Retirement Tax Question

[Snave]

I have a question that I do not know the answer to and was looking for some help. While retirement is a long way off for me, I am trying to determine what I can do now to help with taxes later on. I am not sure how to articulate the question best, so it might take some explaining.

While I know money from a Roth IRA or Roth 401K will not be taxed on future gains, will it be included in your overall income for for the year you pull it out in retirement, therefore INCREASING the taxes you might pay on taxable income? That's confusing. Let's say I pull out so much money from a traditional IRA or 401k plan and that puts me in a certain tax bracket, say the 25% tax bracket, but I need more money and decide to take it out of the roth so as not to take more out of the traditional IRA or 401K and push me in to the higher tax bracket, say the 28% bracket. Will I just continue to pay the 25% tax rate on the taxable income or will they somehow say I have to pay a higher tax portion on that b/c my total income is higher.

[sweeps]

In before the 3 page response.

When you withdraw from your Roth IRA or Roth 401k at retirement, it will not increase your taxable income. If your only source of income in the year 2040 is withdrawing $50,000 from your Roth IRA, then your taxable income will be $0.

(At least this is how the law currently stands. Let's discuss again in 30 years.)

[aida2003]

Hmm, never thought of such a question, but it's a good one, IMO.

So, if we withdraw $25k from 401k (or that's $25k/yr pension every year) + $50K from Roth, then only $25k is taxable??

Sweeps?

[Broken Arrow]

Why would it be 3 pages? Or are those famous last words?

[sweeps]

So, if we withdraw $25k from 401k (or that's $25k/yr pension every year) + $50K from Roth, then only $25k is taxable??

Correct. That's why it is not a bad idea to do both pre-tax and post-tax retirement plans. You can withdraw from both to give you a nice income while staying in a relatively low tax bracket.

Why would it be 3 pages?

Many of the responses to questions lately have been, shall I say, long.

[jIM_Ohio]

Sweeps comment is accurate, but open to interpretation.

If you have a Roth 401k and the company match right now, the match is in pre-tax money, so the question of what bracket that is in will be based on tax law the year of the withdraw of the company match portion. This portion will be subject to RMDs at age 70.5, but could be withdraw as early as age 59.5 without penalty, or even earlier if rule 72(t) is used.

The issue no one knows is what the tax law will be in the future. Here is what current tax law is now:

Roth withdraws do NOT increase taxable income (as sweeps already stated). So the withdraws from the pre-tax accounts like 401ks and rollover IRAs (from company match and/or individual contributions) will be subject to ordinary income taxes at marginal tax rates. Could be 10% bracket, could be some 10%, some 15%, could be some 10%, some 15%, some 25% (the larger the withdraw, the higher the tax rate).

Capital gains in taxable accounts do NOT increase taxable income either (in current tax code). But the withdraws are subject to capital gains rates (5% rate if income is in 15% bracket or lower; 15% if income is in 25% bracket or higher). Again this is based on current tax law, and these rates will probably be changed if a democrat repeals the Bush tax cuts.

So a reasonable strategy is to know your highest marginal tax bracket and try, try, try to stay in it as long as possible, or try to withdraw in the lower bracket if possible.

For example use 72(t) to access money prior to 59.5 and slowly convert it to roth or taxable accounts so the tax rate is lower. If the capital gains rates increase, only convert it to a Roth. By accessing money sooner, you make small conversions at lower tax rates.

For example, my 401k saves me 25% (because that is my marginal tax bracket now). If I can convert my 401k to a Roth IRA at 15% tax bracket (in the future), I saved myself considerable money. The cap for 15% bracket is 65100 right now, and with wife's income, I could only convert around 10-15k per year at 15% bracket. Where as if I wanted to convert it at 25% bracket, I could convert up to 130k per year.

This is why it pays to learn about taxes now (while accumulating) and diversify what account types you have as well. Pay as little tax now as you can, and learn to manipulate money when tax law favors that account.

For example I think LTCG rates are 0% in 2009. Meaning anyone could cash out of a taxable investment next year and not pay any taxes on the gains.

[sweeps]

Many of the responses to questions lately have been, shall I say, long.

I rest my case.

[Snave]

Thanks for the help. Always trying to learn more and realize that someone probably has a bterrer answer than I do out there. The reason I even got to thinking about this was that we just had our taxes done and something like this sort of came up from a state tax situation. We moved from a state where we had no state income tax. Before we moved last January, I received a severance from my previous company. Then we moved to a state with a state income tax. While I obviously didn't have to pay state income on the severance b/c I wasn't even in the new state, when we did our taxes there was something about total income. I don't remember exactly what it was and need to shoot an e-mail to my accountant to have him explain it again. But, it got me thinking about this situation.

As a side not, I was talking with the perosn who handles my investments and we were discussing roths and taxable accounts and he made a good point about wanting to have some sort of taxable income when you retire. Even though many of us might have the house paid off and won't have that deduction, we will most likely have others: a losing stock, a tithe, etc...

[sweeps]

Here's the bottom line. When you're in your 60's, it will be very nice to have lots of options. If you have some 401k money, some Roth money, and some taxable account money, you're going to have a lot more options available to you when you withdraw. Based on the situation at that time, you can choose the optimal withdrawal strategy.

Note that all the previous comments were about federal taxes. Your state likely will handle things differently. YMMV.

[jIM_Ohio]

What is most tax efficient going in (401k) is the least tax efficient coming out (taxed at marginal rates, could be 35%).

What is least tax efficient going in (Roth) is the most tax efficient coming out (taxed at 0%).

What is in middle of tax efficiency going in (taxable brokerage account) can be the cheapest tax you ever pay coming out (5% or 15%).

I have heard of people having a lifesstyle in the 25% tax bracket range, but with most money in Roths and brokerage accounts, they can have the income needed for 25% tax bracket and only pay 5% capital gains taxes and 5% dividend taxes now.

In addition, the accounts where people keep savings accounts (taxable) has the interest taxed at marginal rates (up to 35%). The accounts where people keep stocks (IRAs and 401k) convert a 15% tax for capital gains to a 35% tax for income.

The withdraw rules are important to know for each account you choose to invest in.