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Understanding Income Taxes In Retirement

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You’ve done a pretty good job of building up your 401K and you think you’ve got plenty of money in there for when you retire.

But…how much can you take out each year? Is there some limit on that?

 

Answer: Legally, no. Practically, yes.

First, you’ve got to limit your withdrawals to a level that is sustainable. In other words, you want your money to last at least as long as you do.

Secondly, if you’ve been making contributions to a traditional 401K plan for several years, then you’ve been in partnership with Uncle Sam. Whatever amount you put in (and anything your employer put in for you) was not included as part of your taxable income in the year the contribution was made.

For example, if you made $50,000 in a particular year and put $5,000 in your 401K plan, your taxable income for that year was not considered by the IRS to be $50,000, but only $45,000.

To be clear, you don’t know at that point if you’ve saved taxes or not. You only know that you’ve deferred them. The Big Reveal (did you save taxes or didn’t you?) will come at retirement. Only then will you know if you’ve saved taxes, cost yourself more in taxes or whether it was a wash.

That’s because whatever you pull out of your traditional 401K plan at retirement is fully taxed at the prevailing rate in effect at that time. And what will the prevailing rate be? Go ask Madame Zorba to look into her crystal ball and tell you, because I don’t know.

The traditional thinking is that most of us will be in a lower tax bracket upon retirement. My experience has been that some are surprised to learn that things don’t always work out that way.

One thing most folks don’t think about is how a 401K withdrawal can impact taxes on your Social Security income.

Social Security income is tax free up to a point. If you have “other substantial income (according to the IRS)” you may find it causes half, or even up to 85% of your Social Security benefits to be taxable. Be sure you heard me correctly – I didn’t say you’d be in

an 85% tax bracket. Only that 85% of your Social Security benefits would in included in the calculation of what your overall taxable income is.

The upshot, however, is that income received from a 401K plan may cause some to have their Social Security income taxed at a higher rate.

If most of your retirement wealth is tied up in a 401K retirement plan, it can also cause you to be pushed into a higher bracket in any year you have to make a substantial withdrawal for an extra, or an unexpected expense: a new car, a new roof, medical bills, etc.

Most of us know that diversification is an important risk-shifting strategy when it comes to investing. But diversifying one’s sources of retirement income is also important for shifting the risks of higher tax brackets away from you.

Consider saving money in other places in addition to your 401K plan.

Balance is the key to flexibility in your retirement years.

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