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Retirement requires careful consideration of your finances, and one key question is whether you might be pushed into a higher tax bracket with withdrawals from retirement accounts.
The answer depends on factors like the type of account and how much income you'll need to live comfortably in retirement - experts estimate this could range between 70-80% compared to pre-retirement earnings.
Retirees know that the Roth IRA or 401(k) is a smart way to maximize retirement savings. Put in after-tax dollars, and you can withdraw your full profits tax-free once retired - helping ensure those post-career years are financially secure!
Traditional IRAs and 401(k)s offer varying benefits for retirement savings. Contributions to these accounts may provide a tax break now, but withdrawals will be taxed as ordinary income during your golden years - potentially shifting you into the higher end of the tax bracket then.
Before you read further, you may find it helpful to download our tax cheat sheet. It's the same resource we use to help clients reduce their taxes.
Investing in a traditional IRA or 401(k) helps you save for the future while taking advantage of current tax savings. Each year, contributions to these pre-tax accounts can be deducted from your taxable income, giving savvy savers an added boost towards meeting their retirement objectives.
Investing in traditional accounts for the 2022 tax year comes with certain financial limits. Those under age 50 can add up to $6,000 and those more than 50 can benefit from an additional $1,000 catch-up contribution - totaling a possible investment of $7,000 (all increasing to respective amounts of $6,500 and 7$500 in 2023).
In 2022, retirement savings enthusiasts can contribute up to $20,500 toward their 401(k). The contribution limit will then increase the following year to an impressive amount of $22,500. Plus - workers 50 or older are eligible for additional catch-up contributions that they won't want to miss out on!
Taking advantage of a traditional 401(k) is one way to reduce your taxable income during the year and save money at tax time. Your contributions are deducted from each paycheck in pre-tax dollars, allowing them to grow on a tax deferred basis until retirement when you can withdraw it all without penalty!
An IRA or 401(k) could be an excellent choice for those looking ahead towards their future financial stability.
Required Minimum Distributions
Upon reaching the ripe old age of 72, your retirement savings are ready to roll! But don't forget about those tax-mandated required minimum distributions - if you fail to take them as stipulated, prepare for a hefty penalty.
When you begin taking regular retirement distributions, they are considered taxable income and can have a significant impact on your financial situation. By factoring in the amount of money taken out of your account each year when calculating taxes, it is possible to be pushed into higher marginal tax brackets depending on how much additional earnings were made elsewhere.
If you're looking to delay taking required minimum distributions (RMDs) from your retirement accounts, a qualified longevity annuity contract (QLAC) may be something worth considering. While it may come with some high fees depending upon the annuity provider and the cash value of the annuity cannot easily be accessed in one lump sum, up to $135,000 can be invested into an RMD-deferring deferred annuity account taken right out of traditional IRA or 401(k). QLAC funds will remain separate from what's considered for those withdrawals.
Important Fact: With the passage of 2019's SECURE ACT, Americans can enjoy an extra year-and-a-half before having to start taking their required minimum distributions (RMDs). The rule change means that individuals will now be able to wait until age 72 instead of 70½ - a welcome gift for those who want more time with their retirement savings.
Roth IRA and Roth 401(k) Accounts
Funding a Roth IRA and/or a Roth 401(k) account with after-tax dollars may not grant you the same upfront tax break as traditional accounts, however these investments offer something even better--the assurance that your income in retirement will remain untaxed. Provided certain conditions are met when making withdrawals from both initial contributions and investment earnings, it's possible to experience long-term financial freedom!
Withdrawing contributions from a Roth-type account is both penalty and tax free; however, the five year rule requires that if you're under 59½ years old and have been contributing to any type of Roth IRA or 401(k) for less than 5 years your investment earnings remain taxable. To reap the full benefits of this retirement plan it's important to be aware these requirements exist.
Starting a Roth IRA could be an advantageous choice if you predict your tax rate may increase in retirement. However, those making more than $144,000 (or married couples filing jointly earning over $214,00) are ineligible for a Roth account in 2022 – this amount increases to $153 and 228k respectively the following year. Although there is no limit on how much money can exist within these accounts, individuals cannot contribute more than the annual maximum plus any additional catch-up amounts from age 50 or older each year.
Can You Avoid Required Minimum Distributions Altogether?
Withdrawing your investment earnings too soon can have serious consequences. Not only will any early withdraw be added to your yearly income and taxed, but it could also lead to an additional 10% fine unless you are exempt from the penalty.
If you're looking for a way to leave a legacy, Roth IRAs and Roth 401(k)s may be the perfect option. Unlike other retirement accounts, with these plans there are no forced withdrawals while you’re alive - meaning that any money not withdrawn could grow tax-free until passed down as an inheritance!
How to avoid Penalty Free IRA Withdrawals
Taking an early withdrawal from a traditional or Roth IRA usually comes with heavy financial penalties, but there are times when you can get off the hook! Make sure to check and see if one of these exceptions apply so that you don't have any surprises.
IRA Withdrawal for Medical Expenses. Did you know that when it comes to IRA early withdrawals, there is an exception for major health care costs? If your medical expenses exceed 10% of your adjusted gross income in the same year as the distribution and are not reimbursed by insurance, you may be eligible to take money from your retirement account without being subject to a penalty. To figure out how much can be safely withdrawn from an IRA under this clause – add up all unreimbursed medical expenses and subtract 10% of one's AGI (non-itemizers included).
You Made an IRA Withdrawal to Pay for Health Insurance Premiums. If you find yourself out of work and collecting unemployment benefits, taking money from your IRA to cover health insurance premiums doesn't have to come with a penalty. You can withdraw funds without the usual accompanying consequences as long as it falls within 12 consecutive weeks of receiving unemployment compensation - even if those two periods do not match up perfectly in terms of timing! Just make sure that any withdrawals are made before 60 days pass since finding your new job or else this exception will no longer apply.
You Paid for College. Instead of shelling out big bucks for college tuition, it's possible to take advantage of penalty-free distributions from your IRA. From textbooks and supplies to room and board expenses – if you're the account owner, married or have kids -money can be withdrawn tax-free towards qualifying educational institutions like colleges and universities participating in federal student aid programs. Just keep in mind that withdrawing money could reduce a student’s chances at receiving financial assistance down the line!
IRA Withdrawal for First Time Home Purchase. Have you ever considered using funds from your IRA to help purchase a first home? You may qualify for an early withdrawal of up to $10,000 ($20,000 as a couple) without incurring the penalty. For this exception to apply, however, you will need to prove that neither yourself nor any close family members have owned a residence in the past two years prior and if construction or purchasing is canceled within 120 days then the money must be put back into your IRA account. Investing some retirement savings towards helping loved ones own their very first place could truly make all the difference!
Adoption or Birth of a Child. New parents are now entitled to a special gift - up to $5,000 in penalty-free IRA distributions! If you've welcomed a little one into your family this year, you can access these funds within the first twelve months. Of course it's primarily for financial reasons and not treats and toys; but don't worry if circumstances improve down the road as money that is withdrawn from an IRA can always be put back at any time!
Pay for a Disability. For those with life-altering physical or mental disabilities, there is some relief available. If you can provide appropriate documentation of your condition, the IRS allows for penalty free withdrawals from individual retirement accounts. A doctor's evaluation will be needed to determine if it meets the threshold for a long-term disability that qualifies; unfortunately this includes cases where death may eventually occur as a result of said disability.
Military Service. Members of the military reserves ordered or called to active duty after September 11, 2001 for more than 179 days may be eligible to take an IRA distribution without penalty. Qualified reservist distributions are available across many branches including Air Force Reserve, Army National Guard and Naval Reserve – as long as they take their distribution during the period of active service.
Substantially Equal Periodic Payments. For those looking to make withdrawals from their IRA, annuity payments could be the way to go. The great news is that these IRAs are not subject to early withdrawal penalties - as long as you use an IRS-approved distribution method and withdraw at least once a year! Calculating your payment total requires special assistance though, so it's important take into effect all aspects of life expectancy when planning out how much money needs withdrawing each year; otherwise unplanned fees may apply.
Withdrawal From Your Roth IRA. When it comes to accessing funds in your retirement plan before age 59 1/2, a Roth IRA often offers an easier route than with traditional IRAs. Your contributions can be withdrawn without penalty from one that is at least 5 years old but investment earnings may come with a 10% early withdrawal tax. An additional bonus of having money in the Roth? A lack of income tax on distributions and no requirements for mandated withdrawals after 72!
Withdrawal From an Inherited IRA. Inheriting an IRA can be a complicated process, with different rules for different beneficiaries. Generally speaking, if you are younger than 59 1/2 and not the spouse of the original account holder nor in one of five special categories (minor child; disabled or chronically ill; etc.), any distributions from your inherited traditional IRA will incur income tax but no early withdrawal penalty. Conversely, spouses inheriting IRAs have more flexibility to treat them as their own — though they must still pay taxes on pre-59 1/2 withdrawals while also subjecting themselves to potential penalties.
Leave Your 401 (k) Where It Is. Workers who have reached the age of 55 or greater can withdraw from their 401(k) without incurring a 10% penalty. This becomes even more lenient for public safety employees, allowing them to begin taking withdrawals as early as 50 years old! However if you roll over your money into an Individual Retirement Account (IRA), you need to wait until 59 1/2 before withdrawing funds in order to avoid this fee unless other exceptions apply. As such, it's best not to transfer assets between plans while awaiting retirement eligibility so that those extra protections remain intact.
401 (K) Hardship Withdrawals
Retirement plans like 401(k)s offer a way to save for the future, but you may be able take out funds in an emergency. Known as hardship distributions, these penalty-free withdrawals are reserved for those facing immediate and heavy financial needs.
Struggling to make ends meet? You may be able to take advantage of an IRS-regulated hardship distribution program, allowing you access to funds for essential expenses such as medical bills or housing costs.
Per the IRS website, these include:
Medical care expenses for the employee, the employee’s spouse, dependents or beneficiary.
Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments).
Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary.
Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
Certain expenses to repair damage to the employee’s principal residence.
Understanding Tax Brackets
Withdrawing from traditional retirement accounts doesn't mean the IRS automatically bumps you up to a higher marginal tax rate. It all depends on which bracket you're in and how much extra income those withdrawals create.
Here's a look at the tax brackets for 2022:
For example, If you're married and your income totals $177,000 or less, then 22% is the top marginal rate. However if those earnings push past a threshold of $178,150 dollars per year than any additional income may be subject to 24%, instead! It's important to remember that only the extra money in excess over this cut-off will experience an increase in taxation.
For 2023, the tax rates remain the same as 2022, but the income ranges are slightly higher:
Is It Possible to Sneak Into the Zero Percent Tax Bracket?
For many retirees, avoiding taxation can be a challenge; however, it is not impossible! If you are able to live on an annual income of $25,000 (single) or $32,000 (joint filers), your Social Security benefits will likely remain untaxed.
Otherwise there are strategies available for minimizing taxes in retirement such as converting traditional IRA funds into Roths or investing in tax-free municipal bonds. Additionally selling off the family home and living off those proceeds would help keep capital gains liability at bay.
Will I Be in a Higher Tax Bracket in Retirement?
Tax brackets can be a tricky thing during retirement, and the conventional wisdom that you'll find yourself in a lower one is not quite as straightforward. Although income would decrease with no job to depend on, retirees may end up paying more taxes if they lose deductions like mortgage interest or those associated with children - factors that are difficult to predict accurately years down the road.
How Will My Tax Bracket in Retirement Be Determined?
Retirement can come with some tax surprises, depending on your income stream. When you leave the workforce, it's possible that both Social Security payments and pension or retirement account distributions could push you into a higher or lower bracket than before!
That's why it's so important to incorporate tax planning into your retirement game plan. Financial advisors who specialize in tax planning in retirement should be able to help you navigate tax brackets in retirement so you don't pay more in taxes than necessary.
Conclusion
Retirement tax-free? It really can be a reality for some people. Crossing into the zero percent bracket requires careful planning and budgeting. Individuals making more than $12,959 annually $25,900 if married filing jointly must pay income taxes; add to that earnings over 25K from Social Security benefits alone - you may face even higher taxation! Achieving this goal needs thoughtful strategies but it's an attainable dream with enough smarts and hard work.
Planning for your retirement doesn't have to be taxing. Investing in a Roth 401(k) or IRA can help lessen the amount of money you'll owe come tax season, so consider switching from traditional accounts before it's too late! While transferring funds will require payment upfront, that could provide financial relief down the road - making sure future generations get to enjoy their golden years without worry.
If you’re looking to keep more of your hard-earned money come 2023, consider taking advantage of the 0% long-term capital gains rate – it could be available for those with single filer taxable income up to $44,625 and married couples filing jointly making a combined $89,250 or less!
So, how do you better manage your tax situation in retirement? Work with a financial advisor who specializes in retirement tax planning.
If you are aged 50 plus with over $1 million in retirement savings and investments, contact us for a free consultation. We can help.