Could Your Retirement Withdrawals Be Too Tax-Heavy? A Fast Annual Review

Money taken from retirement accounts can create tax issues that extend far beyond the immediate bill on the withdrawal itself. Pulling too much from a traditional IRA or 401(k) in a single year may bump income into a higher bracket, make more of your Social Security benefits taxable, or even increase Medicare premiums later.

The good news is that a quick yearly review can help retirees catch possible trouble before they take the next distribution.

Begin With the Previous Year’s Tax Return

Jim Swiech, a certified public accountant and founder of Go Beyond Tax, says to start with last year’s Form 1040. Compare taxable income with the top of your current tax bracket to determine whether you have room for additional taxable withdrawals or a Roth conversion without crossing into the next bracket.

For married couples filing jointly, the 12% federal income tax bracket tops out at $100,800 of taxable income. If you are comfortably below that figure, there may still be room in the bracket.

“That gap is where I start, and the rest of the return decides the answer,” Swiech said.

Be Deliberate With Tax-Deferred Withdrawals

If you have options, don’t automatically take all of your spending money from a traditional IRA or 401(k), Swiech said. Taxable, tax-deferred and Roth accounts are treated differently, so the source of each withdrawal can matter.

“In most years, I fill the low brackets with IRA money and cover anything above that from the other two buckets, but the order can change from year to year, so compare the tax cost of the next dollar from each account before you choose,” he said.

Jon Hsu, owner at TrueVector Wealth Advisors, said, “Lifetime tax bracket management is simply the idea of increasing your taxable income when you're in a low tax bracket and decreasing your taxable income when you're in a high tax bracket.”

See How Withdrawals Could Affect Social Security Taxes

Taking money from an IRA or 401(k) can also increase the share of your Social Security benefits that is taxable.

For married couples filing jointly, the key combined-income thresholds for Social Security are $32,000 and $44,000. For single filers, they are $25,000 and $34,000.

Swiech offered a hypothetical example involving two married couples, both age 67, who receive $48,000 in Social Security and already withdraw $30,000 from an IRA. Both couples need another $10,000.

• Couple A takes the extra $10,000 from the IRA.

• Couple B takes $10,000 from savings principal that has already been taxed.

• Couple B ends up with zero taxable income and zero federal income tax.

• Couple A’s additional IRA withdrawal causes another $8,500 of Social Security to become taxable, resulting in $15,500 of taxable income and $1,550 in federal income tax.

Think About Medicare Premium Effects

A large retirement withdrawal can also lift modified adjusted gross income, or MAGI, enough to trigger Medicare’s income-related monthly adjustment amount, known as IRMAA. Because Medicare generally relies on tax information from two years earlier, a withdrawal made in one year can affect Medicare premiums later.

For that reason, crossing the first IRMAA threshold can be costly. For married couples filing jointly, the initial trigger begins above $218,000 of MAGI; for single filers, it begins above $109,000. Moving over that line increases Part B premiums by $81.20 per month and adds $14.50 per month to Part D, or about $1,150 more per year per person.

“One dollar over the line costs the whole step,” Swiech said.

Use the Low-Tax Window Before RMDs Start

The years after retirement but before required minimum distributions begin can be unusually low-tax years, Swiech said. That can create a chance to make strategic withdrawals or complete Roth conversions before RMDs potentially raise taxable income later.

AARP says RMDs generally begin at age 73 for people born from 1951 through 1959 and at age 75 for those born in 1960 or later.

Don’t Treat a Roth Conversion as an Automatic Tax Saver

A Roth conversion can reduce future RMDs and create tax-free qualified withdrawals later, but converting too much at once can also cause tax problems of its own.

“The right yardstick is lifetime tax, not this year's bill,” Swiech said.

If a conversion pushes income into a higher bracket, makes more Social Security benefits taxable, or triggers IRMAA, it may be less appealing.

“Model it year by year before you convert, not in April,” he said.

Repeat the Check Each Year

Income, withdrawals, tax brackets and Medicare exposure can all change from year to year. Before making a large withdrawal, Swiech recommended reviewing the following:

• Form 1040, SSA-1099, 1099-Rs and brokerage 1099s

• Your Medicare premium notice

• Taxable income compared with the top of your current bracket

• MAGI compared with Medicare IRMAA thresholds

“If the gap is large or the year has anything unusual in it, bring someone in,” Swiech said.