In my state, as long as I am over 59 1/2 I can exclude $20K per year of retirement income from state income tax. This is in addition to Social Security and government pensions being non-taxable. IOW even if I have a government pension and am collecting SS, I can exclude another $20K from a private pension, IRA, 401K, 457 etc.
I’m thinking of starting withdrawals even though I don’t need the money and putting it into a bank account or CD. Is there any downside to this other than the possibility that the deferred comp account will earn more than the bank account/CD?
If the money in the deferred comp account (“qualified account” in the argot) has the same range & yield of investment choices as what you’d switch to on the outside taxable account (a “non-qualified account” in the argot) there’s not much reason to withdraw as to the investment aspect of the question.
But: federal income tax generally dwarfs state income tax. So if you choose to withdraw unneeded qualified money and thereby create a $20K increase in federally taxed income, you’ll be paying $4-6K in extra federal taxes even though your much smaller state taxes are unaffected. That is often a mistake.
But …
It is common that middle-class or wealthier retirees have a low spot in their federal taxable income after they finish their paid career and before they begin collecting (federally taxable) Social Security. Typically that’s from age 65 to 70. During those years it can be very advantageous to withdraw a bunch of qualified money and simply move it to a non-qualified account. Despite triggering paying at least Federal, and in some states, also state income taxes, on those withdrawals.
The reason is that RMDs for non-Roth qualified accounts eventually kick in. And once they do, a retiree with a comfortable-to-hefty non-Roth qualified balance may be forced to withdraw a lot more than they need to live on. Which will be taxed at a higher bracket than it would have been had it been withdrawn earlier during that slump in other taxable income. Said another way, due to the progressivity of the tax system, it’s better to eat the elephant of draining your qualified accounts as RMDs require, in smaller bites versus a few much larger bites. Even if that means paying some of that tax money sooner than was otherwise strictly necessary. Paid sooner at a lower percentage tax rate can be better than later at a higher percentage tax rate.
It’s not fully clear to me that any of the above is directly applicable to the OP’s individual situation. But it might be and also might help somebody else.
I’d ask the OP for her rationale behind her proposal. Why do you think these withdrawals are (or might be) a good idea? I’m not saying they’re not, just that I’d like to hear your thinking. Asked another way: “What problem do you think you’re solving by doing these withdrawals?”
That’s easy enough - I’m going to pay Federal taxes whether I take the money out now or later, whether it’s $20K a year for (hypothetically) 30 years or $60K per year for 10 years. but the $20K a year option means I won’t pay any state or local income taxes while withdrawing more per year for a shorter time will have me paying the state and local taxes when I do take it out.
Oh, and I’m pretty much in that spot you were talking about - my Federal taxable income for the next few years before I start collecting SS will be the lowest it will ever be.
You’re certainly thinking rightly as to the state tax numbers. The problem, as I suggested, is the real measure of tax merit is the (federal + state) numbers. I don’t know what state you’re in, nor anything about state income taxes in general. But if the progressivity of federal taxes is high enough, you can waste money sending it to the feds in excess of what you gain from the state. Conversely, by limiting yourself to 20K due to the state bennie cut-off, you might be handing the feds even more money needlessly later.
Here is a blogger I respect who has a post on almost your issue. Which might help focus your thinking on which detailed comparisons to make.
Note the this was written in 2019 when RMDs kicked in at 70-1/2. Since then the age for RMDs is now 72. Which means there is a window from (typically) 65 to 70 to take hefty “pre-RMDs” to reduce the size of eventual RMDs. And also from 70 to 72 to take smaller “pre-RMDs” for the same reason.
As a point of comparison:
I just turned 65 and retired. I’m married and live in a state with no state income tax. I’m also pretty comfy. For 2024 I intend to take as much self-imposed “pre-RMD” as keeps my total taxable income in the 22 or 24% bracket so that I won’t be in the 32 or 39% bracket once real RMDs kick in 7 years from now. Saving 10 or 15% on my federal taxes more than pays for the 7 years early.
As to you, and totally IMO as a non-professional non-expert …
Your 20K state exclusion should NOT be seen as a ceiling on your early withdrawals per year. Instead it should be seen as a discount on the first 20K of early withdrawals per year. Your total assets, income, investment return expectations, etc., may mean that 20K / year is plenty. But if the right answer for federal is more (or even lots more) than 20K in any (or every) year, then do the right thing for the feds and be glad of the first 20K bennie at the state level.