Spreading out your lifetime tax bill, by taking small and voluntary tax hits earlier, can be more efficient than waiting and taking big, mandatory tax hits later.
Why is this the case? For two reasons.
First, the US tax system is progressive. The first dollars we earn in a year are taxed at a low rate, 10 percent. As we earn more, those additional dollars of income are taxed at increasing rates, up to 37 percent on the federal level. That means it’s far better to take, say, $250,000 in income over two years than one. Take it in one year, and you’ll pay a total of $62,693 in federal taxes. Take it over two years, and you’ll pay a total of $48,348—a tax savings of $14,345 (based on a single filer in 2019).
The second reason goes back to those Required Minimum Distributions, which apply to traditional IRAs and 401(k) s. Starting at 72, you are required to withdrawal a certain percentage of your account every year as determined by an IRS calculation of life expectancy. As you get older, this percentage rises. If you were to live to 100, you could be required to withdraw 15.8 percent of your holdings in one year. For families with high net worth in particular, these required distributions can have a profound and pernicious effect. If you were to hold a $3 million IRA account at age 100, the government will require you to withdraw income of $474,000 and pay all the taxes that come with it.
If this concept seems tough to visualize, consider this analogy: Think of income as dry wood blocks. Think of taxes as fire. A large traditional IRA amounts to a giant stack of wood blocks. You can choose to make a slow-burning campfire that burns quietly ever year. Or you can hoard your wood blocks as long as possible—but only until the IRS requires you to build a bonfire.
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Jonathan Bird, CFP®
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