Dear Carrie, I just turned 66 and have recently retired. I'll be collecting Social Security and a small pension. I also have a 401(k) but don't want to touch that until I really need it. Is there a way for me to preserve my 401(k) for later and minimize my current tax bill? —A Reader
Dear Reader, Unfortunately, taxes are a fact of life even in retirement. But your question is a good one as long as you know in advance what's taxable and can plan for it.
Distributions from a tax-deferred account are generally taxed at your ordinary income tax rate, which contrasts to a Roth IRA or Roth 401(k).
Taxation of investment earnings or distributions from taxable accounts is another matter altogether. The tax rate on the profit you make from selling investments in a regular investment account depends on your income and the length of time you owned the investment. Short-term capital gains are currently taxed as ordinary income. Long-term capital gains are currently taxed at a generally more favorable rate ranging from 0 to 20 percent.
What a lot of people don't realize is that a percentage of Social Security benefits may be subject to ordinary income taxes if your provisional income is above a certain amount. Provisional income includes gross income, tax-free interest, and one half of your Social Security benefits.
But it's never quite that simple. That's because the percentage of your Social Security benefits that is subject to income taxes varies depending on how much money you make. Here are the 2017 limits:
—For single filers, if provisional income is between $25,000 and $34,000 up to 50 percent of Social Security benefits may be taxed. Above $34,000, it jumps to up to 85 percent. Below $25,000, Social Security income is not taxable.
—For married filing jointly, if provisional income is between $32,000 and $44,000 up to 50 percent of Social Security benefits may be taxable. If income exceeds $44,000, again it goes up to 85 percent. Below $32,000, Social Security income is not taxable.
Since you don't plan to withdraw money from your 401(k) for a while, it won't affect your tax bill for now. In the meantime, though, you do have to decide where to keep it while it continues to grow tax deferred. The easiest thing could be to leave it with your former employer, as long as you're happy with the investment choices, management and fees.
However, if you want to expand your investment opportunities, you could roll over your 401(k) into an IRA. To avoid any tax consequences, this should be done as a direct rollover from your former employer to your financial institution. This is important because if your 401(k) assets are distributed to you personally, 20 percent will automatically be withheld for federal taxes. Your state may also require you to have income tax withheld from your distribution. You then have 60 days to put the money into another tax-advantaged retirement account or else it's considered a distribution and full taxes apply.
For the record, another choice you might have would be to convert your 401(k) to a Roth IRA. The catch here is that, although you don't pay income taxes on withdrawals from a Roth as long as you've had the account for five years, you do pay income taxes upfront on the amount you convert. That could be quite a large tax-bite, so you could also consider gradually converting your 401(k) assets into a Roth IRA over time. This can make sense if you anticipate being in a low tax bracket for a while and convert just enough to avoid moving into a higher tax bracket.
Technically, you have until the year after you turn 70 1/2 to take your first RMD because you can choose to take it either by the end of the year you turn 70 1/2 or by April 1 of the following year. But if you defer for the first year, you'll end up having to take two distributions in the second year since all subsequent RMDs must be taken by December 31 of each year. That could increase your taxes for that year. Also note that Roth IRA account assets are not subject to RMDs.
And you definitely don't want to miss taking your RMD on time. The penalty is a hefty 50 percent of the amount that should have been withdrawn.
Once you start taking an RMD, your tax bill may go up. It depends on whether adding your RMD to your pension and Social Security and any other income kicks you into a higher tax bracket or increases the percentage of taxation on your Social Security benefits. Beyond the RMD, it's up to you to decide if you need to take larger withdrawals to make ends meet. If you can get by on the minimum, you'll potentially keep your tax bill lower for now, but it could lead to a higher tax bill down the road with larger RMDs.
There are a number of online income tax calculators that let you plug in different numbers to determine your potential tax bill. You could run a few different scenarios to help you feel more confident and prepared, but these calculators may not be a good substitute for meeting with a CPA and a financial advisor to discuss tax planning strategies in greater detail.
Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER(tm), is president of Charles Schwab Foundation and author of The Charles Schwab Guide to Finances After Fifty, available in bookstores nationwide. Read more at http://schwab.com/book. You can e-mail Carrie at [email protected] Information on this website is for educational purposes only. It is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.
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