How are my 401(k) taxes treated when I am drawing from Social Security?
My tax person told me I could take up to $11,500 from my 401(k) pretax dollars and not pay taxes on the $11,500 amount. Is that true?
It is quite possible that your accountant may be correct. The taxation of Social Security has three brackets. For those with very little income, they pay a zero tax on Social Security benefits. Then there those who are taxed on 50% of the Social Security and the maximum are for those who pay a tax on 85% of the Social Security. Assuming your accountant did this correctly, he/she calculated an amount that will keep you below the threshold for paying any taxes. Since we don't have the calculations, I cannot calculate this any further, but it is definitely a possibility if done correctly. I hope this helps and good luck.
Good for your tax advisor! Distributions taken from a 401(k) are treated as ordinary income and simply added into the calculation of your taxes. The tax impact of your Social Security is a bit more complicated, but basically, if half of your Social Security plus other income, including tax-exempt interest, is less than $25K (single) and $32K (MFJ), then the Social Security is non-taxable. Above that, a portion of the SS becomes taxable, up to 85 percent of it.
If you are single, the filing requirement is a personal exemption plus the standard deduction. For a person over age 65, that amount was 11,900 in 2016. That consists of $4,050 for one exemption and $7,850 as the standard deduction.
What your advisor likely did was work backward to arrive at the $11,500 number. Each year the number would change, but it certainly makes sense to take out as much from a retirement plan as you can tax-free.
Hope this makes sense and was helpful.
The first question is fairly straight forward; money that has never been taxed to begin with - all that growth, the reduced taxes throughout your career - is going to be taxable. Taxable, in that not all of it will be automatically be taxed, because there is a window of opportunity where some tax can be avoided or at least controlled.
But your other question is like most tax questions, it depends!
How much Social Security are you drawing?
Are you the only one drawing SS or do you have a spouse that will be adding to that?
Do you live in a state that is favorable to SS tax?
What's the probability that once you take $11,500, it's enough?
If you still have money in your 401(k), does that mean you're still working?
If you're not working anymore, is there a reason you're keeping your account in a 401(k) instead of moving it to an IRA in order to have more control?
Do you have other investments outside of your 401(k) that have even a slight possibility of impacting your income in the next year?
Do you need the $11,500 to live on or would it be a "surplus?"
The traditional tax person has two objectives: 1) to reduce your tax liability for last year (looking in the rear view mirror) and, 2) to bill more hours for next year. They don't want to rock the boat or tell you something you don't want to hear or ask the questions that are beyond the scope of the 1040, even though I'm confident that most of them know they should be doing those things. Do people "in general" want to pay less taxes? Of course. But advice that's in a tunnel and using past information as gospel for future outcomes, is not advice, it's irresponsible.
These are some things to consider, I think I've only scratched the surface of the variables, hopefully it's been helpful.
You don’t have to file a tax return if your gross income is below the threshold. The gross income filing threshold amount generally is the sum of the standard deduction and personal exemptions amounts. For a MFJ 2016 return, if your gross income is below $20,700, you don’t have to file a return, especially most of the time the Social Security income is not taxable. I’m assuming that’s your tax person meant. If it’s still unclear to you, ask him/her to explain further.
If you're working with a credible and experienced tax professional and they know your current and projected income numbers, they can model the tax impact that's specific to your situation.
Withdrawals from your 401(k) and traditional IRAs will generate taxable income reported on your return. Depending on your filing status (single versus married filing jointly, for instance) and the total of all your income from all sources (like W2, interest, dividends and capital gains), you may or may not have a portion of your Social Security benefits included in the calculation of total taxable income.
Generally, if you're single and have under $25,000 in income, then you'd find that none of your Social Security benefits are included in your adjusted gross income total. The limit is higher for married couples. And then this adjusted gross income is offset by things like your deductions (itemized or standard) and exemptions (for each taxpayer), and an extra deduction for those over age 65.
Without knowing your particular details, I'd say that he's right. For instance, if you're single and over 65, and your only income was Social Security and this $11,500 withdrawal from the 401(k), then you'd have $0 tax liability assuming one exemption ($4,050) and standard deduction ($7,850). None of your Social Security benefits would be included in the calculation of income.
How much you need to withdraw from your retirement accounts is based on a formula based on your age and life expectancy. The IRS has a special rule to calculate these Required Minimum Distributions (RMDs). It's roughly 4% of the balance (but this is just a back-of-the-envelope rule). So if you're starting with a balance of about $290,000, then $11,500 meets your RMD.
Now, whether you choose to take distributions above the RMD level really depends on your retirement income plan. Pulling this amount out may not be affecting your taxes as noted in the example above, but it could affect whether or not your distribution plan is sustainable. If you don't plan right, you could run out of money. This is where a good retirement plan is needed that looks at your cash flow needs, your RMD, and taxes.