For those nearing retirement, there is often great anticipation around the many benefits of leaving behind the “daily grind” and spending more time in pursuits of their choosing. In fact, one of the chief goals of building a financial plan for retirement is that it allows you to build a strategy for using your time in retirement in the ways that are most important to you, whether that means more time for travel, more time spent with grandkids, more time on the golf course, or more time volunteering for a cherished cause.
But just because you’re looking forward to feeling more carefree, you still need to plan for some of the inevitabilities that come with this new phase of life. And one of those, unfortunately, is taxes. Retirement income takes many forms: pensions, IRA or 401K withdrawals, Social Security, income from investments of various types, and others. As part of your planning for retirement, you need to know how your income is going to be taxed—if for no other reason than to make sure you have a tax-efficient strategy in place to minimize the bite the government takes out of your retirement income.
- Social Security. Up until 1983, Social Security benefits were tax-free—but no longer. If your “provisional income”—adjusted gross income (AGI) + half of Social Security benefits + any tax-exempt income—is greater than $25,000 ($32,000 for couples filing jointly), you’ll pay ordinary income tax on at least half of your Social Security benefits. For single filers with provisional income above $34,000 ($44,000 for married couples), the percentage goes up to 85%.
- Traditional IRAs and 401Ks. If you’re using a traditional IRA or 401K as part of your retirement funding, you’ve been enjoying years of making deposits that reduced your taxable income, along with years of tax-free growth and compounding. But when you retire or reach the age for required minimum distributions (RMDs), which is 72 in most cases, the withdrawals are taxed as ordinary income.
- Roth IRAs and 401Ks. Here’s the good news: retirement distributions from Roth IRAs and 401Ks are tax-free. For both Roth IRAs and Roth 401Ks, you must have held the account for at least five years from the time you made your first deposit until the time you make the first withdrawal, but when you do, the withdrawal won’t count as taxable income. An additional advantage of Roth accounts is that if you don’t need the income in retirement, you can just let them continue to accumulate tax-free; there are no RMDs for the original owners of Roth accounts.
- Capital gains. If you have a non-tax-qualified investment account and you liquidate appreciated securities to generate retirement income, you will pay taxes on the difference between your purchase price (cost basis) and your selling price. These are called capital gains, and they come in two flavors: long-term (for investments held a year or more) and short-term (investments held less than a year). For long-term capital gains, you’ll pay nothing if your taxable income is less than $40,400 ($80,800 for married filing jointly). If your income is between $40,400 ($80,800) and $445,850 ($501,600 for couples), your long-term capital gains rate is 15%. For those with incomes above that level, the long-term capital gains rate is 20%. Short-term capital gains are taxed at the same rate as your ordinary income.
As you can see, different types of retirement income are taxed differently. That’s why it’s important to have in place a “draw-down” strategy for your retirement assets that takes into consideration the most tax-efficient ways to maintain your retirement income stream.
At Empyrion Wealth Management, we help thriving retirees and those planning for retirement create strategies for retirement income that help them make the most of the resources they’ve gathered. To learn more, click here to read our “Retirement Checklist.”
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