Worried about taxes during retirement? Let’s look at some of the ways different types of retirement income are taxed.
Traditional 401(k)s and IRAs
On the front end, these tax-deferred accounts often reduce your taxable income, thus saving you money in the current tax year. Savings, dividends and investment gains with these accounts grow tax-deferred.
It can be easy to lose sight of the fact that you’ll eventually pay taxes on this money when you retire and begin taking withdrawals. And those taxes apply to gains and pretax or deductible contributions.
And you can’t put off withdrawals forever.
Required minimum distributions, or RMDs, currently begin at age 72 for those with traditional 401(k)s and IRAs. Folks who work past 72 may be able to delay taking RMDs from their current employer’s 401(k) until they officially retire, as long as they don’t own more than 5% of the company that employs them.
You should also bear in mind the tax rate you pay on traditional 401(k) or IRA withdrawals would be your ordinary income tax rate. Additionally, if you take payouts before age 59 ½, you’ll often be smacked with a 10% penalty on top of your regular tax fee.
Roth IRAs come with one potential advantage: While contributions aren’t deductible, but withdrawals are tax-free.
Two important notes here.
First, you must have had your Roth IRA account for a minimum of five years before you can begin tax-free withdrawals. The countdown begins the first time money is deposited into your Roth IRA, whether through a contribution or a conversion from a traditional IRA.
Second, though you may be able to withdraw the amount you contributed at any time, tax free, in most cases you must be at least 59 ½ to withdraw any gains without facing the 10% early withdrawal penalty.
Prior to 1983, Social Security benefits were tax-free. And while many recipients still don’t pay taxes on their benefit, others are in a different boat, depending on their provisional income and some may end up paying federal income tax on up to 85% of their benefits.
If your provisional income is under $25,000 or $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 or between $32,000 and $44,000 for joint filers, as much as 50% of your benefits are taxable.
If your provisional income is greater than $34,000, or $44,000 for joint filers, as much as 85% of your benefits are taxable.
If you own an annuity, there’s a strong likelihood that some — perhaps even all — of any income you get from an annuity will be taxable.
If you bought an annuity that supplies you with retirement income, the portion of the payments that reflects your principal is tax-free, however, the rest is taxable. Here’s an example. If you bought an annuity for $150,000 and after a decade its value is now $225,000, you’d pay taxes on the $75,000 of earned interest.
You should also be aware the insurance company that sold you the annuity is required to inform you what’s taxable.
Additionally, there are different rules if you purchased an annuity with pretax money, like from a traditional IRA, for example. In this scenario, 100% of your annuity payment is taxed as ordinary income. Moreover, you should be prepared to pay any taxes you owe on the annuity at your ordinary income rate, NOT the more advantageous capital gains rate.