Paying Taxes on Your Retirement Accounts: Part 1

Here's my iron clad rule about taking money out of your retirement accounts:

Always do so by paying the least possible amount of

income and estate taxes.

With "Traditional" retirement accounts like IRA's, 401K's etc. you pay tax on your "deferred" savings when you withdraw some or all of your money, that's when you count your withdrawal as income. (I differentiate traditional retirement accounts here from ROTH accounts, where qualified withdrawals of earnings are tax-free.) So, since we usually have some amount of control over the timing of our withdrawals from these plans, we might as well plan to pay as few taxes as possible when we make them. Success with this strategy requires a commitment to good tax planning as early in retirement as you can begin.

As you probably know, in most cases this means waiting until you are over 591/2 to withdraw from your retirement accounts to avoid a nasty 10% penalty, but, what about normal retirement withdrawals when you are in your retirement years?

Here's the worst case, the way to almost guarantee you'll pay the most taxes on your retirement savings: don't touch your accounts at all until you die, then let your heir withdraw the money all at once and pay tax on it all at once. Let's not even get into the debate of if this colossally dumb strategy can even happen- let's just say you somehow do it in the interest of science. On my desk I keep an orange chart, my tax chart, and I look at it almost every time I do financial planning for a client. I've reproduced one of the more important tables here:

This handy little table illustrates our graduated tax system, and as you can see, the more income you have in any given year, the higher your "marginal tax bracket." So, if you are married and filing jointly and have $19,751 of income, you are in the 10% bracket. If you made $1 more, $19,752, you are still in the 10% bracket for everything except that extra dollar, which is taxed at 12%. Now it seems silly, at least to me, that one dollar should be taxed at a higher rate than another but that's the way a graduated tax system is designed, to more fairly spread out the tax burden towards people with higher incomes. Those of you who have a few bucks should, in my opinion, do everything that you can to not pay anymore income tax than you have to. That's why tax planning is an important part of my practice.

I think you can see where I'm going with this: we try, whenever possible, to make withdrawals that will not launch you into a higher tax bracket and if you look at the chart, there are a few places that trigger an 8% or even 10% increase in your marginal rate, so it pays to pay attention to this stuff.

If you have worked hard and saved, oh I don't know, $3,000,000 in your retirement accounts and your heir cashes it in all at once, you can see that a lot of your hard earned money is going to be taxed at the 40.8% marginal tax bracket.  Keep in mind: this example shows no amount of retirement planning, even a rookie financial planner could do better. How about you?

Our government has just launched a stimulus package that will have to be paid back at some point, I'm willing to bet my hands that we will have higher income taxes in the very near future. So, we might be too focused on tax deferral when we might want to look at a proper amount of tax acceleration. The concept of "decumulation" is as important in retirement as the strategy of "accumulation" that got your here and a good retirement plan should take into account some of these more complicated concepts.

In the next few blog posts I'm going to tell you a little about my favorite strategies to lower your overall income tax bill, a concept you might not have thought about very much before. A retirement plan is successful from a tax standpoint when you begin to take action early in retirement to avoid the nightmare tax scenario I described above. Check back for my next post and we'll get a little deeper into the weeds on this stuff, it might just help you to leave a larger estate to the people you care about!

A Roth IRA offers tax deferral on any earnings in the account. Limitations and restrictions may apply.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.