Which is the more tax-friendly account to distribute from?
I am 64 years old and have a pension and SS income. I also have a IRA and a taxable investment account. My question is, which account is more tax friendly to withdraw from considering I will face Required Minimum Withdrawals in a few years? My home is in Ohio and I currently pay Ohio state income tax and a municipal tax in addition to federal taxes.
All Roth IRA distributions are tax free giving investors the most tax friendly distributions. I have attached an article on the benefits of converting your traditional IRA into a Roth IRA which would be a more tax friendly account to take your distributions from, although when you convert from a traditional IRA to a Roth IRA you are required to pay taxes at the time of conversion. Additionally, with a Roth IRA you are not required to take your required minimum distributions. Which would give you more control of your distributions.
Converting your traditional IRA or 401(k) (or at least a portion of these funds depending on what taxes could easily be paid on those dollars that year or over a series of years) into a Roth IRA is a simple solution. By converting your traditional IRA into a Roth IRA you will:
- Reduce your tax rate risk: The risk that taxes in the future could be higher than they are today. Once it is converted, any withdrawals from the Roth account after five years and achieving the age of 59.5 will be tax-free. (For related reading, see: How a Roth IRA Works After Retirement.)
- Eliminate your Required Minimum Distribution (RMD): Once you turn 70.5 years of age the government wants your tax dollars so badly that they require you to take these funds out of your traditional IRA every year. If you forget or choose not to take these funds out of your traditional IRA, the IRS will impose a 50% penalty.
- When withdrawing funds from your traditional IRA, the income counts as provisional income, whereas when withdrawing funds from your Roth IRA, the distributions have no Social Security tax. Roth IRA distributions do not count against income thresholds that may cause Social Security benefits to be taxed.*
- Your heirs will receive your Roth funds tax-free. (For related reading, see: 4 Mistakes Clients Make With Roth IRAs and Their Estate.)
- Roth IRA conversions may be re-characterized if your financial situation changes that year.
Converting from a traditional IRA to a Roth could be a useful tool. By paying taxes today you can take advantage of historically low rates. Additionally, our new White House administration’s tax plan could potentially make it an even more attractive time.
The Required Minimum Distribution from an IRA kicks in when you are 70 1/2 years old, so that's still off in the future. Both your pension and Social Security Income are taxable, though the rates will depend on your overall income level. With that said, your question seems to be whether to draw down from your IRA or your taxable investment account. If you draw from your IRA, your taxes will be at ordinary income rates. If you draw from your taxable account, assuming that you have gains from securities held for more than a year, you would get the more favorable tax treatment for long-term capital gains. In that case, withdrawals from your taxable account would be the better choice.
You may want to consider a Roth IRA conversion where you gradually move your IRA assets into a Roth IRA. All IRA withdrawals count as ordinary income. Therefore, you need to be strategic when choosing your conversion value so that it doesn't significantly increase your taxes at the end of the year.
You can also invest in Ohio municipal bonds. However, you need to do the math right. Muni bonds are generally tax exempt although if half of your Social Security benefit plus other income, including tax-exempt municipal bond interest is higher than $44,000 for a joint return, up to 85% of your Social Security benefits may be taxable.
The playbook says to take withdrawals from your taxable investment account first. The primary reason being long-term capital gains/dividend tax rates are 15% - 20%. For a retiree, your capital gains could be 0% if your taxable income is low enough. You would most likely need to do some tax loss harvesting in order to fall into the low-income tier. Basically for most people paying the capital gains/dividend tax rates is a lower percentage than if they withdrawal money from their IRA. Traditional IRAs are taxed at ordinary income rates and could potentially bump you into a higher tax bracket faster than pulling from your after-tax investments. Also, keep in mind that you can invest in Ohio municipal bonds to generate tax-free income both at the federal and state level. Other types of bonds are taxed at ordinary income tax rates. Feel free to contact me with any questions. Hope this helps!
The complete answer for your case would depend on the details of your tax situation now and in the future years, and the best strategy for you may differ from year to year. Some things that may influence your choices in a given year:
- Is there an opportunity to tactically realize capitals gains or losses in your taxable investment accounts?
- How do your current cash flow needs compare to the size of your eventual RMDs if you delay accessing the IRA balance to age 70? This contrast may help project what marginal tax bracket you would reach in those RMD years.
- Is there "room" in your current tax bracket to fill up the marginal tax rate without stepping to the next rate?
- Have you considered the impact to your estate plan for dying with the bulk of your assets held in brokerage vs the IRA?
As with most tax questions, the main tension is between a "now" versus "later" decision, which is complicated by not knowing how or if the tax code will be different in the later period. Some financial planners and/or tax professionals may provide scenario planning specific to your details.