to withdraw an additional $27,650 from the 401(k) at an income tax rate of 15%. Income beyond this amount will be taxed at 25% or higher.

*Note: Taxable income typically includes wages, interest, non-qualified dividends, short-term capital gains (assets owned for one year or less), and withdrawals from most 401(k), 403(b), and non-Roth IRAs.

It is never simple.

Unfortunately, planning for tax efficient retirement is never simple. There are other things to consider.

  • Your age
  • The taxability of your Social Security Benefits
  • Income phase-outs of other tax benefits
  • Required Minimum Distributions from retirement accounts at age 70 1/2 or older
  • Your state tax situation
  • Other taxes. Unfortunately, the tax code is not only based on income taxes. It also includes estate taxes, inheritance taxes, qualified dividend taxes and long-term capital gain taxes to name a few.

What to do?

Making tax efficiency an integral part of your retirement plan can be complicated. But for those willing to start early, spend the time and ask for assistance, the rewards are tremendous.