Many people save for retirement by putting pretax dollars into an employer-sponsored retirement plan, such as a 401(k). Those dollars may be rolled into an IRA, perhaps at retirement or after a change in jobs. An IRA rollover can maintain the tax deferral.
Ultimately, those pretax dollars will be withdrawn and reported as taxable income. If you are retired then, in a lower tax bracket because you no longer have earned income, the entire process might have saved you considerable amounts of tax.
That’s not necessarily the outcome you’ll experience, though. You might ﬁnd your income is relatively high when you take IRA distributions.
Example 1: Meg Parker saves industriously in her company’s 401(k) plan and rolls the balance to an IRA when she retires. Meg continues to leave her IRA untouched, in order to let the account grow for more years, tax-deferred. However, beginning when Meg reaches age 70½, she must take at least required minimum distributions (RMDs) each year, according to an IRS table.
In this hypothetical example, Meg’s IRA has grown so large that her RMDs plus her other annual income place her into a higher tax bracket than she had during her working years. Thus, her IRA distributions will be taxed at a higher rate than Meg expected.
Other circumstances also might increase the tax rate on Meg’s IRA withdrawals. Overall tax rates might be higher when she takes money from her IRA. Meg might have moved to a state with a high income tax rate; she might be married to a spouse who reports substantial income on their joint tax return.
For these and other possible reasons, it can make sense to take steps to withdraw money from your IRA and other tax-deferred accounts in a tax-eﬃcient manner.
The best time to take money from your IRA may be when you’re between the ages of 59½ and 70½. Once you pass 59½, you can take IRA withdrawals without owing a 10% ﬁne for early distributions. Meanwhile, you don’t have to take RMDs until you reach 70½. In the interim, you can take as little or as much from your IRA without owing any penalties.
One possible tactic is to make the most of relatively low tax brackets, in a calendar year.
Example 2: Paul King is 62 years old in 2016. He ﬁles a joint tax return with his wife Lynn, who is 57. The Kings reported $125,000 of taxable income on their 2015 tax return, and they expect their taxable income to be about the same in 2016. If so, the Kings will be in the 25% federal income tax bracket this year, which ranges from $75,300 to $151,900 of taxable income.
In this example, Paul could take $25,000 from his IRA, bringing the couple’s taxable income for the year to $150,000. Therefore, the Kings would remain in the 25% tax bracket for the year, and they would owe only $6,250 (25% of $25,000) on his IRA withdrawal.
The Kings could spend those dollars, or Paul could move the money into a Roth IRA. Because Paul already is older than age 59½, after ﬁve years he would be able to take as much as he wants from the Roth IRA, tax-free.
Such a strategy can be implemented every year, to provide the Kings with extra cash ﬂow in retirement or to accumulate funds within a Roth IRA. Moreover, drawing down a traditional IRA during those years will enable Paul to reduce the size of his account and decrease his future taxable RMDs.
Note that taking $25,000 from his traditional IRA will increase Paul’s adjusted gross income (AGI) as well as his taxable income. A higher AGI, in turn, could add to the Kings’ tax bill in other areas—they might lose medical deductions, for instance. Our oﬃce can review any IRA withdrawals you plan for overall tax eﬃciency.
In example 2, the money came out of Paul’s IRA rather than Lynn’s IRA. At age 57, Lynn would trigger a 10% penalty by taking money from her IRA, negating the beneﬁt of the relatively low tax bracket. However, there are many exceptions to the 10% early withdrawal penalty. If you can qualify for one of them, you might be able to take IRA withdrawals at a modest tax rate, at any age.
One such exception covers withdrawals for higher education expenses.
Example 3: Gregg and Lois Carter are both age 48; in 2016 their taxable income, after deductions, is expected to be around $60,000. This year, the Carters estimate that they’ll spend $15,000 on their daughter’s college costs.
In 2016, the 15% tax bracket includes up to $75,300 of taxable income. Thus, Gregg and Lois could take $15,000 from their traditional IRAs and remain in the 15% tax bracket. They would not owe a 10% early withdrawal penalty because that $15,000 withdrawal does not exceed their qualiﬁed higher education costs.
Other exceptions to the 10% penalty for IRAs include those for the account owner’s death or disability, qualiﬁed ﬁrst-time home purchases (up to $10,000), certain medical insurance premiums paid while unemployed, unreimbursed medical expenses that exceed a certain percentage of your adjusted gross income, payments due to an IRS levy and qualiﬁed reservist distributions. In addition, you can avoid the penalty by taking substantially equal periodic payments for your life (or life expectancy) or the joint lives (or joint life expectancies) of yourself and a designated beneﬁciary.