Manage your tax brackets in retirement

A mix of taxable and nontaxable income may help boost retirement income and manage your tax bracket.

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How Roth accounts, a health savings account (HSA), investments that have lost value, and annuities can give you the ability to make tax‐smart choices in retirement.

Key takeaways

Help you retain more of what you earn.

Help you to be focused on the tax considerations associated with withdrawals.

Help you to understand Roth withdrawal considerations.

When planning for retirement, many people think that what they see in their retirement accounts is what they’ll have to spend in retirement. What they sometimes forget about are the taxes they will need to pay on certain withdrawals, like those from traditional 401(k)s and IRAs.

“It’s not what you earn that counts but how much you get to keep after taxes,” says Matthew Kenigsberg, vice president in Fidelity’s Strategic Advisers. “Also, managing your tax brackets in retirement can help preserve more of your money for the next generation.”

To manage taxes effectively in retirement, you’ll want to have taxable and nontaxable income sources. That way, you will have the flexibility to take withdrawals from different accounts in order to help reduce your taxes overall.

To do that you will want to keep your taxable income in the lowest possible tax bracket. The biggest benefit comes for those who can remain in the 15% bracket. That’s true for several reasons, including the fact that if you’re in the 15% bracket, long-term capital gains aren’t taxed at the federal level at all.

For 2017, the 15% bracket tops out at $75,900 in taxable income for joint filers ($37,950 for single filers). The next bracket is 25%, so bumping up a bracket costs you 10 cents more in federal taxes on your next taxable dollar. See 2017 tax brackets.

What do you do if your taxable income is about to push you into a higher tax bracket? The easy answer is to substitute income that isn’t taxed as ordinary income to help you stay within the lower income tax bracket. Here are four nontaxable income sources to consider setting up before you retire—so you’ll have the ability to make tax‐smart choices afterward:

1. Roth accounts—IRA or 401(k)

Qualified withdrawals from Roth IRAs and 401(k)s aren’t subject to federal income tax, making them a way to help manage tax brackets in retirement. For example, if you need money to pay for unanticipated expenses, you can withdraw money from a Roth account without triggering a federal tax liability as long as you meet the qualifying criteria.1 Moreover, Roth accounts offer estate-planning benefits, because currently any heirs who inherit a Roth account generally won’t owe federal income taxes on distributions.2

2. Taxable investments at or below cost basis

Even if the investments in your taxable account have gained in value, there may be tax lots that are at or below your cost basis. If you sell those, you won’t owe taxes. And if they are sold at a loss, you can use those realized losses to offset capital gains (and up to $3,000 a year in ordinary income if no realized gains are available to offset with remaining realized losses). Consult a tax professional.

3. Health savings accounts (HSAs)

HSAs are typically offered by employers in conjunction with a high‐deductible health care plan to cover qualified medical expenses. However, contributions to HSAs can accumulate tax free and can be withdrawn tax free to pay for qualified medical expenses, including those in retirement.3

Note that the medical expenses need not be from the current year. It’s important to keep good records of past expenses so that those expenses can be applied to future HSA withdrawals if needed.

4. Annuities

Annuitized income consists of both taxable income and nontaxable return of principal when purchased with non-qualified assets. A portion of the income you receive is a return of premium and is not taxable. Depending on the age you purchased the annuity, your cash flows may be mostly nontaxable return of principal.4

Managing brackets: an example

Now, let’s look at an example of how managing tax brackets might work. Consider the Smiths, a hypothetical married couple who have a variety of different accounts and $100,000 in yearly expenses in retirement.5 They have $42,000 in gross income (all taxable) before tapping their retirement accounts. They also anticipate $20,000 in tax deductions and exemptions, so their expected taxable income before withdrawals is $22,000. Their gross income gap (i.e., before taxes) is $58,000.

If they withdraw $53,300 from their traditional IRA, it would bring their taxable income to $75,300—the top of the 15% bracket for 2016.They could then withdraw the remaining $4,700 that they need to cover their income gap, plus $10,368 to cover their tax bill, for a total of $15,068, from a Roth IRA, which does not generate taxable income as long as the withdrawal is qualified.6 If the Smiths could get some or all of the $15,068 from a taxable account without generating capital gains taxes—for example, from a bank account—that would work as well.

As the chart shows, this strategy saves the Smiths $5,023 in taxes this year compared with just withdrawing everything they’ll need from the traditional IRA. It also means they can withdraw from the traditional IRA in the future when their tax bracket may be lower. The picture would be similar with any of the other tax‐free income sources listed above. (Important note: The chart illustrates only one year, but a tax-bracket management strategy should consider the preceding and following years as well. Sometimes the impact of events in those years can affect the strategy and its results. Also, the use of a tax-bracket management strategy is not appropriate for all investors, so be sure to consult with a tax professional before implementing one.)

Keep in mind

Finally, be sure to keep abreast of your state’s tax laws. Some states offer favorable tax treatment for certain sources of retirement income, such as some 401(k) plans and pensions (and several states have no state income tax at all). So you will want to make the most of state tax law as well. As always, be sure to consult a tax professional so that you can choose the appropriate strategy for you.

Learn more

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1. A distribution from a Roth IRA is federal tax free and penalty free provided that the five‐year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, die, become disabled, or make a qualified first‐time home purchase.
2. While heirs typically don’t have to pay income tax on Roth distributions, unlike the original Roth IRA owners, they are subject to minimum required distributions (MRDs). The rules for MRDs on inherited IRAs can be complex, so be sure to check with a tax professional.
3. Tax advantages are with respect to federal taxation only. Most states follow federal tax law, but there are a few exceptions, so be sure to check with the state tax authority in your state of residence.
4. The computation of taxation on annuity income can be complex, with many rules and exceptions, so be sure to consult a tax professional. That said, in general, it is assumed that the purchase price of an annuity is returned to the purchaser in equal installments over the life expectancy of the purchaser. This is known as return of principal and is not taxable income, although once the entire purchase price has been returned, any further payments to the annuitant are assumed to consist entirely of taxable income. For example, say an investor purchases a single premium immediate annuity for $100,000 and has a life expectancy of 20 years at the time of purchase. If the annuity paid the investor a distribution of $7,000 every year, then $5,000 would be considered nontaxable return of principal and $2,000 would be considered taxable income for 20 years. After that, all the $7,000 annual distribution would be fully taxable.
5. The hypothetical scenario relies on the following assumptions: 2016 federal tax figures, “married filing jointly” filing status, standard deduction for married couples who are age 65 or older, two personal exemptions, no alternative minimum tax, no state income tax, tax‐deferred account has no basis, and gross income is total reported income prior to tax deductions and exemptions.
6. The taxes of $10,368 on $75,300 of taxable income are composed of two parts: $1,855 in tax on the first $18,550 of taxable income, which is taxed at a 10% rate, plus $8,513 in tax on the next $56,750 of taxable income, which is taxed at a rate of 15%. Any taxable income above this point would be taxed at a 25% rate.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

Guidance provided by Fidelity through the Planning & Guidance Center is educational in nature, is not individualized, and is not intended to serve as the primary basis for your investment or tax‐planning decisions.
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