How Retirement Income Gets Taxed
Planning for retirement can be fun if you just think about the vacations, but don’t forget the taxes.
Many people don’t consider the cumulative effect of federal and state income taxes on their nest eggs. One way to reduce retirement taxes is to move to a state with lower tax rates. The other is to understand how your retirement income will be taxed.
In the spirit of David Letterman, here are the Top 10 types of retirement income and how they are taxed:
10) US Savings Bonds. The gold standard in conservative investing and a popular choice for older retirees. The interest on the bonds is taxable at ordinary income rates in the year they are redeemed or mature, whichever is earlier.
9) Money Market, Savings and CD Accounts. As above, interest on these accounts is taxed at ordinary income rates and most retirees hold a small portion of their cash in these accounts in order to maintain emergency funding.
8) Municipal Bonds. In order to encourage investment in municipal bonds, the IRS exempts interest on the bonds from federal tax. Some states also exempt tax on bonds purchased in the investor’s home state. Like the US Savings Bonds, this strategy can work well for older retirees but the low returns don’t make it a good choice for anyone saving for retirement.
7) Dividends. If you own stock outside of your retirement fund, you will pay tax on the dividends. Dividends paid by companies to their stockholders are treated for tax purposes as qualified (most common) or non-qualified. Qualified dividends are taxed at long-term capital gains rates (see below). Non-qualified dividends are taxed at ordinary income tax rates. Generally, a stock must be held over 60 days for the dividends to be considered qualified so limit your day-trading in retirement.
6) Annuities. This type of long-term investment is issued by an insurance company and is designed to help protect you from the risk of outliving your income. Through annuitization, your purchase costs are converted into periodic payments that pay out over your lifetime. Be aware that you'll have to pay any taxes that you owe on the annuity at your ordinary income tax rate, not the preferable capital gains rate.
If you purchased an annuity that provides income in retirement, the principal portion of the payment is tax-free; the rest is taxable.
If you bought the annuity with pretax funds (such as from a traditional IRA), 100% of your payment will be taxed as ordinary income.
5) Sale of Stocks, Bonds and Mutual Funds. The taxation on the sale of these investments, if you hold them outside of your retirement fund, depends upon how long you have held the investment.
If you sell investments that you've held for a year or less, the gains are short-term and are taxed at your ordinary income tax rate.
If you sell stocks, bonds or mutual funds that you've held for more than a year, the proceeds are taxed at long-term capital gains rates. Those rates for 2020 are 0%, 15% or 20% depending upon your total taxable income. Compare these figures to the current top tax rate of 37% on ordinary income.
4) Pensions. Payments from private and government pensions are usually taxable at your ordinary income rate, assuming you made no after-tax contributions to the plan. Most pensions are funded with pretax income, and that means the full amount of your pension income would be taxable when you receive the funds.
3) Social Security. Once upon a time, Social Security benefits were tax-free for everyone--but that fairy tale ended in 1983. Tax on your Social Security benefits depends on your "provisional income”. To determine your provisional income, take your modified adjusted gross income, add half of your Social Security benefits, and add all of your tax-exempt interest.
If you are are planning on more than $50k in annual income as a married couple in retirement, you can plan on 85% of your SS Benefits being taxed at the ordinary income rates.
If you plan on pinching pennies and having annual income of less than $30k for a married couple, your SS benefits will be tax-free.
2) Traditional IRAs and 401(k)s. Many people love these tax-deferred retirement accounts. Contributions to the plans generally reduce your taxable income and save you money on your current tax bills. Additionally, you get to watch your dividends and investment gains grow inside the accounts on a tax-deferred basis.
What you may forget is that you will pay taxes down the line when you retire and start taking withdrawals. The tax rate you pay on your traditional IRA and 401(k) withdrawals will be your ordinary income tax rate.
Additionally, the IRS requires that you withdraw a portion of the money from the accounts annually, starting at age 72. These Required minimum distributions (RMDs) force the taxation of the funds even if you don’t need those funds for living costs. There are RMD strategies, like gifting your RMD to charity, that can be used to reduce your tax bill.
1) ROTH IRAs and 401(k)s. ROTH retirement plans come with the biggest long-term tax advantage: Contributions to ROTHs aren't deductible when you make them, but withdrawals are tax-free. Since both the contribution and earnings are withdrawn tax-free, the ROTH is the perfect vehicle for anyone under 40 and/or a place to make your riskier investments. Additionally, the ROTH accounts are not subject to the same RMD requirement as the Traditional plans.
Since you must hold the money in the ROTH for at least 5 years before withdrawal and you are generally in your highest tax bracket in the 10 years prior to retirement, generally the ROTH advantages are limited to those over 55.