How Different Forms of Retirement Income Get Taxed
By: Stacey Nickens
If you have reached retirement, congratulations! It is so beautiful to have more time to explore your hobbies, spend time with loved ones, relax, and travel. However, I never want my retired clients to be bogged down by financial worries. A surprise tax bill in retirement can be especially concerning and frustrating. Accordingly, take a few moments to better understand how your different forms of income can be taxed at the federal level. Preparing for your tax bill will help you have an easier, more relaxed retirement.
1. Traditional IRAs and 401(k)s
Traditional IRAs and 401(k)s can be very attractive because they reduce your tax bill at the time of your contribution. Additionally, your contributions, dividends, and investment gains are allowed to grow in these accounts on a tax-deferred basis.
However, your money cannot sit in these accounts forever. You will need to start taking Requirement Minimum Distributions (RMDs) from your Traditional IRAs or 401(k)s when you turn 72. (If you were born before July 1, 1949, your RMDs kick in when you turn 70 1/2.) If you work past the age of 72, you may be able to delay your RMDs for your workplace retirement plan until after you retire. While the Cares Act waived RMDs for 2020, there has been no sign that RMDs will be waived in 2021. Knowing this, your withdrawals from traditional IRAs and 401(k)s will be taxed at your ordinary income rate.
2. Roth IRAs
Unlike traditional IRAs, Roth IRA contributions are not deductible. However, withdrawals from Roth IRAs are tax-free. In order for your withdrawals to be tax-free, you must have held the Roth IRA for at least five years. You can also make tax-free withdrawals of your Roth IRA contributions at any age, if you meet the five-year holding period requirement. However, you must be at least 59 1/2 to make tax-free withdrawals of the gains in your Roth IRA. If you’re younger, withdrawing gains will force you to pay a 10% early-withdrawal penalty.
3. Social Security
Depending on your “provisional income,” you may or may not pay taxes on your Social Security benefits. You calculate your provisional income by taking your modified adjusted gross income (AGI), adding in half of your Social Security benefits, and adding in your tax-exempt interest.
Your Social Security is tax-free if your provisional income is less than $25,000 (or $32,000 if you’re married filing jointly.) 50% of your Social Security benefits are taxable if your provisional income is between $25,000 and $34,000 (or between $32,000 and $44,000 if you’re married filing jointly.) 85% of your Social Security benefits are taxable if your provisional income is more than $34,000 (or more than $44,000 if you’re married filing jointly.) You can use this tool on the IRS website to determine if your Social Security benefits are taxable.
4. Pensions
Most pension distributions are taxed at ordinary income rates, unless you made after-tax contributions to your pension.
5. Stocks, Bonds, and Mutual Funds
When you sell securities that you’ve held for less than one year, the proceeds are taxed as short-term capital gains and are taxed at your ordinary income rate. When you sell securities that you’ve held for more than one year, the proceeds are taxed as long-term capital gains and are taxed at 0%, 15%, or 20%. Your income determines your long-term capital gains rate. Click here to review the 2020 and 2021 income thresholds for long-term capital gains rates.
In addition to capital gains taxes, you will owe a 3.8% surtax on net investment income if you are an individual with modified AGI over $200,000 or a joint filer with modified AGI over $250,000. This surtax applies to the smaller of net investment income or the excess of modified AGI over $200,000 (individual filers) or $250,000 (joint filers). Net investment income includes taxable interest, capital gains, passive rents, annuities, royalties, and dividends.
6. Annuities
The taxes you will owe on an annuity depend on the funds you used to purchase the annuity. If you used regular, after-tax dollars to purchase the annuity, you will only owe tax on the portion of your annuity that represents earned interest. For example, if the annuity cost $100,000 at the time of purchase, and is now valued at $150,000, you will only pay taxes on the $50,000 of earned interest. The insurance company that sold you the annuity must tell you what portion of the annuity is taxable.
However, some individuals pay for annuities with pretax funds, such as funds from a traditional IRA. When this is the case, the entirety of your annuity is taxable at your ordinary income rate.
7. Dividends
Dividends paid by companies to their stockholders are either considered qualified or non-qualified. Qualified dividends are the most common and are taxed at long-term capital gains rates. Non-qualified dividends are taxed at your ordinary income rate.
Generally, a shareholder must a hold a stock for a specific period of time in order for that stock’s dividend to be treated as a qualified dividend. For example, common stock must be held for more than 60 days within the following timeframe: 60 days before the company declares the dividend payment up until 60 days after the declaration.
8. Municipal Bonds
Interest on municipal bonds is exempt from federal taxation. (Capital gains from municipal bonds can still be subject to federal taxation.) Similarly, interest on bonds issued in your home state may be exempt from state taxation, depending on your state’s laws.
9. CDs, Savings Accounts, and Money Market Accounts
Interest payments on these investment vehicles are taxed at ordinary income tax rates.
