“Taxes in retirement will likely be lower than you expect and not all your retirement income is taxable.”
Managing taxes in retirement can be complex. Yet, thoughtful planning may help reduce the tax burden for you and your heirs. By formulating a tax-efficient investment and distribution strategy, retirees may keep more of their hard-earned assets for themselves and their heirs.
The inconvenient truth is that you’ll continue to pay taxes in retirement, which in most cases will be typically at a lower effective tax rate. And, there are a variety of reasons why your tax rate in retirement will be lower.
When you’re working, the bulk of your income is earned from your job and is fully taxable (after deductions and exemptions) at ordinary income tax rates.
When you’re retired, different tax rules can apply to each type of income you receive. You should know how each income source shows up on your tax return in order to estimate and minimize your taxes in retirement.
In retirement, only pension income, withdrawals from taxable retirement accounts such as 401(k), and any rental, business, and wage income you have is taxable at ordinary income tax rates.
Withdrawals from tax-deferred retirement accounts are taxed at ordinary income rates. These are long-term assets, but withdrawals aren’t taxed at long-term capital gains rates. IRA withdrawals, as well as withdrawals from 401(k) plans, 403(b) plans, and 457 plans, are reported on your tax return as taxable income.
Social Security is taxed at ordinary income rates, but only part of it is taxable.
You probably won’t pay any taxes in retirement if Social Security benefits are your only source of income, but a portion of your benefits will likely be taxed if you have other sources of income. The taxable amount—anywhere from zero to 85%—depends on how much other income you have in addition to Social Security.
Withdrawals from Roth accounts are tax-free if you’ve had the account for at least 5 years and are over age 59 1/2.
Accessing the principal from savings and investments is tax-free and long-term capital gains are taxed at lower rates or can even reduce other taxes if you’re selling at a loss.
You’ll pay taxes on dividends, interest income, or capital gains from investments. These types of investment income are reported on a 1099 tax form each year. Each sale of an asset will generate a long- or short-term capital gain or loss, and is reported on your tax return. Short term capital gains are taxed as ordinary income and long term gains are taxed at lower capital gains tax rate.
Tax rate: Marginal vs. Effective
Marginal tax rate is the tax rate you pay on an additional dollar of income. The reason is because the next dollar that you contribute to your retirement account would normally be taxed at the marginal tax rate.
For example, a single person with a taxable income of $50k would have a 22% marginal tax bracket for 2021. But according calculations, the effective tax rate would be 13.5% of taxable income since only taxable income over $40,525, or $9,475, would be taxed at that 22%.
When you take funds out of your 401(k) in retirement, some of your income won’t be taxed at all because of deductions and exemptions. In fact, your standard deduction would be $1,700 higher if you were age 65 or older this year.
The first $9,950 of taxable income would only be taxed at 10%. Then the next bucket of income up to $40,525 would be taxed at 12%. Only the income over $40,525 would be taxed at the 22% rate.
Ideally, you want to use the lower effective tax rate when you’re estimating how much of your retirement income will go to pay taxes.
Tax strategies
Less taxing investments
Municipal bonds, or “munis,” have long been appreciated by retirees seeking a haven from taxes and stock market volatility. In general, the interest paid on municipal bonds is exempt from federal income tax and sometimes state and local taxes as well. The higher your tax bracket, the more you may benefit from investing in munis.
Also, tax-managed mutual funds may be a consideration. Managers of these funds pursue tax efficiency by employing a number of strategies. For instance, they might limit the number of times they trade investments within a fund or sell securities at a loss to offset portfolio gains. Equity index funds may also be more tax efficient than actively managed stock funds due to a potentially lower investment turnover rate.
It’s also important to review which types of securities are held in taxable versus tax-deferred accounts. Because the maximum federal tax rate on some dividend-producing investments and long-term capital gains is 20%.
Securities to tap first
Another major decision facing retirees is when to liquidate various types of assets. The advantage of holding on to tax-deferred investments is that they compound on a before-tax basis and therefore have greater earning potential than their taxable counterparts.
On the other hand, you’ll need to consider that qualified withdrawals from tax-deferred investments are taxed at ordinary federal income tax rates of up to 37%, while distributions — in the form of capital gains or dividends — from investments in taxable accounts are taxed at a maximum 20%. Capital gains on investments held for one year or less are taxed at regular income tax rates.)
For this reason, it potentially could be beneficial to hold securities in taxable accounts long enough to qualify for the favorable long-term rate. And, when choosing between tapping capital gains versus dividends, long-term capital gains may be a consideration from an estate planning perspective because you could get a step-up in basis on appreciated assets at death.
It may also make sense to consider taking a long term view with regard to tapping tax-deferred accounts. Keep in mind, however, the deadline for taking annual required minimum distributions (RMDs).
The ins and outs of RMDs
Generally, the IRS mandates that you begin taking an annual RMD from traditional individual retirement accounts (IRAs) and employer-sponsored retirement plans after you reach age 72.
The premise behind the RMD rule is simple — the longer you are expected to live, the less the IRS requires you to withdraw (and pay taxes on) each year.
In most cases, RMDs are based on a uniform table based on the participant’s age. Failure to take the RMD can result in an additional tax equal to 50% of the difference between the required minimum distribution and the actual amount distributed during the calendar year. Tip: If you’ll be pushed into a higher tax bracket at age 72.
Estate planning and gifting
There are various ways to reduce the burden of taxes on your beneficiaries. Careful selection of beneficiaries of your retirement accounts is one example. If you do not name a beneficiary of your retirement account, the assets in the account could become distributable to your estate. Your estate or its beneficiaries may be required to take RMDs on a faster schedule (such as over five years) than what would otherwise have been required (such as ten years or over the remaining lifetime of an individual beneficiary). In most cases, naming a spouse as a beneficiary is ideal because a surviving spouse has several options that aren’t available to other beneficiaries, such as rolling over your retirement account into the spouse’s own account and taking RMDs based on the surviving spouse’s own age
Key takeaways
“Nothing in life is certain except death and taxes.” Benjamin Franklin
When it comes to investing, nothing is certain but taxes.
- Taxation and rates varies depending on the type of retirement income you receive.
- You may pay taxes on Social Security benefits if you have other sources of income.
- Income from pensions, traditional IRAs, 401(k)s, and similar plans are taxed as ordinary income.
- You’ll pay taxes on investment income, including capital gains taxes if applicable.
- Know and calculate your effective tax rate, which in most cases, will be lower than your marginal tax rate.
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Strategies for making the most of your money and reducing taxes in retirement are complex. Plan ahead and consider meeting with a competent tax advisor, an estate attorney, and a financial professional to help you sort through your options.
References:
- https://www.merrilledge.com/article/tax-strategies-for-retirees
- https://www.fidelity.com/insights/retirement/lower-taxes-retirement
- https://www.thebalance.com/taxes-in-retirement-how-much-will-you-pay-2388987