Understanding How Different Types of Retirement Savings Are Taxed
Creating a Tax-Efficient Retirement Plan Can be More Complex Than You May Think
If anyone ever describes the United States Tax Code as “simple” or “straightforward” then it’s a clear sign they know very little about it! In truth, it is one of the most complex administrative codes in the world, and this becomes all the more accurate when you’re about to retire and you have to determine how your various sources of retirement savings income will be taxed. (Spoiler alert: many of them will have different tax treatments!)
Below, we will review the different types of retirement savings and how the IRS taxes each one. In doing so, we hope to give you a sense of what you might owe, as well as whether it makes sense to adjust your retirement savings strategy.
Income Source: Social Security
Social Security is often a central part of a retiree’s income plan since it is a guaranteed source of income for as long as you live. What is not guaranteed is how much of this benefit you’ll pay taxes on in any given year. This is because how much you pay in taxes depends on how much you make, meaning it can be complicated to determine just how much you’ll owe. You can get some clarity from the Social Security Administration here, but you’ll never owe taxes on more than 85 percent of your benefits, and sometimes you may owe nothing at all.
Income Source: Qualified Investments
This refers to accounts like your 401(k), 403(b), or traditional IRA. All of these account contributions were pre-tax, meaning the government will collect the taxes when you retire and begin taking income distributions from them. You’ll pay your typical income tax on withdrawals, based on your income tax bracket. This means that the more you withdraw in any given year, the higher the percentage you might owe. However, the amount you withdraw isn’t entirely up to you – the IRS requires that you withdraw a certain amount, at minimum, each year. This is called a required minimum distribution (RMD), and you must withdraw it annually once you turn 70 and a half, even if you don’t need the income. If you fail to withdraw your RMD, you’ll face a penalty. So, it’s essential to calculate how much you’ll need to take out each year without taking more than you need and pushing yourself into a higher income tax bracket.
Income Source: Roth Accounts
The beauty of a Roth account, which you likely know if you have one, is that contributions to it have already been taxed. So, when you retire and begin taking withdrawals, you won’t owe the government anything at all. However, if you have a Roth 401(k), you’ll be subject to an RMD. You can avoid this fate, though, by rolling a Roth 401(k) into a Roth IRA.
For many people, Roth accounts play an important role in keeping their retirement income tax-efficient. For instance, you can ladder your income by taking just enough from your qualified accounts up to a certain tax bracket, then withdraw from your Roth accounts to access more income without crossing into the next tax bracket.
Income Source: Non-Qualified Investments
This refers to any type of investment that doesn’t get special tax treatment, but we’re going to focus on two of the most common: stocks and bonds. When you sell a stock, the amount you paid for it is tax-free. This is called the basis. However, any money you made on the sale will be taxed, and the amount is subject to timing. If you sold the stock before owning it for a full year, you’ll pay short-term capital gains, which is essentially ordinary income tax. If you owned a stock for longer than a year when you sold it, you’ll pay long-term capital gains. Depending on your income, this could be nothing, or it could be 15 or 20 percent.
Bonds are taxed in a way that is a bit more complex. If you buy and sell bonds on the secondary market, you pay capital gains, just as you would with stock. However, if you hold a bond and earn interest from it, what you owe will depend entirely on the type of bond. Most often, you’ll owe ordinary income tax on bond interest. However, interest earned on municipal bonds is tax-free. Some other types of government and savings bonds may offer limited tax benefits on interest income, so it’s best to talk with your financial advisor to determine what type may be best for you.
Oftentimes, you may own stocks and bonds indirectly through mutual funds. In that case, your taxes owed are based on the underlying investments. This means that the people operating the fund may make decisions that impact your tax burden, so it’s smart to make sure you fully understand how your mutual fund operates and how decisions about buying and selling will be made. The actual tax impact of owning mutual funds in non-retirement accounts may be significant.
Income Source: Pensions
These days, pensions are largely myths of the past. However, if you’re still lucky enough to have one, taxes on your pension income will work like a traditional 401(k). The money wasn’t taxed when it went into your pension, so you’ll likely owe ordinary income tax on it. However, there are a few exceptions depending on your circumstances.
Income Source: Income Annuity
Income annuities offer flexibility such that you can make both qualified and non-qualified contributions. So, when you receive your annuity payments over time, you’ll pay ordinary income tax on your qualified contributions and on any earnings. You won’t owe any taxes on non-qualified contributions, in which case the insurance company will pay out a “return of premium” over time. Usually, a portion of your payment will include that return of premium, while the rest of your payment will be taxable.
Income Source: Whole Life Insurance
If you purchased a whole life insurance policy when you were young, chances are you’ve accumulated quite a sizeable amount by the time you’re ready to retire. These are funds that will not decline with the market, making them a savvy way to mitigate potential drops in your investment portfolio during market downturns. Like the non-qualified investments mentioned above, you won’t pay taxes on your basis. For any gains, you’ll pay ordinary income tax if you choose to surrender your policy. It should be noted, however, that if you borrow against your policy rather than withdrawing the cash through a surrender, you won’t owe tax on the withdrawal as long as your policy remains in place.
Final Thoughts on Retirement Savings and Taxes
As mentioned at the start of this discussion, the U.S. tax code is quite complex. As you plan for a tax-efficient retirement, there won’t be a one-size-fits-all approach. That’s why it’s important to work with a financial advisor to ensure you develop a retirement savings strategy that makes sense for your unique circumstances.
At Charles Carroll Financial Partners, we are committed to providing personalized retirement guidance based on your needs, goals, and aspirations. Contact us today to begin taking more control over your financial future.