Retirement Basics: Understanding Tax Efficiency
One of the basics when considering how to fund your retirement is to be as tax efficient with your income as possible. In 2022, income tax rates range from 0 to 37 percent, plus a potential 3.8 percent net investment tax. Understanding how these progressive tax rates apply to ordinary income creates a tremendous retirement planning opportunity.
The basic concept
Many retirees can control their taxable income each year by the amount they work and how much they withdraw from retirement savings accounts like IRAs and 401(k)s. Because you can control the amount of your taxable income by the amount you withdraw from your retirement savings, you can ensure your income is as tax efficient as possible.
Example: A single taxpayer pays 24% on taxable income from approximately $89,000 to $170,000. The next taxable dollar you earn above $170,000 is then taxed at 32%. So if you are making $100,000, you can choose to be tax efficient withdrawing up to $70,000 from your traditional IRA before you jump to the next tax bracket.
Note: Taxable income typically includes wages, interest, non-qualified dividends, short-term capital gains (assets owned for one year or less), taxable Social Security benefits and withdrawals from most 401(k), 403(b), and non-Roth IRAs.
Other factors add complexity
Planning for tax-efficient retirement, however, is never simple. There are other things to consider:
- Your age
- The taxability of your Social Security benefits
- Income phaseouts of other tax benefits
- Required minimum distributions at age 72 or older
- Your state tax situation
- Other taxes (estate taxes, inheritance taxes and capital gain taxes)
What to do?
Making tax efficiency an integral part of your retirement plan can be complicated. But the rewards are tremendous for those willing to start early, dedicating the time to planning, and asking for assistance.
