Retirement planning includes formulating a strategy for how your retirement income will be taxed. Retirement income can be taken from many sources that have different tax implications.   A tax efficient withdrawal strategy helps maximize your retirement income.

Types of Tax

Before we look at the accounts themselves, it is important to have an understanding of the type of tax you will be dealing with when it comes to investing.

#1: Capital gains tax rates

Capital gains tax must be paid on appreciated assets that are sold for a profit. The amount of the capital gains tax depends on the type of stock, the length of time you had the stock, and the amount the stock was worth. If you hold a stock for a year or more, you are often taxed at a lower capital gains rate.  Capital losses may be used to offset capital gains and excess losses may be carried forward to future tax years. It is important to note that below certain taxable income levels, capital gains are not taxed at all. Also, qualified dividends are taxed at capital gains rates.

#2: Ordinary income tax rates

Income tax must be paid on earned income, interest, non qualified dividends, required minimum distributions (RMD) from your retirement accounts, pension income, and social security income above specified limits.  Income tax rates are sometimes much higher than the capital gains tax rate.

Taxes affect your investments in different ways. Let’s look at different accounts you may have for your retirement savings strategy and see how taxes will impact each of them.

Taxable Individual or Joint Account

When it comes to long-term investing, the stock market sees an average 7% return rate.  However, investment return is not as important as the investor return. Investor return is your after tax return.  When you sell investments in a taxable account, gains are subject to the capital gains tax. You will either pay short-term capital gains or long-term capital gains depending on the amount of time you held the stock.  Short-term capital gains are taxed at ordinary income rates giving investors incentive to hold investments with gains at least one year to receive the favorable tax treatment.

Long-term capital gains treatment is received when you have held the stock for over a year. In taxable accounts capital losses may be used to offset capital gains and excess losses may be carried forward to future tax years  Interest and dividends are taxed in the year incurred and qualified dividends are taxed at capital gains rates above certain income limits. Below these taxable income limits, capital gains and qualified dividends may be taxed at 0%.   

Traditional IRA or 401k

In a traditional IRA or 401k, you most often contribute with pre-tax dollars. The money in the account grows tax-deferred until you start withdrawing from the account or taking required minimum distributions in retirement.   All distributions are taxed as ordinary income.

Since these types of accounts are tax deferred, selling investments is not subject to capital gains tax and interest and dividends are not taxed until they are withdrawn from the account.  If you lose money on an investment in your IRA, you cannot claim that loss on your taxes.

Roth IRA

Your Roth IRA is different from your traditional IRA or other tax-deferred retirement accounts because you contribute to it with after-tax dollars. This means that you pay income tax on the money before you put it into a Roth IRA. After the money is contributed the investment growth is tax-free so that when you withdraw from it, you won’t have to pay income or capital gains tax.

This tax structure makes Roth IRAs appealing to many investors, but there are many restrictions attached to this retirement account. In order to contribute directly to a Roth IRA in 2019, you must not exceed modified adjusted gross income (MAGI) of $137,000 if filing single or $203,000 if married and filing jointly.

You may have noticed that I used the word directly in the sentence above, implying that there is an indirect way to contribute to a Roth IRA, and there is. The process is called a Backdoor Roth IRA Conversion.

Roth conversions are different than Roth contributions in that there is no MAGI limitation.  You are allowed to convert any amount of an existing IRA (including some 401ks) by simply paying the taxes due.  

For people who cannot contribute to a Roth IRA because they exceed the MAGI limit, they can make a non-deductible contribution to a Traditional IRA and then convert the same amount to a Roth IRA.

It is important to note that this backdoor method does not let you get away tax-free. You are responsible for paying ordinary income taxes on any earnings in the IRA between the time you made the contribution and when you converted the traditional IRA into a Roth IRA.  However, if the funds are converted to a Roth IRA in a timely manner so that there are no interest, dividends or gains, then there is no tax due.

Can you say: taxes?

When you are devising your retirement planning strategy, it is important to know when and how your investments will be taxed so you can make the best decisions for a lower after tax return.  A tax efficient withdrawal strategy can help you reach this goal.

If you want to know more about how taxes will impact your investments, give us a call!