One of the biggest mistakes retirees make when calculating their living expenses is forgetting how big a bite state and federal taxes can take out of savings. And how you tap your accounts can make a big difference in what you ultimately pay to Uncle Sam.
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Conventional wisdom has long held that you should tap taxable accounts first, followed by tax-deferred retirement accounts and then your Roth. This strategy makes sense for many retirees, but be careful if you have a lot of money in a traditional IRA or 401(k). When you turn 70 1/2, you'll have to take required minimum distributions (RMDs) from the accounts. If the accounts grow too large, mandatory withdrawals could push you into a higher tax bracket. To avoid this problem, you may want to take withdrawals from tax-deferred accounts earlier.
Here's how retirement assets are taxed.
Tax-deferred accounts. Prepare to feel pain. Withdrawals from traditional IRAs and your 401(k) will be taxed as ordinary income, which means at your top tax bracket.
Taxable accounts. Profits from the sale of investments, such as stocks, bonds, mutual funds and real estate, are taxed at capital-gains rates, which vary depending on how long you've owned the investments. Long-term capital-gains rates, which apply to assets you have held longer than a year, can be quite favorable: If you're in the 10% or 15% tax bracket, you'll pay 0% on those gains. Most other taxpayers pay 15% on long-term gains. Short-term capital gains are taxed at your ordinary income tax rate.
Interest on savings accounts and CDs and dividends paid by your money market mutual funds is taxed at your ordinary income rate. Interest from municipal bonds is tax-free at the federal level.
Roth IRAs. Give yourself a high five if your retirement portfolio includes one of these accounts. As long as the Roth has been open for at least five years and you're 59 1/2 or older, all withdrawals are tax-free. In addition, you don't have to take RMDs from your Roth when you turn 70 1/2.
Social Security. Many retirees are surprised—and dismayed—to discover that a portion of their Social Security benefits could be taxable. Whether or not you're taxed depends on what's known as your provisional income: your adjusted gross income plus any tax-free interest plus 50% of your benefits. If provisional income is between $25,000 and $34,000 if you're single, or between $32,000 and $44,000 if you're married, up to 50% of your benefits is taxable. If it exceeds $34,000 if you're single or $44,000 if you're married, up to 85% of your benefits is taxable.
Pensions. Payments from private and government pensions are usually taxable at your ordinary income rate, assuming you made no after-tax contributions to the plan.
Annuities. If you purchased an annuity that provides income in retirement, the portion of the payment that represents your principal is tax-free; the rest is taxable. The insurance company that sold you the annuity is required to tell you what is taxable. Different rules apply if you bought the annuity with pretax funds (such as from a traditional IRA). In that case, 100% of your payment will be taxed as ordinary income.