Business owners are all too familiar with the need to be tax-efficient in order to maintain their profit margins. The same goes for retirement income. Nothing is more infuriating than setting aside a sizable nest egg, built on years of hard work, only to see it chipped away by taxes.
Here I want to focus on just one piece of the puzzle: managing one’s retirement income (or “drawdown”) to be as tax-efficient as possible. Many types of distributions are taxed – and this can even include Social Security. Many retirees aren’t aware of those tax implications and fail to plan accordingly.
The amount of tax you pay on retirement income depends largely on the investment vehicle from which the funds are distributed. Most will be taxed as ordinary income, including qualified retirement plan distributions, some types of rental income, royalty income, nonqualified dividends and short-term capital gains. If you earn any income from self-employment (for example, you do some consulting), that will also be taxed as ordinary income.
Some investment vehicles allow for income that is not taxed (when the distributions are properly structured to meet certain criteria). Roth IRAs and Roth 401(k)s are the most common tax-free sources for distributions taken after age 59½. Life insurance also can fit this category when a combination of principal and loans is distributed, but the policy must not lapse for this to work.
Qualified dividends and long-term capital gains fall somewhere in between. They are taxed as income but not at the ordinary rate – they receive special treatment as long-term capital gains rates, which currently range from 0% to 20% based on your tax bracket.
Annuities may be qualified (IRA) or nonqualified, and both have tax implications. Qualified annuity distributions are fully taxable, while nonqualified annuities are a bit more complex. Here, the portion of the payment that represents a return of your principal is nontaxable; the rest is taxable.
The order in which you draw down your assets depends on a number of factors, including your amount of earned income, whether you’re taking Social Security, your age and the potential return on the various accounts. Many clients prefer to defer taxable distributions (and thus the tax payment) as long as possible. However, there are cases where this is not always best, so it is important to work with a qualified adviser to determine the best course for your particular situation.
Potential taxes on Social Security benefits can be especially complex. Depending on the amounts of other income sources, your benefits may be partially taxable – 0%, 50% or 85% of the benefit may be counted as taxable depending on the income levels. So there may be situations when lowering your realized income may net you more after-tax dollars in your pocket.
The broad range of account types and investment vehicles available, along with the complexity of the tax law, makes having a retirement strategy prudent. Working with a qualified wealth manager and a certified tax professional to find the ideal drawdown strategy for your situation can be money well-spent.
Read this article on Small Business Monthly here.