Your retirement is in sight: you’ve done the work, checked and re-checked your math, and reviewed your budget. Maybe you’ve even booked the tickets for your first, long-planned trip. You are looking forward to spending your time on what is most important to you, rather than reporting to the workplace.
But don’t forget to factor in the impact of taxes—federal, state, and local—on your retirement income. In addition to the federal government, all but nine states and some 4,900 local governmental authorities levy taxes on residents’ income.
Not all income sources are taxed the same way, however, and knowing which is which can be an important part of your retirement planning. Here’s a quick list of the ten most typical sources for retirement income, with key taxation points for each.
- Traditional IRAs, 401Ks, 457Bs, and 403Bs. For decades, these have been the most popular tax-advantaged vehicles for retirement savings. You get a tax deduction for your deposits, and the account grows tax-free until you start tapping it in retirement. But once you start taking withdrawals, including the required minimum distributions—RMDs—that must begin by age 72 (70 ½ for those born before July 1, 1949), they are taxed at your ordinary income rate at the time of withdrawal.
- Roth IRAs, 401Ks, 457Bs, and 403Bs. Increasingly popular in the last few years, Roth accounts do not provide a deduction for deposits, but the income still grows tax free and is generally nontaxable upon withdrawal, as well (and there are no RMDs). But you must have had the account for at least five years before beginning withdrawals, and if you pull money out before age 59 ½ (unless for certain specific qualified purposes), you will pay a 10% federal early withdrawal penalty.
- Social Security benefits. This one gets a little complicated. If you make less than $25,000 ($32,000 for married couples), your Social Security benefits are not taxed. But above that amount of income, you must pay taxes on anywhere from half to 85% of your benefits. The IRS offers an online tool you can use to calculate how much of your Social Security income is taxable.
- Pensions. Generally, public and private pension income is taxed at your ordinary income rate.
- Stocks, bonds, and mutual funds. If you sell stocks, bonds, or mutual funds at a profit, you will pay either long-term or short-term capital gains taxes on the amount of your profit. Under current tax law, your long-term capital gains rate (profit on investments held for a year or more) may be 0%, 15%, or 20%, depending on your other income. Even at the top rate, though, a 20% tax on long-term capital gains is better than the top ordinary income rate of 37%. For short-term gains (investments held less than a year), you’ll pay at your ordinary income rate. To learn more, you can go to the IRS website.
- Dividends. Many retirees own stocks or mutual funds that pay dividends, and these can be an important source of retirement income. Qualified dividends (generally, from stocks or funds held at least 60 days during the two months before and after declaration of a dividend) are taxed at the same rate as long-term capital gains (see above). Non-qualified dividends are taxed at ordinary income rates.
- Annuities. Sold by insurance companies, annuities accumulate tax-free, but the accumulation amount is taxed when it is withdrawn from the annuity. In most cases, income from annuities is taxed at the ordinary income rate.
- Municipal bonds or bond funds. Interest from municipal bonds or bond funds is free from federal income tax and also from state and local income tax if the bond was issued in your state. However, if you sell municipal bonds or bond funds at a profit, the gain is taxable as either long-term or short-term capital gains.
- Bank interest. The income you receive from your certificates of deposit, savings accounts, or money market accounts is taxable as ordinary income. (Although, considering how low interest rates are right now, you’d need to have a pretty big amount on deposit to generate much in the way of interest income).
- US Treasury notes and bonds or bond funds. Interest on US Treasury obligations is subject to federal tax at your ordinary income rate, but it is not subject to state or local income taxes.
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