Understanding Retirement Income Tax
When you retire, you’ll likely draw your income from several sources—such as retirement accounts, taxable investment accounts, and Social Security Benefits. Each of these sources is taxed according to its own rules.
So, in order to accurately plan for your retirement, you need to know what these rules are, whether (and when) you’re required to make withdrawals, and how paying taxes on distributions will impact your overall financial goals.
Here’s a breakdown of the most commons sources of retirement income and how they’re taxed:
Traditional IRA and traditional 401(k)
Withdrawals from traditional tax-deferred retirement accounts are taxed at your normal income tax rate.
Once you reach a certain age, you must start taking—and paying taxes on—required minimum distributions (RMDs).
Under the Secure Act 2.0 passed in 2022, RMDs were pushed further out. Now, your starting age is age 73 if you were born between 1951-1959, and age 74 if you were born in 1960 or later.
Roth IRAs
Because contributions to Roth IRAs are made with after-tax money, withdrawals from these accounts are tax-free.
You can withdraw contributions to your Roth account at any age; however, withdrawals on earnings before age 59½ are subject to early withdrawal penalties.
Roth IRAs do not have RMDs like traditional IRAs, so your money can continue growing in the account. Because withdrawals from Roth IRAs are tax-free, consider making withdrawals from this account last to allow your savings to benefit from tax-free growth for as long as possible.
Taxable investments
Profits from the sale of stocks, bonds, and other investments outside of tax-advantaged retirement accounts are taxed at capital gains rates, which vary depending on how long you’ve owned the investments.
Short-term capital gains are taxed as ordinary income and apply to investments you’ve owned for one year or less.
Long-term capital gains apply to investments held for more than a year before selling and are subject to preferential capital gains rates of 0%, 15%, or 20%, depending on your tax bracket.
Social Security
The tax rate for Social Security benefits depends on your provisional income, which is the sum of your adjusted gross income, tax-exempt interest from other investments such as municipal bonds, and one-half of your Social Security benefits.
You pay income tax on up to 85% of your Social Security if your provisional income exceeds $25,000 for an individual filer or $32,000 for joint filers.
Annuities
If you purchase an immediate annuity with after-tax income, it will pay income over the period you’ve elected. Under this type of annuity, the portion of the payment representing your principal is not taxed. Thus, you’ll pay taxes on the portion that represents earnings.
If you purchase the annuity with pretax funds, such as from a traditional IRA, your entire payment is taxed as ordinary income.
Making a withdrawal plan
Once you understand how your retirement income is taxed, you can make a tax-efficient plan to support you in your retirement years. You might consider a plan that looks like the following:
- Taking withdrawals from traditional IRA and traditional 401(k) accounts first to satisfy annual RMDs.
- Next, take withdrawals from taxable accounts.
- Take withdrawals from Roth IRAs, and Roth 401(k) accounts last. The longer you can avoid drawing down these plans, which aren’t subject to RMDs, the longer they can benefit from tax-free growth.
A careful withdrawal plan—and keeping your money in tax-free accounts as long as possible—can help you maximize your investment returns while minimizing the taxes you’ll owe.
Source: Internal Revenue Service: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds
Source: Internal Revenue Service: https://www.irs.gov/taxtopics/tc409
Source: Social Security Administration: https://www.ssa.gov/benefits/retirement/planner/taxes.html
This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Please note, changes in tax law or regulations may occur at any time and could substantially impact your situation. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was created by The Oeschli Institute to provide information on a topic that may be of interest.