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All Contents © 2020The Kiplinger Washington Editors
By Sandra Block, Senior Editor
Joy Taylor, Editor
| March 1, 2019
When you’re planning for retirement, it’s fun to contemplate all the cruises, rounds of golf and restaurant meals you have ahead of you. You've earned it! However, many retirees don’t take into consideration the cumulative impact of federal and state income taxes on withdrawals from their nest eggs.
"Finding tax-efficient investments is the key to successfully saving for retirement," says financial planner Carlos Dias Jr., of Excel Tax & Wealth Group. Unfortunately, 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.) So, do yourself a favor before you retire and take a look at the federal income taxes you’re likely to face on 11 common sources of retirement income.
Savers love these tax-deferred retirement accounts. 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 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) kick in at age 70½ for holders of traditional IRAs and 401(k)s. (People who work past age 70½ can generally delay taking RMDs from their 401(k)s until they retire.)
The 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 59½ to be able to withdraw the gains without facing a 10% early-withdrawal penalty.
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, take your modified adjusted gross income, add half of your Social Security benefits, and add all of 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 calculator 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 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.
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. These rates can be quite favorable. For the 2018 tax year, if you’re single with taxable income less than $38,601 or married filing jointly with taxable income under $77,201, your long-term capital gains are taxed at 0%.
For people with higher taxable incomes, the rates go up. The next rate is 15% (singles with incomes between $38,601 and $425,800, and married couples with incomes between $77,201 and $479,000). For people with incomes above those amounts, the top rate is 20%.
There’s also a 3.8% surtax on net investment income (long-term capital gains, dividends, etc.) of single people with modified adjusted gross incomes over $200,000 and married couples with modified AGIs exceeding $250,000. The 3.8% extra tax is due on the smaller of net investment income or the excess of modified AGI over the $200,000 or $250,000 amounts.
If you sell investments that you’ve held for a year or less, the proceeds (i.e., short-term capital gains) are taxed at your ordinary income tax rate.
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.
Life insurance proceeds paid to a beneficiary upon the death of the insured person are not taxable.
As for a life-insurance policy with a cash-value component, under IRS rules a cash-value withdrawal is tax-free as long as it is structured properly and doesn’t become a Modified Endowment Contract, according to financial planner Carlos Dias, Jr.
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; 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.
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.
Ordinary income tax rates apply to interest payments on certificates of deposit, savings accounts and money market accounts.
For federal income tax purposes, interest on 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.
The income exclusion is subject to income limits. For 2018, it begins to phase out for joint return filers with modified adjusted gross income over $119,300…$79,550 for everyone else ($121,600 and $81,100, respectively, for 2019). The tax break disappears when modified AGI hits $149,300 and $94,550, respectively ($151,600 and $96,100 for 2019).