Retirement is hopefully a time for rest, relaxation and perhaps work in one capacity or another. Regardless of how you spend your time in retirement, taxes will remain a fact of life. Effective tax planning is an essential part of your retirement distribution strategy and can result in substantial savings for you.
Here is a rundown of some of the tax issues retirees will potentially face.
Taxation of Social Security Benefits
Your Social Security benefits can be subject to federal income tax.
Up to 85% of your benefit can be subject to taxes. This will depend upon your combined income which is defined as:
- Adjusted gross income
- plus nontaxable interest earned
- plus ½ of your Social Security benefit
For those filing as single in 2018 the limits are:
- For combined incomes between $25,000 and $34,000 your benefit may be subject to income tax on up to 50% of your benefit.
- For combined incomes over $34,000 your benefit may be subject to income tax on up to 85% of your benefit.
For those filing a joint return in 2016 the limits are:
- For combined incomes between $32,000 and $44,000 your benefit may be subject to income tax on up to 50% of your benefit.
- For combined incomes over $44,000 your benefit may be subject to income tax on up to 85% of your benefit.
13 states also have provisions for taxing your benefit.
Taxation of Earned Income
If you work during retirement, any earnings from employment will be subject to income tax, FICA and Medicare just as when you worked prior to retirement. There are no age limits here.
Though not a tax, if you work and draw a Social Security benefit prior to reaching your full retirement age (66 for those born in 1960 or earlier), your benefits may be reduced if your earnings are too high.
Taxation of Pension Benefits
Payments received from a private or a governmental pension are generally subject to income tax at ordinary income tax rates.
If you have made any after-tax contributions to the plan while working, the amount of these contributions would not be subject to tax, but it is advisable to have any records of these contributions handy just in case.
Some pensions may be exempt from state income tax; this will vary widely and you should check the rules for your state.
Taxes on Investments Held in a Taxable Account
Investments held in a taxable account for at least a year and a day are taxed at preferential capital gains rates that range from 15% to 20%. Those in high income brackets could be subject to an additional 3.8% Medicare tax.
Taxes on IRA and 401(k) Account Withdrawals
The rules on the taxation of IRAs can be a bit complex. The basics are this:
- Withdrawals from traditional IRA accounts are fully taxable at ordinary income tax rates. The exception to this is contributions made with after-tax money; the amount of these contributions is not taxed.
- Withdrawals from a Roth IRA account are generally not taxed as long as you are at least 59½ and your first contribution to the Roth IRA was made at least five years ago.
- Withdrawals from traditional 401(k) and Roth 401(k) accounts are generally taxed in a similar fashion to IRA accounts.
There is generally a 10% penalty in addition to the taxes due on withdrawals made before age 59½. See Early Withdrawal Penalties — How to Keep More of Your Retirement Funds for more information.
Taxes on Annuities
Annuities that are held in a retirement account such as an IRA or 403(b) will be taxed at ordinary income tax rates in line with the rules for that type of account. It is not uncommon for some governmental or non-profit organizations to use annuities as the investment vehicle in these types of accounts.
Annuities purchased outside of a retirement plan, called non-qualified annuities, are fully subject to taxes when withdrawn as follows:
- The money you put into the account is not subject to tax.
- The gains on the money you invested are taxed as ordinary income.
Withdrawals work as follows:
- If you annuitize, a portion of your monthly or periodic payment will be taxed in proportion to the ratio of gains to your investments into the account. If you live past a certain date, you could go through the entire principal layer and then 100% of the payment would be taxed.
- If you take a lump sum equal to the total amount of the account value, the portion that is considered gains will be taxed and the amount considered your investment in the contract will not be taxed.
- If you take a partial withdrawal, it is assumed you are taking a withdrawal of your gains first and the withdrawal will be fully taxed. After you have “eaten through” your gains, any portion that is attributed to being a return of your investment in the contract will not be taxed.
Some Special Situations
- Generally, if you take a distribution from your 401(k) plan prior to age 59½ the distribution will be subject not only to taxes, but also to a 10% penalty. There is a special provision for those who leave their jobs and who are least age 55 when they do so. The last piece is important; if you separate from service with your employer prior to age 55 the 10% penalty would still apply. In any case, normal taxes will still apply.
- Under certain circumstances, those who are under age 59½ can take a series of payments from their IRA while avoiding the 10% penalty. This falls under the 72(t) rules, and they are very complex. Many custodians do not fully understand them, so if this is something that interests you be sure to study the rules or find a financial advisor or tax professional who can guide you.
- If you leave your employer and have highly appreciated company stock in your 401(k) account, you might consider using the net unrealized appreciation (NUA) rules when rolling your money over to an IRA. Under the NUA rules you would take a distribution of the company stock in-kind to a taxable brokerage account. You would pay tax on the cost basis of the stock and this would become your basis going forward. Later, when you sell the stock, you’ll pay preferential capital gains tax versus the higher ordinary income tax paid on IRA distributions. This can result in major tax savings. The other assets in the 401(k) would be rolled into an IRA.
With these and other unique situations it may be best to seek a qualified financial or tax advisor.
Pulling It Together
As you plan your retirement distribution strategy, it is important to look at your mix of investments and your other streams of income and to understand the tax impact of taking distributions from various accounts in light of your overall situation.