It’s fun to contemplate all the travel, rounds of golf and restaurant meals you have ahead of you. You’ve earned it! However, many retirees don’t take into consideration the cumulative impact of federal and state income taxes on withdrawals from their nest eggs and passive monthly income.
Most forms of retirement income — including Social Security benefits, as well as withdrawals from your 401(k)s and traditional IRAs — are taxed by the Federal Government. And unless you live in one of nine states without a traditional income tax, you can expect your home state to tax you in retirement as well.
Traditional IRAs and 401(k)s
Savers love these tax-deferred retirement accounts. Contributions to the plans generally reduce their taxable income, saving them money on their tax bills in the current year. Their savings, dividends and investment gains within the accounts continue to grow on a tax-deferred basis.
What they tend to forget is that they will pay taxes down the line when they retire and start taking withdrawals, and that those taxes apply to their gains and their pretax or deductible contributions. And at some point, you must withdraw money from the accounts. Required minimum distributions (RMDs) kick in at age 72 for holders of traditional IRAs and 401(k)s (age 70½ if you were born before July 1, 1949). People who work past age 72 can generally delay taking RMDs from their 401(k)s until they retire. (The CARES Act, enacted in March 2020, waived RMDs for 2020 from IRAs; workplace defined contribution plans such as 401(k)s; 403(b) and 457(b) plans from government employers; and the Federal Thrift Savings Plan.)
The tax rate you pay on your traditional IRA and 401(k) withdrawals would be your ordinary income tax rate.
Roth IRAs come with a big long-term tax advantage: Contributions to Roth IRAs aren’t deductible, but withdrawals are tax-free.
Two important caveats: You must have held your account for at least five years before you can take tax-free withdrawals. And although you can withdraw the amount you contributed at any time tax-free, you generally must be at least age 59½ to be able to withdraw the gains without facing a 10% early-withdrawal penalty.
Once upon a time, Social Security benefits were tax-free for everyone–but that fairy tale ended in 1983. For many Social Security recipients, the benefits still aren’t taxed. But others, depending on their “provisional income,” aren’t so lucky and may have to pay federal income tax on up to 85% of the benefits. To determine your provisional income, take your modified adjusted gross income, add half of your Social Security benefits, and add all of your tax-exempt interest.
If your provisional income is less than $25,000 ($32,000 for married couples filing a joint return), your Social Security benefits are tax-free.
If your provisional income is between $25,000 and $34,000 ($32,000 and $44,000 for joint filers), then up to 50% of your benefits are taxable.
If your provisional income is more than $34,000 ($44,000 for joint filers), then up to 85% of your benefits are taxable.
Most pensions are funded with pretax income, and that means the full amount of your pension income would be taxable when you receive the funds. Payments from private and government pensions are usually taxable at your ordinary income rate, assuming you made no after-tax contributions to the plan.
Stocks, Bonds and Mutual Funds
If you sell stocks, bonds or mutual funds that you’ve held for more than a year, the proceeds are taxed at long-term capital gains rates of 0%, 15% or 20%. Compare these figures to the top 37% tax rate on ordinary income.
The 0%, 15% and 20% rates on long-term capital gains are based on set income thresholds that are adjusted annually for inflation. For 2021, the 0% rate applies to individuals with taxable income up to $40,400 on single returns, $54,100 for head-of-household filers, and $80,800 for joint returns ($40,000, $53,600, and $80,000 for 2020). The 20% rate starts at $445,851 for single filers, $473,751 for heads of household, and $501,601 for joint filers ($441,451, $469,051, and $496,601 for 2020). The 15% rate is for individuals with taxable incomes between the 0% and 20% break points. The favorable rates also apply to qualified dividends (see below).
There’s also a 3.8% surtax on net investment income (NII) on top of the 15% or 20% capital gains rate for single taxpayers with modified adjusted gross incomes over $200,000 and joint filers over $250,000. This 3.8% extra tax is due on the smaller of NII or the excess of modified AGI over the $200,000 or $250,000 amounts. NII includes dividends, taxable interest, capital gains, passive rents, annuities, royalties, etc.
If you sell investments that you’ve held for a year or less, the gains are short-term and are taxed at your ordinary income tax rate.
There’s a good chance that some (or all) of the income you receive from any annuity you own is taxable.
If you purchased an annuity that provides income in retirement, the portion of the payment that represents your principal is tax-free; the rest is taxable. For example, if you purchased an annuity for $150,000 and it is worth $225,000 in 10 years, you would only pay tax on the $75,000 of earned interest. The insurance company that sold you the annuity is required to tell you what is taxable.
Different rules apply if you bought the annuity with pretax funds (such as from a traditional IRA). In that case, 100% of your payment will be taxed as ordinary income. In addition, be aware that you’ll have to pay any taxes that you owe on the annuity at your ordinary income tax rate, not the preferable capital gains rate.
Many retirees own stock, either directly or through mutual funds. Dividends paid by companies to their stockholders are treated for tax purposes as qualified (most common) or non-qualified. Qualified dividends are taxed at long-term capital gains rates (see above). Non-qualified dividends are taxed at ordinary income tax rates.
Shareholders generally must hold stock for a certain period of time to take advantage of the capital gains rates for dividend payments (i.e., for the dividend to be treated as a “qualified dividend”). For example, dividends paid on common stock must be held for more than 60 days within the window beginning 60 days before and ending 60 days after the date the company declares a dividend payment.
Municipal bond interest is exempt from federal tax. Likewise, interest from bonds issued in an investor’s home state is typically exempt from state income taxes (but check your own state’s laws). Keep in mind, however, that capital gains can be subject to federal tax if you sell municipal bonds.
CDs, Savings Accounts and Money Market Accounts
Ordinary income tax rates apply to interest payments on certificates of deposit, savings accounts and money market accounts.
For federal income tax purposes, interest on U.S. savings bonds is generally taxable at ordinary income rates in the year the instruments mature or when they are redeemed, whichever is earlier. Holders of HH bonds report and pay U.S. tax on interest annually as it is paid to them. Interest on U.S. savings bonds is exempt from state and local income taxes.
If you’re heading back to school in your golden years, know that interest on EE and I bonds that are used to pay for higher education may be tax-free, provided certain rules are followed. The bonds must have been purchased after 1989 by buyers who were age 24 or older. They must also be redeemed to pay for college, graduate school or vocational school tuition or fees for the bondholder or the bondholder’s spouse or dependent. Room and board costs aren’t eligible. Also, the bonds are required to be in the taxpayer’s name. Grandparents can’t use this tax break to help pay for their grandchild’s college tuition unless the grandparent can, on his or her federal tax return, claim the grandkid as a dependent.
The income exclusion is subject to income limits. For 2021, it begins to phase out for joint return filers with modified adjusted gross income over $124,800…$83,200 for everyone else ($123,550 and $82,350, respectively, for 2020). The tax break disappears when modified AGI hits $154,800 and $98,200, respectively ($153,550 and $97,350 for 2020).
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