Why squirreling away every spare dime into your 401(k) is a bad idea

  • Once you’ve reached retirement, you want a combination of taxable, tax-deferred and tax-free pots of savings.
  • Hoarding all of your savings into 401(k)s and traditional IRAs leaves you with less flexibility – and more of your income will be subject to rates as high as 37 percent.
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If the bulk of your retirement savings is locked up in 401(k) plans and traditional individual retirement accounts, you may have set yourself up for unnecessarily higher taxes once you’ve stopped working.

That’s because once it’s time to start taking withdrawals from those tax-deferred accounts, the majority of your savings will be subject to ordinary income tax rates, which can be as high as 37 percent.

Instead, it’s ideal to have your savings put away in a combination of tax-free, taxable and tax-deferred accounts so that you can adjust your retirement income and manage your tax bracket.

With the appropriate withdrawal strategy, you can even keep your taxable income low enough to avoid paying higher Medicare premiums.

“The more diversified your tax characteristics are, the more leverage you have for better outcomes,” said Gavin Morrissey, managing partner of Financial Strategy Associates in Needham, Massachusetts.

“What people do is pile everything into a pre-tax retirement plan, then they don’t have a lot to do when they retire other than to pull the money out at ordinary income tax rates,” he said.

Here’s what you need to know about saving on taxes as you draw down retirement income.

Tax diversification

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Your 401(k) and traditional IRAs are subject to income taxes (and a 10 percent penalty if you withdraw before age 59½).

Meanwhile, taxable accounts incur capital gain levies when you sell your holdings. Long-term capital gains rates range from 0 percent to 20 percent, based on your bracket.

Finally, withdrawals from Roth IRAs are tax-free because you paid Uncle Sam when you made your contribution.

See below to find your income tax bracket.

Multiple sources

Rather than taking withdrawals strictly from just a 401(k), retirees can pull money from other sources.

Let's say you're single, and your pension income puts you close to the top of the 12 percent bracket — $38,700. You need a little more money to cover your expenses, but you want to do it without jumping into the 22 percent bracket.

In this case, you might turn to your Roth IRA. This way, you get the cash you need without the additional income tax bite.

“You can choose whether you want the next withdrawal to add to your taxable income or you can keep yourself in your current tax bracket,” said Marcy Keckler, vice president, financial advice strategy at Ameriprise Financial.

On the other hand, you might have retired early enough that you don’t need to take a required minimum distribution from your IRA or 401(k), and you’re not claiming Social Security just yet.

In that case, you might want to tap your taxable account instead, said Morrissey at Financial Strategy Associates. “We can probably capture some long-term capital gains on the front end of retirement and fill that first year’s need.”

Managing Medicare premiums

If you can manage your income tax brackets, you can also manage your premiums for Medicare Part B and D, which cover outpatient care and prescription drugs, respectively.

What you pay in 2018 for Medicare is based on your modified adjusted gross income from 2016. Beneficiaries with a MAGI of $85,000 if single or $170,000, if married and filing jointly, will pay more each month for coverage.

Here are the Part B premiums for high-income beneficiaries.

This is a breakdown of Part D premiums, based on MAGI.

If you’re approaching an MAGI threshold that will lead to higher Medicare premiums, you might turn to your taxable account to manage your income.

“You can sell something at a loss and then use that to offset other liabilities,” said Keckler at Ameriprise. “If you’re getting close to the threshold, the next dollar will have higher potential tax liability.”

Where to start

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How you distribute income from your savings will vary based on your goals and your financial needs in retirement.

“It requires a case-by-case and year-by-year approach,” said Jeff Fosselman, a CPA and senior wealth advisor for Relative Value Partners in Northbrook, Illinois.

Get together with your financial advisor and your accountant and hash out the following.

• Start with Social Security and any pension: Find out how these two sources of retirement income will affect your marginal tax rate. How much room do you have for additional income before your rate rises?

“That’s the amount of money that you can take out of your 401(k) and IRA and still remain in the same bracket,” said Keckler at Ameriprise.

• Know when to tap the other buckets: “If your MAGI is approaching the threshold for higher Medicare premiums, having accounts that generate little tax are a great alternative,” said Fosselman of Relative Value Partners.

• Remember your goals: There’s no rule of thumb for drawing down in retirement. If you’re planning to keep your Roth IRA intact for your heirs, your strategy will be different. “If the client wants the Roth to be part of a legacy, we may be more aggressive investing it,” said Morrissey at Financial Strategy Associates.

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