Financial Advice
Rich Best has spent 28 years in the financial services industry, as an advisor, a managing partner, directors of training and marketing, and now as a consultant to the industry. Rich has written extensively on a broad range of personal finance topics and is published on several top financial sites. Recent books include The American Family Survival Bible and Annuity Facts Revealed: What You MUST Know Before You Invest.

For Retirement Income, are Capital Gains or IRA Withdrawals Better?

For Retirement Income, are Capital Gains or IRA Withdrawals Better?

A question often posed by retirees is whether it is better to utilize capital gains as retirement income or withdrawals from an IRA. As with just about any question having to do with financial strategy, the situation is the boss. Not only will your circumstances dictate the answer, but there are some variables, such as prevailing tax rates, that will weigh on it as well. But, we can at least frame the answer in a way that can provide you with some basic guidelines. And, if you are still in the planning stages of your retirement, there may be some strategies to consider now that will ensure greater tax efficiency when you start taking income.

Which has the lower tax rate?

As it pertains to capital gains as a potential source of income, the tax rate for long term capital gains is 0% if your income is $40,000 or less. It’s 15% for taxpayers earning between $40,001 and $441,450 and 20% for those earning more than $441,450.

Conversely, withdrawals made from a traditional IRA to the extent that they are from pre-tax contributions will be taxed at your ordinary tax rate. Assuming, as an example, that your tax rate after retirement is 22% (for married couples earning between $81,051 and $172.750), that is the rate at which you will pay. Therefore, on the surface, you would be better off to take your income from capital gains. One advantage of using capital gains as income is that you have the opportunity to manage your taxes by offsetting gains with losses in any given year.

Running up against Required Minimum Distributions

For practical purposes, it makes sense to defer taxes on your qualified assets as long as possible. But, there are some potential problems in doing so. First, with a traditional IRA, you will eventually run up against the required minimum distribution (RMD) provision, which means that at age 70½, you will need to take a sufficient amount of money out each year to avoid a 50% penalty on any shortfall.

Depending on your circumstance, you could be forced to take more income than you need and pay ordinary income taxes at an accelerated rate. That could also increase the amount of your Social Security income that is taxed.

Avoid future taxes and RMDs by converting to a Roth IRA

As an alternative, you could consider converting your traditional IRA into a Roth IRA. The primary difference between the two is that the income from a Roth is tax-exempt. That’s because contributions to a Roth are made with after-tax dollars. When you convert to a Roth from a traditional IRA or a 401k plan, you are required to pay a tax now on the total gain in the account. That may seem like a big sacrifice for most people, but it may be worth considering now before federal taxes are increased. Having your money in a Roth IRA also protects your income against future tax increases. You can use a Roth conversion calculator available on the Internet to help you determine if this would benefit you in the long run.

If you hold your retirement assets in a Roth IRA, you don’t have to be concerned with taxes on the income. That would give you more options with your taxable investments, either allowing them to grow or take capital gains distributions at the lower tax rate. You would have a more significant tax cushion that would allow you to take some combination of capital gains distributions and Roth IRA withdrawals.

It’s important to remember that if you own mutual funds or index funds in a taxable account, your account is credited with taxable capital gains generated by the fund managers even though you don’t actually receive them.

There is no clear cut answer to the question of capital gains or IRA withdrawals for retirement income. Every situation is different, so it would be important to have a financial advisor conduct a thorough assessment of yours to help you determine your best retirement income solution.

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