What Account Should You Spend From in Retirement?

When you retire, you may have money spread across several different types of accounts. The account you choose to spend from can change how much you pay in taxes. A good retirement withdrawal strategy considers how each source of income is taxed and how they stack up against one another. To see how this works, we’re going to follow one couple through retirement. We’ll start with income from their taxable investment account, then add capital gains, a pension, IRA withdrawals, Roth conversions, and Social Security to see how each affects their tax picture.

Why Your Retirement Withdrawal Strategy Matters

Some taxable income in retirement is difficult to avoid. If you have money in a taxable investment account, for example, you may receive dividends and interest throughout the year.

But you also have choices. You can decide whether to sell investments and realize capital gains, take money from an IRA, or complete a Roth conversion. If you have a pension, that adds another source of taxable income to the mix. Each source of income is taxed differently, and they can affect one another. So rather than looking at each account on its own, it helps to see how they all fit together.

Start With Dividends and Interest

Let’s start with a couple that has $2 million in a taxable investment account. That account will generate taxable income whether or not withdrawals are taken. In our example, the couple receives $40,000 in dividends and another $6,000 in taxable interest. That gives them $46,000 of income before we start making any decisions about selling investments, taking IRA withdrawals, or doing Roth conversions.

Ordinary vs. Qualified Dividends

Dividends come in two different forms. Ordinary dividends are taxed at your ordinary income tax rates. Qualified dividends receive different tax treatment and fall into the same tax brackets as long-term capital gains.

Of the couple’s $40,000 in dividends, $12,000 are qualified dividends. That distinction becomes important when we look at their total tax bill. After applying their $30,000 standard deduction, they have $16,000 of taxable income. Of that amount, only $4,000 falls into the ordinary income tax brackets. The remaining $12,000 consists of qualified dividends and falls within the 0% long-term capital gains and qualified dividend bracket in this example. Their total federal income tax comes to just $400.

How Interest Is Taxed

Taxable interest goes into your ordinary income tax bucket. That can include interest from:

• Bank accounts
• Certificates of deposit
• Taxable bonds
• Treasury securities
• Corporate bonds
• Money market accounts

In our example, the couple has $6,000 in taxable interest, which is included with their ordinary income.

Next, Look at Long-Term Capital Gains

Now let’s say this couple needs another $50,000 a year to live on. They have that $2 million taxable investment account, so they decide to sell some investments and use the cash for spending. When you sell an investment in a taxable account, you don’t necessarily pay tax on the entire amount you receive. You pay tax on the gain.

You Only Pay Tax on the Gain

Let’s say you bought an investment for $10,000 and later sold it for $20,000. You now have $20,000 available to spend, but only the $10,000 gain is taxable. You can also choose which investments to sell. Sometimes we’ll sell investments with losses alongside investments with gains to reduce the overall net gain when we’re raising cash for clients. For our couple, let’s assume the $50,000 they raise is 50% cost basis and 50% gain. They receive $50,000 in cash, but only $25,000 is a taxable gain. When we add that to the dividends and interest from our earlier example, the couple now has $96,000 available to spend. Their taxable income is much lower because $25,000 of the $50,000 they raised from the portfolio was their original cost basis.

Long-Term vs. Short-Term Capital Gains

How long you’ve owned an investment also affects how the gain is taxed. If you sell an investment you’ve held for less than a year, the gain is generally a short-term capital gain and goes into your ordinary income tax brackets.

If you’ve held it for more than a year, the gain generally falls into the long-term capital gains brackets. In this example, the couple’s $25,000 gain falls into the same bucket as their qualified dividends. They now have $37,000 of qualified dividends and long-term capital gains, all of which falls within the 0% bracket. Their ordinary federal income tax is still only $400, even though they have $96,000 available to spend.

Where Does Pension Income Fit?

Now let’s add a $32,000 pension to the couple’s income. Pension income is taxed as ordinary income. Once we add that $32,000, the couple fills the 10% tax bracket and starts moving into the 12% bracket. Their qualified dividends and long-term capital gains are still taxed separately. At this point, they have $37,000 in qualified income, and all of it still falls within the 0% long-term capital gains bracket. With the pension added, their total federal income tax increases to about $3,843. Their marginal tax bracket is now 12%. But there’s still room left in that 12% bracket. And that gives us another decision to make with our retirement withdrawal strategy.

Use Lower Tax Brackets While You Have Them

If we have room left in a lower tax bracket, we can look at whether it makes sense to use some of that space now. Think about it like exercise. It may not feel great today, but it can put you in a better position down the road. Taxes can work the same way. Paying a little more tax today through an IRA withdrawal or Roth conversion may help improve your tax situation later.

IRA Withdrawals and Roth Conversions

Let’s say our couple needs another $20,000 from their IRA for spending. They also decide to complete a $40,000 Roth conversion. Together, those decisions add $60,000 of income. Their total income increases to about $163,000, and their total federal income tax increases by roughly $13,000. We’re intentionally using most of the room available in the 12% bracket. About $24,000 of their ordinary income falls within the 10% bracket, with the rest falling within the 12% bracket. None of it reaches the 22% bracket.

There are situations where it could make sense to convert even more and pay tax at a higher rate today. But that depends on your age, your liquidity needs, and how the decision fits into your overall financial plan. For this couple, we’ll keep the Roth conversion at $40,000. Later, we’ll see what happens when Social Security gets added to the mix.

SEE ALSO: 8 Completely LEGAL Ways to Pay Less Tax In Retirement

What Changes When Social Security Starts?

Now let’s fast forward a couple of years and add Social Security to the couple’s income. Let’s say they receive $50,000 a year in Social Security benefits. Depending on your income, up to 85% of your Social Security benefits can be included in your taxable income. For this couple, that means $42,500 of their $50,000 benefit is taxable.

How Much of Social Security Is Taxable?

The amount of your Social Security that is taxable depends on what’s called provisional income.

Provisional income includes:

• Your adjusted gross income
• Tax-exempt interest, including municipal bond interest
• Half of your Social Security benefits

For a married couple filing jointly, the threshold in this example is $44,000. Once provisional income exceeds that amount, up to 85% of Social Security benefits can be included in taxable income. Adding Social Security brings our couple’s total income to about $205,000. Their taxable Social Security income falls into the ordinary income tax brackets, pushing part of it into the 22% bracket. Their average tax rate also increases to about 12.6%. This changes the decisions we were making earlier. We had room to take IRA withdrawals and complete Roth conversions while staying in the 12% bracket. Once Social Security starts, some of that room disappears.

SEE ALSO: DON’T Claim Social Security Until You Understand This!

Watch Your Income for IRMAA

Taxes aren’t the only thing we need to consider as the couple gets older. Once they’re on Medicare, their income can also affect how much they pay for Medicare Part B and Part D. These additional costs are known as IRMAA surcharges. In the scenario we’re following, the first IRMAA threshold for a married couple filing jointly is $212,000. Our couple is at about $205,000, putting them fairly close to that threshold.

IRMAA works differently from ordinary income tax brackets. With a tax bracket, only the dollars that spill into the next bracket are taxed at the higher rate. With IRMAA, crossing the income threshold can trigger the full additional Medicare surcharge. For this couple, crossing that first threshold could mean roughly $2,000 more per year if they’re both on Medicare. The additional cost continues to increase as you move through the higher IRMAA brackets. That gives us another reason to pay attention to where our retirement income is coming from.

Adjust Your Withdrawals as Your Income Changes

Earlier, our couple completed $40,000 in Roth conversions and took another $20,000 from their IRA for spending. We were doing that because they had room available in the 12% tax bracket. Now they have another source of income from Social Security. So we can adjust.

Instead of converting $40,000 to Roth, let’s reduce the conversion to $18,000. And instead of taking $20,000 from the IRA for spending, let’s eliminate that withdrawal. With those changes, the couple’s total income comes back down to about $163,000. Their total federal income tax drops back to roughly $16,000, and their marginal tax bracket returns to 12%. By changing which accounts we use as the couple’s income changes, we can keep their taxable income within the 12% bracket. That also leaves more room before they reach the first IRMAA threshold. If they suddenly need extra money for a large expense, such as a $50,000 car, they have more flexibility to raise that cash without immediately starting from an income level that’s already close to the threshold.

Why Roth Money Gives You More Flexibility

Those Roth conversions we completed earlier have also created another bucket the couple can use. Qualified withdrawals from a Roth IRA don’t add to the ordinary income we’re tracking here. They also don’t fill the long-term capital gains and qualified dividend brackets or increase the income used for the IRMAA calculation.

That gives the couple another place to get money when they need it. They may not want to spend their entire Roth balance at once. But they can use it strategically in years when taking additional money from a traditional IRA or another taxable source would push their income higher. This brings us back to the Roth conversions we made earlier. Paying some tax on those conversions gave the couple a source of tax-free money they can draw from later without changing the tax brackets we’re trying to manage.

Build Your Retirement Withdrawal Strategy Around Your Tax Picture

There isn’t one account that everyone should spend from first in retirement. The answer can change as new sources of income begin and your tax situation changes. For our couple, we started with dividends and interest, raised cash from their taxable account, added pension income, used some of the available room for IRA withdrawals and Roth conversions, and then adjusted the strategy once Social Security started.

At Paces Ferry Wealth Advisors, we look at these decisions as part of your overall financial plan. If you’d like help building a retirement withdrawal strategy around your income needs and tax situation, contact us to schedule a conversation.

Paces Ferry Wealth Advisors, LLC is a registered investment advisor with the U.S. Securities and Exchange Commission (“SEC”). This material is intended for informational purposes only. It should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney or tax advisor.