When you’re planning for retirement, it’s fun to contemplate all the travel, rounds of golf, and restaurant meals you have ahead of you. You may also want to financially help your children and grandchildren. However, many retirees don’t take into consideration the cumulative impact of federal and state income taxes on withdrawals from their nest eggs.
Most forms of retirement income – including Social Security benefits, as well as withdrawals from your 401(k)S and traditional IRAs – are taxed. An unless you live in a state without a traditional income tax, you can also expect another hit in retirement.
Traditional IRAs and 401(k)s
Savers love tax-deferred retirement accounts like 401(k)s and traditional IRAs. Contributions to the plans generally reduce their taxable income, saving them money on their tax bills in the current year. Their savings, dividends, and investment gains within the accounts continue to grow on a tax-deferred basis.
What they tend to forget is that they will pay taxes when they retire and start taking withdrawals, and those taxes apply to their gains and their pretax or deductible contribution. The tax rate tax rate you pay on your traditional IRA and 401(k) withdrawals would be your ordinary income tax rate.
Roth IRAs come with a big long-term tax advantage: Contributions to Roths aren’t deductible, but withdrawals are tax-free.
Two important caveats: You must have held your account for at least five years before you can take tax-free withdrawals. And although you can withdraw the amount you contributed at any time tax-free, you generally must be at least age 59 ½ to be able to withdraw the gains without facing a 10% early-withdrawal penalty.
For many Social Security recipients, the benefits are tax-free. However, for others, depending on their “provisional income” may have to pay federal tax on up to 85% of the benefits. The IRS offers an online tool that can help you determine whether your benefits are taxable.
Most pensions are funded with pretax income, and that means the full amount of your pension would be taxable when you receive the funds.
Stocks, Bonds and Mutual Funds
If you sell stocks, bonds or mutual funds that you’ve held for more than a year, the proceeds are taxed at long-term gain rates. If you sell investments you’ve held for a year or less, the gains are short-term and are taxed at your ordinary income tax rate.
If you have purchased an annuity that provided income in retirement, the portion of the payment that represents your principle is tax-free; the rest is taxable.
Many retirees own stock, either directly or through mutual funds. Dividends paid by companies to their stockholders are treated for tax purposes as qualified or non-qualified. Qualified are taxed at long-term capital gain rates. Non-qualified are taxed at ordinary income tax rates.
Municipal bond interest is exempt for federal tax. Likewise, interest from bonds issued in an investor’s home state is typically exempt from state income taxes (but check your own state’s law).
CDs, Savings Accounts and Money Market Accounts
Ordinary income tax rates apply to interest payments on certificates of deposit, savings accounts, and money market accounts.
For federal tax purposes, interest on savings bonds is generally taxable at ordinary income rates in the year the instruments mature or when they are redeemed, whichever is earlier.
Questions about your investments? We invite you schedule a complimentary consultation with one of our financial advisors.