When it comes to generating retirement income, conventional wisdom says to spend down/consume your taxable assets first, then your tax-deferred assets (like 401k and traditional IRAs), and then tax-free assets last (like Roth IRAs). After spending all your taxable assets, should you only withdraw from your tax-deferred accounts exactly what you need for expenses each year? Maybe not. Here’s why.
Let’s assume you are married and both of you are age 65. Each of you receives $15,000 annually from Social Security, for a combined benefit of $30,000, and you have no other income (to keep things simple). In 2012 (just to illustrate this point, because who knows what will happen to tax rates in 2013 and beyond??), you would have about $20,000 worth of personal exemptions and a standard deduction to claim on your tax form 1040. That would bring your potential taxable income down to about $10,000. We’re also assuming almost all of your Social Security income will be taxable, for simplicity’s sake.
Here’s where tapping the traditional IRA for more than you need might make good tax sense. Let’s assume you and your spouse need another $35,000 from your traditional IRA savings to meet your expenses for this year. That puts your taxable income for the year at about $45,000. In 2012, this amount of taxable income puts you in the 15% tax bracket. But you can actually withdraw about another $25,000 from your IRA and stay in the same tax bracket. Why in the world would you want to do that?
Think of this strategy as “locking in your tax rate” on that extra $25,000 at the 15% rate. Now you have an extra $25,000 in the bank, if you will, that has already paid taxes. If you were to need the same amount for expenses in 2013 (so another $35,000), you’ve already got $25,000 set aside. That could lower how much you might need to withdraw in 2013. Now if tax rates rise in 2013, then pulling that extra $25,000 in 2012 at a lower rate becomes an even better strategy!
So will tax rates rise in 2013 and beyond? Your crystal ball is as good as mine. You can make arguments either way. With a ballooning federal deficit, taxes have to rise. With a sputtering economy and weak job growth, any tax increase will kill the recovery. And so on. Bottom line: no one knows for sure yet what will happen.
But hopefully this tax strategy gives you some ideas about how much money to take from your retirement accounts each year. It can be a good long-term approach to “fill up” your tax bracket each year with withdrawal amounts, to lock in your tax payment–an easy step toward maximizing your retirement readiness. About the only time this scenario won’t make sense is if tax rates will fall in the future. That sounds like a great deal, but I can’t imagine that happening any time soon (though I can hope!). Can you?