Smart Withdrawals Can Stretch Your Retirement Income

Ask someone what tax bracket they fall into and you’ll likely hear a percentage such as 15%, 28% or 33%. But the fact is, people could fall into all these brackets -- and more. You don’t pay the same tax rate on every dollar of income you receive.In this country we have what’s called a “graduated” or “progressive” tax rate system: as your income increases, the tax rate you pay goes up, but only on the amount above a certain threshold.

Here are what the tax brackets look like for a married couple who files jointly this year:(1)

If this couple’s 2011 taxable income is $78,000, their federal tax bill will come to $11,750.  Here’s how it’s calculated:

1. 10% tax on the first $17,000 = $1,7002. 15% tax on the first  next $52,000 = $7,8003. 25% tax on the first  $9,000 = $2,250

In the above example, this couple’s weighted average tax rate is actually about 15.4%, not 25%.Knowing the best way to convert the money they’ve saved into income is one of the biggest challenges  retirees face. Which accounts do you tap first? How much from each? If a retiree takes out too much, you risk running out of money before you run out of life. At the other extreme, if you’re too stingy with your withdrawals, you’re likely to have a miserable retirement.While we can’t foresee or control what the financial markets will return or where interest rates will be, one area that (usually) provides a large measure of predictability is taxes.

If you know in advance (even if it’s only for the next two years) what tax rates are going to be, you can -- and should -- use this to your advantage. The lower your tax bill, the less you have to withdraw, and the longer your money can remain invested and (hopefully) growing.As a retiree, you may have assets sitting in a variety of different accounts including company retirement plans, individual stocks and IRAs.

When you break it all down, they fall into one of four categories:

1. Pension - Defined benefit plan income from a former employer (lucky you!) as well as Social Security. This is taxable income that is automatically paid at least monthly.

2. Taxable Accounts - you pay tax on any realized gains or income and can also deduct any losses. These include brokerage accounts, savings accounts, CDs, and checking accounts.

3. Tax-deferred Retirement Accounts - 401(k), 403(b), 457, Keogh, SEP, SIMPLE, traditional IRA. Income tax is due when withdrawals are taken. (Mandatory withdrawals generally begin at age 70½.)

4. Tax-free Roth IRA, 401(k), and 403(b) accounts. Qualified withdrawals are completely free of income tax.The key is to not waste a chance to pull money out of taxable accounts -- even if it’s more than you need that year -- whenever you can do so at very low tax rates.

As Dr. Bill Reichenstein, professor of investments at Baylor University, likes to say, “The government is the minority owner of your 401(k). Look for opportunities to lower the government’s percentage.”Next week: filling your retirement income “bucket” with the right kind of dollars will prolong the life of your retirement portfolio.1.. IRS Rev. Proc. 2011-12.

2. After all deductions, exemptions, adjustments, etc.

Ms. Buckner is a Retirement and Financial Planning Specialist at Franklin Templeton Investments. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

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