As you envision how you’ll spend your nest egg in retirement, don’t forget what could be one of your biggest expenses: taxes.
The government will want a share of the money that’s been building up in tax-deferred retirement accounts for years, if not decades. Your monthly pension check and possibly your Social Security benefits will be taxed, too.
Not all retirement income, however, is taxed the same way. And knowing the differences can help you and your tax advisor develop a strategy to minimize the federal tax bite. (Check with your home state to learn how it taxes retirement income.)
1. 401(k)s, 403(b)s and 457 plans
Money goes into these employer- sponsored retirement plans pre-tax, and the earnings on your account’s investments grow tax-sheltered. But withdrawals will be taxed as ordinary income, at rates as high as 37%.
406,000 Number of people with at least $1 million in a Fidelity- managed 401(k) plan at the end of the first quarter of 2022.
Source: Fidelity® Q1 2022 Retirement Analysis
2. Social Security
About 4 out of 10 Social Security recipients pay federal taxes on their benefits, according to the Social Security Administration.
Whether you’ll be one of them depends on your “provisional income,” calculated by adding up your adjusted gross income, tax-exempt interest plus half your Social Security benefits.
Less than $25,000
$25,000 to $34,000
Less than $32,000
$32,000 to $44,000
Benefits are tax-free
Up to 50% of benefits may be taxable
Up to 85% of benefits may be taxable
States that tax Social Security retirement benefits
DON’T TAX SOCIAL SECURITY BENEFITS
Map of the U.S.
3. Stocks, bonds and funds
You’ll be taxed on any profit from a sale of stocks, bonds, mutual funds and exchange-traded funds in your brokerage account. If you owned the securities for more than a year, you will be taxed at long-term capital gains tax rates, which range from 0% to 20% depending on income.
Sell earlier, and your gains will be taxed as ordinary income, at rates of up to 37%.
Tax tip: If you also sell investments for a loss, you can use those losses to offset any capital gains on other investments. If losses exceed gains, you can use up to $3,000 of excess losses to offset up to $3,000 of regular income. Losses above that can be carried forward to offset gains in future tax years.
Traditional and Roth IRAs are taxed differently.
Traditional IRAs offer an upfront tax break by allowing you to deduct your contributions on your tax return. Your withdrawals will be fully taxable at ordinary income tax rates. (Did you also make non-deductible contributions to a traditional IRA? If so, a portion of your withdrawals won’t be taxed to prevent you being taxed twice on those contributions.)
Money going into a Roth IRA has already been taxed so you can withdraw your contributions at any time without triggering taxes.
Your earnings can also be withdrawn tax-free once you turn 59 and have held the Roth for five years.
Did you buy an annuity with after-tax dollars? Or did you purchase it with money that’s never been taxed, such as through a traditional IRA?
In the first scenario, you won’t owe tax on a portion of the annuity payments that represent a return of your original investment. The other portion the earnings on the investment is taxable. And in the second, the annuity payments will be fully taxable as ordinary income.
6. Traditional pensions
Pension checks are fully taxable as ordinary income. But if you made after-tax contributions to the pension plan, you won’t have to pay taxes on the part of the pension check that’s considered a return of your contributions.
Most dividends are “qualified,” and you’ll pay tax on the income at the favorable longterm capital gains tax rates. Nonqualified dividends from, say, real estate investment trusts, are taxed as ordinary income.
Interest earned on savings accounts, certificates of deposit, money market accounts and corporate bonds are taxed as regular income. You typically won’t pay federal taxes on interest earned from municipal bonds. (You won’t pay state taxes either if the municipal bond’s issuer is from your state.)
A note about Required Minimum Distributions (RMDs)
You can’t avoid taxes forever by keeping all your money socked away in retirement accounts. After you turn 72, the IRS requires you to start taking minimum withdrawals annually from most retirement accounts, including 401(k)s, 403(b)s, and 457 plans, as well as SEP, SIMPLE and traditional IRAs. The money is taxed as ordinary income (unless you made any nondeductible contributions).
Exceptions: Roth IRAs don’t have RMDs. And while you must take RMDs from a Roth 401(k), the withdrawals won’t be taxed.
Did you know? Legislation pending in Congress would gradually raise the age for starting RMDs to age 73 in 2023, 74 in 2030 and 75 in 2033.
(c) September 2022, Future US
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