How 13 Types of Retirement Income Get Taxed
When you're planning for retirement, it's fun to contemplate all the travel and rounds of golf ahead of you, but don't forget about taxes.
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've earned it! 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 by Uncle Sam. And unless you live in one of nine states without a traditional income tax, you can expect your home state to ding you in retirement as well. (Taxes on retirees vary from state to state, so make sure you check our retiree tax map for each state's overall tax impact on your retirement income.) Do yourself a favor before you retire and take a look at the federal income taxes you're likely to face on 13 common sources of retirement income.
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 down the line when they retire and start taking withdrawals, and that those taxes apply to their gains and their pretax or deductible contributions. And at some point, you must withdraw money from the accounts. Required minimum distributions (RMDs) currently kick in at age 72 for holders of traditional IRAs and 401(k). People who work past age 72 can delay taking RMDs from their current employer's 401(k) until they retire, provided they don't own more than 5% of the company that employs them.
The tax rate you pay on your traditional IRA and 401(k) withdrawals would be your ordinary income tax rate. Payouts before age 59½ are generally slapped with a 10% penalty on top of the regular tax hit.
Roth IRAs
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 a Roth IRA account for at least five years before you can take tax-free withdrawals. The five-year clock starts ticking the first time money is deposited into any Roth IRA, through either a contribution or a conversion from a traditional IRA. Second, although you can withdraw the amount you contributed at any time tax-free, you generally must be at least age 59½ to be able to withdraw the gains without facing a 10% early-withdrawal penalty.
Social Security
Once upon a time, Social Security benefits were tax-free for everyone – but that fairy tale ended in 1983. For many Social Security recipients, the benefits still aren't taxed. But others, depending on their "provisional income," aren't so lucky and may have to pay federal income tax on up to 85% of the benefits. To determine your provisional income, start with your adjusted gross income and add half of your Social Security benefits and all your tax-exempt interest.
If your provisional income is less than $25,000 ($32,000 for married couples filing a joint return), your Social Security benefits are tax-free.
If your provisional income is between $25,000 and $34,000 ($32,000 and $44,000 for joint filers), then up to 50% of your benefits are taxable.
If your provisional income is more than $34,000 ($44,000 for joint filers), then up to 85% of your benefits are taxable.
The IRS has a handy online tool that can help you determine whether your benefits are taxable.
Pensions
Most pensions are funded with pretax income, and that means the full amount of your pension income would be taxable when you receive the funds. Payments from private and government pensions are usually taxable at your ordinary income rate, assuming you made no after-tax contributions to the plan.
Sales of 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 capital gains rates of 0%, 15% or 20%. Compare these figures to the top 37% tax rate on ordinary income.
The 0%, 15% and 20% rates on long-term capital gains are based on set income thresholds that are adjusted annually for inflation. For 2022, the 0% rate applies to individuals with taxable income up to $41,675 on single returns, $55,800 for head-of-household filers, and $83,350 for joint returns. The 20% rate starts at $459,751 for single filers, $488,501 for heads of household, and $517,201 for joint filers. The 15% rate is for individuals with taxable incomes between the 0% and 20% break points. The favorable rates also apply to qualified dividends (see below).
There's also a 3.8% surtax on net investment income (NII) on top of the 15% or 20% capital gains rate for single taxpayers with modified adjusted gross incomes over $200,000 and joint filers over $250,000. This 3.8% extra tax is due on the smaller of NII or the excess of modified AGI over the $200,000 or $250,000 amounts. NII includes dividends, taxable interest, capital gains, passive rents, annuities, royalties, etc.
If you sell investments that you've held for a year or less, the gains are short-term and are taxed at your ordinary income tax rate.
If you sell at a loss, that amount can offset capital gains for the year, plus up to $3,000 of other income. Excess losses can be carried forward indefinitely each year, subject to the same tax treatment, until those losses are exhausted.
Dividends
Many retirees own stock, either directly or through mutual funds. Dividends paid by companies to their stockholders are treated for tax purposes as qualified (most common) or non-qualified. Qualified dividends are taxed at long-term capital gains rates (see above). Non-qualified dividends are taxed at ordinary income tax rates.
Shareholders generally must hold stock for a certain period of time to take advantage of the capital gains rates for dividend payments (i.e., for the dividend to be treated as a "qualified dividend"). For example, dividends paid on common stock must be held for more than 60 days within the window beginning 60 days before and ending 60 days after the date the company declares a dividend payment.
Annuities
There's a good chance that some (or all) of the income you receive from any annuity you own is taxable.
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. For example, if you purchased an annuity for $150,000 and it is worth $225,000 in 10 years, you would only pay tax on the $75,000 of earned interest. 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. In addition, be aware that you'll have to pay any taxes that you owe on the annuity at your ordinary income tax rate, not the preferable capital gains rate.
Municipal Bonds
Municipal bond interest is exempt from 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 laws). Keep in mind, however, that capital gains can be subject to federal tax if you sell municipal bonds.
CDs, Savings Accounts, Money Market Accounts, and Corporate Bonds
Ordinary income tax rates apply to interest payments on certificates of deposit, savings accounts, money market accounts, and corporate bonds. Capital gains rates apply when you sell corporate or municipal bonds.
Savings Bonds
For federal income tax purposes, interest on EE and I U.S. savings bonds is generally taxable at ordinary income rates in the year the instruments mature or when they are redeemed, whichever is earlier. Holders of HH bonds report and pay U.S. tax on interest annually as it is paid to them. Interest on U.S. savings bonds is exempt from state and local income taxes.
If you're heading back to school in your golden years, know that interest on EE and I bonds that are used to pay for higher education may be tax-free, provided certain rules are followed. The bonds must have been purchased after 1989 by buyers who were age 24 or older. They must also be redeemed to pay for college, graduate school or vocational school tuition or fees for the bondholder or the bondholder's spouse or dependent. Room and board costs aren't eligible. Also, the bonds are required to be in the taxpayer's name. Grandparents can't use this tax break to help pay for their grandchild's college tuition unless the grandparent can, on his or her federal tax return, claim the grandkid as a dependent.
The income exclusion is subject to income limits. For 2022, it begins to phase out for joint return filers with modified adjusted gross income over $128,650…$85,800 for everyone else. The tax break disappears when modified AGI hits $158,650 and $100,800, respectively.
Life Insurance Proceeds
Any proceeds you receive as a beneficiary of a life insurance policy when the insured person dies are generally nontaxable. The tax rules are more complicated if you're the holder of the policy and surrendered it for cash. The IRS has an online tool that can help you determine whether the proceeds you receive are taxable.
Home Sales
A home is often the biggest and most valuable asset that retirees own. Luckily, the tax laws give a generous federal income tax break when you sell your primary home at a gain. If you have owned and used the property as your personal residence for at least two out of the five years before the sale, you can exclude up to $250,000 of the gain from income ($500,000 for married couples filing a joint return). Any gains in excess of the $250,000 or $500,000 exclusion are taxed at long-term capital gains rates. Losses aren't deductible.
Reverse Mortgages
Payments that you get from a reverse mortgage on your home are treated as nontaxable loan proceeds and not income. Also, you can't deduct the interest you eventually pay when you satisfy the mortgage, unless you used the original proceeds to buy, build, or substantially improve the home securing the loan.
