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We all know about the beauty of the Roth IRA. We’ve spoken about it at length. It can greatly help supplement retirement income in a tax-efficient way.
But not everyone may have a Roth IRA, or they may want to allow it to grow tax-free and utilize tax-deferred and taxable assets instead.
Ultimately, smart tax-planning can take place despite the absence of Roth IRA income.
The Sources of your Retirement Income
In order to take advantage of this type of opportunity for your retirement income, it’s important to understand how taxable income works.
Ordinary Income
Ordinary income includes earned income, but also includes income such as pension income, interest income, and for Social Security recipients, the taxable portion of their Social Security benefits is considered ordinary income as well.
You’re likely familiar with these tax brackets and standard deductions:
Since the standard deduction would apply, for a married couple (both over A65), the first $33,200 of ordinary income is not taxed at federal rates.
Long-Term Capital Gains Income
Much like the progressive tax system we see with ordinary income, Long-Term Capital Gains follow a similar bracket. However, this income is taxed at generally more favorable rates:
How To Minimize Tax on Retirement Income
The power of utilizing accounts in a timely fashion can decrease your federal tax liability substantially.
Let’s walk through a quick example:
Donald & Donna Donaldson have combined Pre-Tax Retirement assets of $1M, and an after-tax (non-qualified) brokerage account of $375k.
Neither are collecting Social Security at this point, and neither are working.
As a result, they have flexibility in determining how they can withdraw their assets.
Scenario 1 – All Pre-Tax Withdrawals
Donald and Donna decide to utilize Donald’s pre-tax IRA for income in 2025.
The $130k of taxable IRA distribution looks as follows:
With the standard deduction applied, $96,800 is subject to ordinary income tax. The total federal income tax due is $11,139.
Their income net of tax is $118,861.
Scenario 2 – Long-Term Capital Gains Only
If we instead would say that the Donaldson’s recognize $130,000 of a long-term capital gain from their brokerage account, the taxes look far different:
As we can see, the taxable income is the same number, but that income is different. Since ordinary income & Long-Term Capital Gain income have different brackets, the tax due is substantially different.
Scenario 3 – Blending Retirement Income Sources
Tax planning can involve a smarter strategy yet. By blending the income sources together, you can instead recognize pre-tax income that is negated by the standard deduction, while also recognizing LTCG income at the favorable 0% rate.
Being that pre-tax retirement accounts will be subject to Required Minimum Distributions, this is an opportunity for the Donaldson’s to be opportunistic:
As we can see, the 3rd scenario (blend of pre-tax & LTCG), has the same tax due as the second scenario. However, as we can see from the sources of income above, we were more selective in our withdrawals:
The middle scenarios create a substantial difference in tax due compared to the first example.
Your Takeaway
The purpose of this is not to walk away and plan like this accordingly. But rather, you should do an audit of your own plan to make sure you are minimizing your annual and lifetime tax liability. Your retirement income will likely contain different sources. Minimizing taxes can be done regardless of which account you hold.
By using each account to your benefit, and playing within the rules, you can minimize the tax due, while maximizing the enjoyment of your hard earned dollars.