Cares Act Retirement withdrawal- How is Income bracket determined

[Lmoot]

Posted in "Ask a Mustachian", but also posting in tax forum for more visibility and hopefully get a faster response.




I am sadly not well-versed in income brackets and am trying to understand how un-earned income affects which tax bracket you are placed in, specifically in regards to the new Cares Act penalty-free retirement withdrawal rule.

Everything I've read says that any retirement withdrawal will be taxed at your income bracket....but what are they using to calculate your bracket? 2019 income? 2020 income minus the withdrawal, 2020 income including the withdrawal?

For example, in my case I am not going to earn as much this year because of being out of work in one job (quit...long story, bad timing on career change), and furloughed from a part time job. I have not decided if I am going to file for unemployment for the furloughed job, so I am assuming my 2020 income as it stands, will be what I've earned through March (when I stopped earning income), plus what I may earn when/if I start working again later this year.

I didn't earn much to begin with, but income was close to the minimum income level of the 22% bracket in 2019, and because of the reduced income, will fit solidly in the 12% bracket this year.

So....

If I were to take $40,000 total out of my retirement account. Does that mean I will be bumped up to the 22% income bracket? Or would they tax it at what my income bracket is without the distribution (12%?).
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[seattlecyclone]

This withdrawal will be included toward your taxable income the same as if you received the same amount as wages, and will determine your tax bracket accordingly.

One thing to note is that you will have the option to split the taxation of this retirement withdrawal across the next three years for tax purposes. You'd take the full amount out this year and then only claim a third of it on your taxes this year, with the remainder claimed in equal amounts in 2021 and 2022. You'll have to look at the numbers to see whether it makes more sense to claim the full amount this year when you have less work income, or if you want to assume you'll have a better-paying job next year and wouldn't want a third of this year's retirement withdrawal added on top in the next two years.

[phildonnia]

If I were to take $40,000 total out of my retirement account. Does that mean I will be bumped up to the 22% income bracket? Or would they tax it at what my income bracket is without the distribution (12%?).
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This is one of the most significant misunderstandings about tax brackets; so let's get it cleared up.

You do not get "bumped up" into a new tax bracket.  The only thing taxed in the higher tax bracket is whatever amount of income pokes up into that bracket.  The rest continues to be taxed at the lower rates.

If you were to get extra income that puts you into the 22% bracket, only the income over the threshold will be taxed at 22%.  For this reason, you may want to avoid having any income in that bracket.  But you do not suddenly pay 22% on all your income.

[Lmoot]

If I were to take $40,000 total out of my retirement account. Does that mean I will be bumped up to the 22% income bracket? Or would they tax it at what my income bracket is without the distribution (12%?).
Modify message

This is one of the most significant misunderstandings about tax brackets; so let's get it cleared up.

You do not get "bumped up" into a new tax bracket.  The only thing taxed in the higher tax bracket is whatever amount of income pokes up into that bracket.  The rest continues to be taxed at the lower rates.

If you were to get extra income that puts you into the 22% bracket, only the income over the threshold will be taxed at 22%.  For this reason, you may want to avoid having any income in that bracket.  But you do not suddenly pay 22% on all your income.

Yes, I am guilty for using the incorrect verbiage even though I know the only thing that gets “bumped up”, is the amount over the income threshold. Laziness on my part but I am glad you mentioned it bc you are right that it’s a very common and impactful misunderstanding.

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Wow, thank you everyone for the feedback. It’s what I suspected, but I was still hoping for the unlikely lol. I can’t believe I totally forgot about standard deduction, so that will definitely help me minimize taxes. I decided to pay off my $38k mortgage this year (using the penalty-free withdrawal) and thus priming  myself to be in a position to buy a second property when/if the housing market dips next year. My 401k/IRA hasn’t come close to  the earnings and value I’ve gotten from real estate investment over the same time period, So I’m going to take my lesson from the last financial crisis, and go for where I know I have the best chance.

Fortunately the reason why my accounts haven’t moved much is because they are in low risk investments, so I haven’t lost much, yet. So the sooner I can take it out and use it as capital for something that will really earn me money, the better.

[Pizzabrewer]

Thanks for this discussion. I am also looking into the tax implications of this unique opportunity. I understand the taxes on the withdrawal can be spread over 3 years. I’ve also heard you can repay or rollover the amount in the next 3 years to avoid any taxes. I assume that would need to be done in 3 equal yearly installments?  If so, can you repay the first 2 installments then pay the tax in the third year on the final 1/3?

I’m in a fairly unusual situation with my tax planning in which this might make a lot of sense.

[MDM]

I understand the taxes on the withdrawal can be spread over 3 years.

Sort of.  It's the income that one can spread over 3 years.

I’ve also heard you can repay or rollover the amount in the next 3 years to avoid any taxes.

It will likely require amending earlier returns to remove the income one had to claim, but the IRS has not published the details.