Even in retirement, our obligation to Uncle Sam remains a constant. For many, tax obligations may even be the largest retirement expense. Each type of income received will be taxed at different rates, therefore understanding tax consequences and developing a withdrawal plan in coordination with your tax professional will help to achieve a financially smooth retirement.
How various retirement assets are taxed
Note: The following categories and descriptions are meant to be broad in nature. Applicability to your individual situation may vary. We recommend you consult your tax advisor.
Qualifying dividends and any profits generated on long-term investments (held for longer than one year) such as stocks, bonds, mutual funds, and real estate are taxed at capital gains rates, varying from 0-20% depending on your tax bracket. However, short-term capital gains and interest paid on taxable bonds in taxable accounts is taxed as ordinary income. Taxable accounts have greater flexibility prior to retirement as there are no required distributions or penalties for withdrawals prior to age 59.5, but taxes are paid as you go.
Only those with Social Security as their sole source of income will pay no taxes during retirement. Those with multiple sources of income will be taxed by a predetermined formula with up to 85 percent of the benefits as taxable.
For those individuals lucky enough to have a pension, most pension accounts are funded with pre-tax income, meaning your annual income will be taxed at your ordinary income rate if no after-tax contributions were made. In other words, pensions are treated the same as a paycheck during your working years.
Retirement Accounts (IRAs and Roth IRAs)
If the Roth IRA has been open for at least five years and the owner is at least 59.5 years old all withdrawals are tax-free. There are no required minimum distributions at any age.
To the contrary, IRAs grow tax-deferred and withdrawals are taxed fully as ordinary income in the year of the withdrawal. There is also a mandatory required distribution beginning at age 70 ½, so while you are forced to pay taxes, the tax rate is still at ordinary income rates.
There are both qualified (pre-tax) and non-qualified (after-tax) annuities. If you purchased the annuity with pre-tax funds, all of your payment is taxed as ordinary income (the same as for an IRA). After-tax annuities treat withdrawals as last-in-first-out. This means that as you make withdrawals, all gains above your original basis is taxed as ordinary income. Once your full gain has been withdrawn, principal can be withdrawn with no tax obligations. Note that the above taxation is for annuity withdrawals; annuitization is subject to different tax obligations.
The case for withdrawing from taxable accounts first
The order in which you withdraw from your accounts can greatly affect your tax bill. Conventional wisdom says you should withdraw from your taxable accounts first. This assumes that the money in the account has been invested for longer than one year and is taxed at long-term capital gain rates. Recall that the amount you’re being taxed on is only the growth, not the full withdrawal amount. This leads to less taxes owed, compared to withdrawals from tax-deferred accounts, where you’re taxed on the entire amount. Therefore, withdrawing from taxable accounts first allows tax-deferred and tax-free assets to grow longer and faster.
Case for withdrawing from tax-deferred accounts first
Those who have a significant amount of their net worth in tax-deferred accounts may elect to go a different route. Required minimum distributions at age 70.5 can push you into a higher tax bracket. Beginning to withdraw from tax-deferred accounts earlier may help to ease some of this tax burden.
As your tax bracket fluctuates with various types of income you may choose to utilize different strategies during different time periods. The decision of which accounts to withdraw from first is likely not static. Analyzing each type of retirement income and factoring in all your options can help to greatly reduce what you will owe to Uncle Sam.
Each individual’s situation is unique. As such, we strongly suggest consulting with your team at Republic, or your own financial advisor, in coordination with your tax professional to better plan for taxes in retirement.
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