After years of saving, it can feel reassuring to know you have enough set aside for a major purchase or an unexpected expense. You can look at your account balances, decide what you can comfortably afford, and begin making plans.
Choosing where to take the money from deserves a little more thought. You may have several accounts available, each with a different tax treatment. Even within the same account, the cost of a withdrawal can change depending on what else is happening in your finances that year.
You need another $10,000 from your savings. Maybe you’re replacing a car, helping with a wedding, or finally booking the trip you’ve been talking about. Your traditional IRA has enough to cover it, and the money is all pretax. You expect the withdrawal to stay within your 12% federal tax bracket, so you estimate $1,200 in federal income tax. If you need the full $10,000 for the expense, you’ll also need money to cover that tax. Taking it from the IRA would require a larger withdrawal. You have run the numbers, and you’re ready to request the transfer.
What you may not have considered is how the withdrawal could affect income you’ve already recognized that year. It may increase the tax rate applied to your investment gains, cause more of your Social Security benefits to become taxable, or affect future Medicare premiums. The tax on the withdrawal itself may be only part of the cost.
Understanding those connections can help you choose which account to use and how much to take. You may still decide to use the IRA, but you’ll have a clearer picture of what that decision will cost.
Your Income Has Different Tax Treatments
To understand why a withdrawal can affect other income, it helps to first look at how different sources of income are taxed. The money arriving in your bank account may all be available for the same expenses, but its source determines how it is treated on your tax return.
Taxable traditional IRA withdrawals generally count as ordinary income, along with wages, taxable pension payments, and interest. That income moves through the ordinary income tax brackets, with higher rates applying as you reach each successive bracket.
Qualified dividends and most long-term capital gains receive preferential treatment, with federal rates generally set at 0%, 15%, or 20%. Long-term gains generally come from selling investments held for more than a year. Gains on investments held for a year or less generally receive ordinary income treatment.
Although these income sources have different rates, the calculations are connected. Your ordinary taxable income fills the tax brackets first. Qualified dividends and long-term capital gains then stack above it to determine which preferential rates apply. If some of your gains fall within the 0% capital gains bracket, an additional IRA withdrawal can use up space those gains previously occupied. The displaced gains could then be taxed at 15%.
That means an IRA withdrawal can increase the tax on gains you realized earlier in the year, even if you don’t sell another investment.
How a Withdrawal in the 12% Bracket Can Cost 27%
The effect becomes clearer when you follow what happens to an additional $1,000 withdrawal. If that money falls entirely within your 12% ordinary income bracket, the tax on the withdrawal itself is $120.
When at least $1,000 of your existing long-term gains sits at the top of the 0% capital gains bracket, adding $1,000 of ordinary income underneath them can push that $1,000 of gains into the 15% bracket. That creates another $150 of tax on income you had already recognized.
Holding deductions and other income unchanged, the withdrawal increases your federal tax bill by $270. You owe $120 on the IRA income and another $150 on the displaced gains. Your effective marginal tax rate on that additional $1,000 is therefore 27%, even though the withdrawal itself remains in the 12% ordinary income bracket.
That added cost applies only while additional ordinary income is pushing gains from the 0% bracket into the 15% bracket. It would not necessarily apply to the entire $10,000 withdrawal, so different portions could carry different effective tax rates.
This is why the room remaining in your ordinary income bracket tells only part of the story. Before choosing a withdrawal or Roth conversion amount, you need to know how each additional portion would change your overall tax bill. Plotting your effective marginal tax rate across a range of income amounts shows where those changes occur, and our workshop on Using Tax Maps to Enhance Tax Planning Decisions for Retirement walks through how to build that picture from your own numbers.
Why a Deduction May Not Prevent Higher Medicare Premiums
A sizable deduction may make an additional IRA withdrawal seem more affordable. It can reduce your income tax, but it may leave other costs associated with the withdrawal unchanged.
Your adjusted gross income, or AGI, is calculated before the standard deduction or itemized deductions are subtracted. Those deductions reduce taxable income without lowering AGI. Medicare premium surcharges generally use AGI plus tax-exempt interest. Because standard and itemized deductions do not lower that amount, they may reduce your income tax without preventing a surcharge.
An IRA withdrawal could push your income above a Medicare surcharge threshold even after you account for deductions on your return. Because Medicare generally uses income information from two years earlier, the higher premiums could arrive well after you’ve spent the money.
Social Security taxation also uses an income calculation that comes before standard and itemized deductions. Taking the standard deduction or claiming itemized deductions can therefore reduce your income tax without reducing the amount of Social Security benefits included in taxable income. Understanding which income measure a deduction affects helps you see what it can accomplish before relying on it to offset a withdrawal.
The Withdrawal Can Make More of Your Social Security Taxable
If you receive Social Security, you may already know that some of your benefits can be taxable. What is less obvious is how an IRA withdrawal can change that amount, even though your benefit payments stay the same.
Social Security uses a measure called combined income, sometimes called provisional income. It generally includes your income from sources other than Social Security, tax-exempt interest, and half of your Social Security benefits, with certain adjustments. As combined income rises, more of your benefits may become taxable, up to a maximum of 85% of the benefits you receive. That portion is taxed at your applicable income tax rates. The 85% figure describes how much of your benefit may be taxable, not the tax rate applied to it.
Within part of the calculation, an additional $1,000 of IRA income can cause another $850 of Social Security benefits to become taxable. The withdrawal gives you $1,000 more before taxes, but adds $1,850 to the income reported before deductions.
The effect depends on where you fall in the formula. Once 85% of your benefits are already taxable, additional income won’t make more of those benefits taxable. Before that point, however, the interaction can make an IRA withdrawal more expensive than its ordinary income tax rate suggests. A tax projection can show whether you’re in that range and how a proposed withdrawal would affect the benefits included on your return.
Different Spending Sources Give You More Control
Having savings in different account types gives you more options when deciding how to pay for a large expense. Each source can provide the money you need, but the amount added to your income may differ considerably.
Returning to the $10,000 expense, a withdrawal from a fully pretax traditional IRA would generally add the entire amount to ordinary income. Selling $10,000 of investments in a brokerage account with an adjusted cost basis of $8,000 would instead generate a $2,000 capital gain. A qualified Roth withdrawal would provide the same spending money without adding federal taxable income. For a Roth IRA, that generally means you’ve met the five-tax-year requirement and are at least age 59½, although certain other qualifying circumstances apply.
Those differences give you room to manage how the expense affects the rest of your finances. If another IRA withdrawal would push existing gains into a higher tax bracket or trigger higher Medicare premiums, using qualified Roth money could help you avoid that additional cost. A brokerage sale might generate less income than the IRA withdrawal, although even gains taxed at 0% can affect income-based calculations.
Before making another withdrawal, check the cash you already have available. Money from an IRA distribution taken earlier in the year may still be sitting in your bank account. If it isn’t needed for other commitments, you could use it without creating another distribution.
You can also divide the expense among accounts. Using some available cash, selling selected investments, and taking a smaller IRA withdrawal may help you limit additional income while keeping enough money available for other needs.
Evaluate the Amount Before Making the Transfer
The same reasoning applies when you’re deciding how much to convert to Roth. A conversion may fit within your ordinary income bracket while affecting capital gains, taxable Social Security, deductions, or future Medicare premiums.
The cost can also change as the amount increases. The first portion may have relatively little effect elsewhere on your return. The next portion could push gains into a higher rate or cross an income threshold. Looking at the proposed transaction in smaller increments can reveal differences that a single bracket estimate would miss.
Before choosing an amount, compare your projected taxes and income-related costs with and without the additional income. That gives you a clearer basis for deciding whether to use the IRA, draw from another account, or spread the transaction over more than one year when timing allows.
Taking the money from your IRA may still be the right choice, particularly if you expect withdrawals to face higher costs in future years. In a year when additional income would trigger several costs at once, qualified Roth money or available cash may be more useful.
Before requesting the $10,000, compare what would happen if you used your IRA, another account, or a combination of sources. Look at how much you would need to withdraw to cover both the expense and the resulting taxes, along with any effect on future Medicare premiums. You can then choose where the money should come from with a fuller understanding of what the purchase will cost.
Want to learn more? Listen to Episode 251 of the Retire With Style Podcast.
