Tax Rates on Retirement Income: The golden years are a time to relax and appreciate your hard-earned money, but navigating income taxes during retirement can be tricky. The tax implications of your IRAs, pensions, taxable accounts, and Social Security distributions are diverse. Therefore, it is essential to comprehend them and implement strategies to minimise your tax liability and maximise your retirement savings. You may wish to consult a financial advisor for a more personalised assessment of how your retirement income will be taxed.
Differential Federal Tax Rates for Retirement Income
Federal tax rates vary by type and level of income. In order to plan for retirement, it is essential to determine the nature of each anticipated source of income. Here is a breakdown of the most common retirement taxes:
IRAs and 401(k)s are retirement accounts
Traditional IRAs and 401(k)s offer tax-deferred growth, which means that contributions and investment earnings are not taxed until the funds are withdrawn in retirement. Generally, withdrawals from these accounts are taxable income. The tax rate is determined by your total income, filing status, and the federal income tax brackets in effect during the withdrawal year.
On the other hand, Roth IRAs and Roth 401(k)s are funded with after-tax contributions, meaning the money is taxed prior to being deposited. Included in tax-free withdrawals from Roth accounts are both contributions and earnings.
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Taxable Assets
After-tax funds are used in taxable accounts, such as brokerage and savings accounts. Consequently, you must pay taxes on any interest, dividends, or capital gains generated by these accounts. Specifically, interest income is taxed at ordinary income tax rates, whereas dividends and capital gains are taxed at varying rates depending on the holding period (short-term vs. long-term).
The government treats short-term capital gains as ordinary income when they are imposed on the sale of assets held for less than a year. On the other hand, the sale of assets held for a year or more results in long-term capital gains taxes, as illustrated below:
Pension Payments
Monthly disbursements from an employer-sponsored pension plan or a private annuity are subject to standard income taxes. In addition, if you choose a one-time large sum payment that depletes your pension, you will be responsible for paying income taxes on the entire amount.
Remember that employer pension payments are subject to a specific amount of tax withholding. This feature ensures that you won’t be hit with a hefty tax bill at filing time (provided you haven’t received any unanticipated income that year).
Earned Revenue
Earned income is taxed at standard rates, as are the majority of the other categories of income listed. However, wages from an employer or self-employment are subject to FICA taxes (Social Security and Medicare). Part-time employment income incurs an additional FICA tax rate of 7.65%, while self-employment income incurs an additional FICA tax rate of 15.3% (you will receive 50% of this amount back when you file your taxes).
Remember that excessive earned income can reduce your Social Security benefits. For 2023, if you are under the age the government considers full retirement age, earning more than $21,240 will result in a $1 deduction for every $2 earned above the threshold. Once you attain full retirement age, the limit increases to $56,520 and the penalty is a $1 reduction for every $3 earned.
Security Benefits
Social Security is also subject to income and filing status-based taxes. When calculating tax thresholds, the Social Security Administration combines your adjusted gross income with nontaxable interest income and fifty percent of your Social Security benefits. The government then applies federal income tax rates to 50 percent or 85 percent of your Social Security payment.
Income Percentage of Social Security Income Taxed for Single Filers $0 – $24,999 0% $25,000 – $34,000 50% $34,001+ 85% Income Percentage of Social Security Income Taxed for Married Filing Jointly, $0 – $31,999 $32,000 – $44,000 50% $44,001+ 85%
Consider that if you are married and file a separate tax return, you will likely be required to pay taxes on your benefits.
How to Minimise Your Retirement Tax Liability
The objective of the vast majority of individuals is to minimise their prospective tax liability during retirement. While your income and location will have a significant impact on the taxes you pay, there are steps you can take to enhance your situation. In fact, the following strategies can help you reduce your retirement tax burden.
1. Remember To Withdraw From Your Retirement Accounts
When you attain the age of 73 (or 7012 if you were born before July 1, 1949), you must begin taking RMDs from most retirement accounts, including traditional IRAs and 401(k)s. Failure to withdraw the RMD amount results in a 25% penalty plus the income tax that would have been incurred.
If you have multiple retirement accounts, you can choose which account(s) to withdraw from. By strategically planning your withdrawals, you can optimise your tax situation by controlling the timing and quantity of taxable income.
2. Recognise Your Tax Bracket
Understanding your tax bracket is crucial when planning for retirement. You can reduce your tax liability by maintaining a lower tax classification with your taxable income. Use the above tables and the federal income tax brackets for the year to calculate a comfortable quantity of income without exposing your funds to higher tax rates.
3. Withdraw Funds Before You Need Them
If you have a blend of taxable and tax-advantaged accounts, such as a 401(k) and a Roth IRA, you can strategize your withdrawals. Making withdrawals from taxable or tax-free accounts, such as a Roth IRA, before you need the funds can help reduce your future RMDs and potentially reduce your overall tax burden in retirement.
4. Invest in tax-exempt bonds.
Municipal bonds and other tax-exempt bonds can be an attractive investment option for retirees seeking tax efficiency. Generally, interest income from municipal bonds is exempt from federal and sometimes state and local income taxes.
5. Invest with a Long-Term Perspective, Not a Short-Term Perspective
Long-term investment holding, especially in taxable accounts, can be advantageous from a tax standpoint. When you sell investments held for more than a year, you are eligible for long-term capital gains tax rates, which are typically lower than ordinary income tax rates. You can minimise the realisation of short-term capital gains, which are subject to the standard federal income tax rates, by averting frequent purchases and sales.
Suppose you are a single taxpayer with a $44,000 income. A portion of this income consists of capital gains. However, if the capital gains are short-term, your marginal tax bracket is 12%, whereas it is 0% for long-term gains.
6. Relocate to a low-tax state
Some states have minimal or no state income tax, which can have a significant impact on your retirement tax burden. If possible, consider relocating to a state with favourable tax rates. Prior to making such a decision, it is essential to evaluate various factors such as cost of living, healthcare, and individual preferences. Remember that Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming do not impose personal income taxes.
The Conclusion
The taxation of your retirement income may vary depending on the source of your income. Most individuals cannot completely avoid this by moving to a tax-friendly state, but some can. It is essential to comprehend your prospective personal tax liability and to plan accordingly in order to be financially prepared for retirement.
Advice for Being More Tax-Effective
The path to financial security in retirement varies for each individual. Your investment account types, medical conditions, and desired way of life can present unique obstacles, but a financial advisor can assist you. Finding a financial advisor need not be difficult. SmartAsset’s free tool connects you with up to three verified financial advisors in your area, and you can have a free introductory call with your advisor matches to determine which one is the best fit. If you are ready to locate a financial advisor who can assist you in achieving your financial objectives, get started now.
Social Security is a financial lifeline for innumerable retirees, but it can have undesirable tax consequences. Therefore, it is preferable to avoid heavy Social Security tax burdens.
