When we stop working, we continue to pay taxes on our income in retirement. How much and what type of tax we pay varies depending on which account the money comes from – and the tax characteristics of that account. Different income streams are also taxed in different ways. Ideally, our retirement savings should be in multiple account types – at least from a tax perspective.
When you retire, how much you pay in taxes can differ from what your neighbors, friends, and relatives pay. That price tag or cost depends on your goals and desired lifestyle. It also depends on what type of accounts you have and where your retirement funds come from.
It’s not easy to build a healthy nest egg you can live off in retirement. Trying to strike a balance between spending to enjoy today versus saving for tomorrow makes it even harder.
When evaluating your retirement landscape, you should start by identifying the sources of income you can depend on. For most people, the bulk of retirement income comes from personal savings and investments and Social Security benefits. Some will receive earnings from continued employment or a pension.
Examples of personal savings and investments include individual retirement accounts (IRAs or Roth IRAs), employer-sponsored retirement plans (401(k)’s or 403(b)’s), savings accounts, and brokerage accounts. Brokerage accounts include assets such as stocks, bonds, and mutual funds.
The IRS doesn’t make things easy. Different tax rules apply to each income source. That makes planning important. (Please see here, here, and here for prior blogs discussing some tax planning ideas.) Tax-advantaged strategies can help you minimize your tax costs. Please keep in mind that this is not a one-size fits all topic. The best solution for you will be based on your specific circumstances. You may benefit most if you combine different strategies to minimize or eliminate taxation on your retirement income.
Taxable Income in Retirement
Please note that this discussion will not consider the taxation of financial products such as annuities and whole life insurance. It also focuses on federal tax liabilities. Some states do not tax certain types of income in retirement. Others may exclude some of your income in retirement from tax. There are also states that tax all of it. See this article for an overview of how the different states tax income in retirement.
Traditional Retirement Plans
While working, we contribute to retirement plans such as traditional 401(k)’s, 403(b)’s, traditional IRAs, and SEP IRAs (IRAs for self-employed individuals). These contributions provide a meaningful tax advantage. They get funded with pre-tax dollars. They give you tax deferral on your income and gains until you withdraw funds from the account. Note that any withdrawals you take before age 59 ½ result in a 10% penalty. Beyond that, your withdrawals get taxed at your ordinary income tax rate.
Employers fund most pensions with pre-tax income. If you’re lucky enough to have earned a pension, for most, any pension income you receive in retirement gets taxed at your ordinary income tax rate. (If the payment is a qualified distribution from a Roth account or the contributions were made with after-tax dollars, you may not be taxed at your ordinary income tax rate.)
You can choose to take a lump sum payout instead. But if you do, you must pay the total tax due on the amount received. That tax will be payable in the year in which the payment is received. This could move you into a higher tax bracket. You can also roll over your pension into a traditional retirement account. You shouldn’t pay tax on the rollover. Future withdrawals will then be taxed similarly to amounts withdrawn from traditional retirement plans.
Non-Retirement or Brokerage Accounts
If you have a brokerage account in which you hold stocks, bonds, mutual funds, or exchange-traded funds, you pay tax on any gains. If you hold an asset for more than a year, any gain is considered long-term. The taxation on long-term gains depends on your income. It could be taxed at 0%, 15%, or 20%. For example, in 2022, single filers with less than $41,675 of taxable income ($83,350 for married filers) pay no taxes on their gains. If your income exceeds that threshold, you pay capital gains tax on the income as earned.
Partially Taxable Income in Retirement
Anywhere from 0% to 85% of your Social Security income may be taxable. That means that at least 15% will always be tax-free. How much of your benefit you pay tax on depends on your income. If Social Security benefits represent your only source of income, you generally won’t pay taxes on the benefits you receive. You can calculate how much of your Social Security benefits are taxable. You start by adding your non-Social Security income (also called your provisional income) to one-half of your annual Social Security benefit. If the amount falls below $32,000 (married tax filers) or $25,000 (single filers) in 2022, you will avoid federal taxes on your benefits.
You also want to avoid the Social Security tax torpedo. This can cause you to pay a very high rate of tax as your income crosses certain thresholds.
You should note that 37 states (plus Washington, D.C. do not tax Social Security benefits.
Tax-Free Income in Retirement
Health Savings Accounts (HSAs)
As discussed in more detail here, HSAs represent a triple tax-free retirement account. You get a tax break for amounts deposited into your HSA. You do not pay taxes on any income earned from your investments in an HSA. Any distributions used to pay for qualified medical expenses are not subject to tax either. Unlike a flex spending account (FSA), funds in an HSA can carry over from one year to the next. In 2022, individuals can contribute a maximum of $3,650 to an HSA ($7,300 for families). Those who are 55 or older can contribute an additional $1,000.
Roth IRAs and Roth 401(k) Withdrawals
From an income in retirement perspective, Roth IRAs are the exact opposite of traditional IRAs. You contribute after-tax dollars to a Roth IRA. If you meet the requirements – the account must be open for five years, and you must be at least 59 ½, withdrawals are tax-free. Keep in mind that since you contribute after-tax dollars to a Roth, you can withdraw those contributions at any time without worrying about taxes or penalties. You may have to pay taxes and a 10% penalty on investment earnings – amounts in the account that exceed your original deposit. This applies if you’ve had the Roth IRA for less than five years, and you are under age 59 ½.
You can also make tax-free withdrawals from Roth 401(k)’s (as well as Roth 403(b)’s and 457(b)’s. These accounts differ from Roth IRAs in that you can fund them regardless of your earnings. But your employer must offer this plan option.
As you approach retirement, you may lower our allocation to stocks and increase our allocation to bonds. In general, you pay federal and state taxes on the interest income you earn from bonds. But income earned from municipal or “muni” bonds, in particular, is exempt from federal income taxes. Holding muni bonds issued in your state of residence provides an additional benefit as you may also be exempt from state and local taxes. For example, residents of Maryland who buy muni bonds issued in Maryland don’t have to pay state tax on the related income.
Gain from the Sale of Your Home
The IRS provides a significant benefit to homeowners. You may be able to exclude some or all of your gain from tax. If the gain on the sale of your primary residence is less than $500,000 (married filers) or $250,000 (single filers) you may be able to avoid paying taxes on your capital gains. You must have owned and lived in your home for at least two out of the past five years for this exclusion to apply.
While working, we are subject to one set of tax rules. We may try to take steps to minimize our current taxes by saving in tax-deferred accounts. When we retire, the rules change. We switch from asset accumulation to asset decumulation.
Many retirees expect to pay less in taxes in retirement. Any taxes you do pay reduce your available income. Fortunately, you can take some steps to minimize your tax bill and retain more income later in life.
To do so, you should focus on having different types of accounts from a tax perspective. You should understand the tax rules that apply to the different types of income you receive. Tax planning can help you reduce your tax bill now and in the future. If you would like help navigating these rules or have any questions, please schedule a free call. We are here to help.
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Phil Weiss founded Apprise Wealth Management. He started his financial services career in 1987 working as a tax professional for Deloitte & Touche. For the past 25+ years, he has worked extensively in the areas of financial planning and investment management. Phil is both a CFA charterholder and a CPA.
Located just north of Baltimore, Apprise works with clients face-to-face locally and can also work virtually regardless of location.