Imagine grabbing a cookie from the cookie jar and finding a shockingly large tax bill attached.
That, in a nutshell, is what’s happening to far too many wealthy retirees today. These retirees aren’t reaching for cookies, of course—they’re tapping their IRAs to pay for somewhat spontaneous expenses such as new cars or family vacations. In some cases, they’re withdrawing retirement funds to pay for emergencies or unanticipated medical expenses.
But in turning to their IRAs for funds beyond what they’d planned, these retirees are inadvertently pushing themselves into higher tax brackets and setting up staggering tax bills.
To be clear, the problem in these scenarios isn’t that retirees are withdrawing extra money beyond what they’d planned. It’s the fact that their entire nest eggs are completely tied up in IRAs or other tax-deferred vehicles. The solution, then, is straightforward: Keep part of your retirement reserves in a taxable account.
Funding a taxable brokerage account may seem a bitter pill to swallow given the appeal of tax-deferred accounts. But the numbers don’t lie: Using a taxable account rather than your IRA to pay for unanticipated expenses in retirement can create significant tax savings. More importantly, it can help keep you from slipping into a higher tax bracket.
Here’s a quick example. It’s February; Bob and Jane, in San Francisco, get a phone call from their only daughter: She’s engaged and set on having a June wedding. A big wedding.
With $3 million in their IRAs, Bob and Jane can afford to be generous; they decide to take out $40,000 to pay for the wedding. What Bob and Jane don’t realize is that their $40,000 distribution will push their tax bracket from 28% to 33%.
Come April, they’ll find themselves with an additional tax of a whopping $16,920, which reflects a 42.3% tax rate (33% federal tax and the 9.3% California state income tax). Talk about an expensive wedding! Being in the 33% federal tax bracket rather than the 28% bracket accounted for an additional $2,000 of Bob and Jane’s tax liability.
And the couple will pay that higher, 33% federal rate on any other income they generate this year—including additional withdrawals for emergencies!
Now suppose the couple had taken the $40,000 from a taxable brokerage account instead of their IRAs. Let’s say they sell an index mutual fund they had purchased for $34,000 that has a $6,000 long-term capital gain. Because the taxable brokerage account is funded with after-tax money, they will pay the favorable 15% rate on long-term capital gains and a 9.3% state income tax rate. The total tax for this $40,000 will be $1,458, which is substantially lower than the $16,920 they would have paid from the IRA accounts.
Here’s the key part: Unlike IRA accounts, withdrawals from taxable accounts are not considered ordinary income, so Bob and Jane will remain in their 28% bracket. And they’ll avoid the cycle of having to make withdrawals from their IRA every year to pay those giant tax bills.
Maintaining a properly funded taxable account provides you with an option to effectively pay for unexpected expenses without facing a massive markup from Uncle Sam. The proper asset total within the taxable account depends on each family’s financial profile; a financial advisor can help you pinpoint the optimal number.
If you are approaching retirement with all of your nest egg in tax-deferred accounts, now is the time to set up and start funding a taxable account. If you’re already retired, don’t sweat it: You still have the flexibility to build a taxable account by moving assets each year from an IRA into a taxable account.
As early as age 59 ½, you can start taking penalty-free distributions from a traditional IRA. If you move, let’s say, $50,000 a year from your IRA into a taxable account, by age 70 you will have $500,000 plus any income or capital gains the account generates. By serving as a piggy bank for unanticipated expenses, a well-funded taxable account can serve as insurance against the risk of moving into a higher tax bracket.
Remember that unanticipated expenses in retirement aren’t a matter of if, they’re a matter of when. With a little planning, however, you can avert a nasty tax suprise. Please don’t hesitate to contact us if you’d like to discuss structuring your retirement savings for maximum tax efficiency.
Bijan Golkar is a Certified Financial Planner™ and licensed tax preparer with FPC Investment Advisory, Inc., in the San Francisco Bay Area. He provides wealth management services for high-net-worth individuals and families.