Ask Carrie: Can I Protect My Retirement Income and 401(k) From Taxes?

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.

Understand how different types of income are taxed

Distributions from a tax deferred account (such as an IRA, 401K, pension, etc.) are generally taxed at your ordinary income tax rate. This contrasts to a Roth IRA or Roth 401(k); anyone 59 ½ or older can take distributions from these without paying any income tax, provided the account has been open for at least five years.

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 (on investments held for one year or less) are currently taxed as ordinary income. Long-term capital gains (on investments held for more than a year) are currently taxed at a generally more favorable rate ranging from 0 to 20 percent (plus a 3.8% surtax for certain taxpayers).

Whether or not your Social Security benefits will be taxed depends on what the IRS calls your ‘provisional’ income. The fact that Social Security benefits are taxed at all takes many people by surprise, so we’ll explain that in depth next. Then we'll talk more about your 401(k).

How Social Security benefits are taxed

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, of course, with taxes, 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.

No one pays federal income tax on more than 85% of his or her Social Security benefits. In addition, depending on the state that you reside in, Social Security benefits may be taxable on a state level.

What you can do with your 401(k)

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. (And keep in mind that there are also other considerations, including distribution options, legal protections, loan provisions, and other particulars of each account.)

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 (provided your plan allows for partial distributions). 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.

When you have to start taking an RMD

If you keep your 401(k) where it is or roll it over into a traditional IRA—and don't take any withdrawals—you won't have to pay taxes on it until you reach age 70½. At that time you'll have to take a required minimum distribution (RMD)—which will be taxed as ordinary income.

Technically, you have until the year after you turn 70½ to take your first RMD because you can choose to take it either by the end of the year you turn 70½ or by April 1st 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 31st 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—and you still have to pay taxes on it.

How to manage your tax bill

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. Best of luck.

Editor’s Note: As of publication, Congress is debating significant income tax reforms. This will not impact your 2017 tax return. However, it is important to stay abreast of changes in the future and adjust your plans accordingly.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article.

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This article originally appeared on Schwab.com. You can e-mail Carrie at askcarrie@schwab.com, or click here for additional Ask Carrie columns. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.

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