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Many things in life get simpler when you retire, but unfortunately, your finances aren't one of them. If you're like most people, you'll rely on multiple sources of income during retirement—Social Security, pension payments, 401(k) plans, personal savings, even wages if you start a new career or work part time.
You'll also have to pay taxes. Since different income sources have different tax implications, it can get complicated! You'll need a tax plan and strategies to manage taxes and strive to avoid paying more than you need to in any given year.
The first step is knowing how different types of retirement income are taxed.
Understand how your retirement income will be taxed
Before you develop a retirement tax strategy, you need to know what's taxable and what's not. Here are some general guidelines:
Social Security, if:
According to the Social Security Administration, about 40% of people have to pay taxes on their Social Security benefits.i The taxable amount varies based on your combined earnings and filing status, up to a maximum of 85%.ii
Half of workers age 60 and older plan to keep working until at least age 70.iii No matter how old you are, if you work, your earnings will be taxed.
Payments from private and government pensions are usually taxable as ordinary income, assuming you made no after-tax contributions to the plan.
Tax-deferred accounts: 401(k), VIP, 403(b), Traditional IRAs
Withdrawals of pre-tax contributions and all investment earnings are taxed as ordinary income, so think twice before tapping into tax-deferred savings. These plans are also subject to Required Minimum Distributions rules once you reach age 70-1/2, and there are stiff penalties for failure to do so.
Interest and Dividends
Interest from savings accounts and CDs, and dividends/interest from taxable money market mutual funds and brokerage accounts are taxed as ordinary income.
Capital gains on investments
Profits from the sale of assets—stocks, bonds, mutual funds, even your car—are taxable. If you owned the asset for less than a year, you'll pay short-term capital tax at ordinary income rates. Long-term capital gains rates are more favorable. The maximum tax rate is 20%, but most taxpayers pay zero-to-15%.iv
Social Security, if:
If Social Security is your only source of retirement income, or if your total income falls below certain limits, chances are good that you won't pay taxes on your benefits.
Tax-deferred Accounts: 401(k), VIP, 403(b), Traditional IRAs
Withdrawals of after-tax contributions from 403(b) plans, 401(k) plans, Traditional IRAs and other tax-deferred retirement savings plans are not taxable. RMD rules and taxes on gains would still be applicable.
Roth IRAs and Roth 403(b)s
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. Unlike traditional IRAs, you don't have to take Required Minimum Distributions from your Roth when you turn 70 1/2.
Municipal bonds and mutual funds are tax-free at the federal level.
Other factors affecting retirement taxes
Aside from how your retirement income is taxed, there are other things you'll want to factor into your retirement tax strategy. Among the biggest changes you'll need to plan for are:
Required Minimum Distributions
Annual mandatory distributions from tax-deferred accounts such as 401(k), VIP, 403(b) and traditional IRAs begin when you're 70-1/2. That additional income is significant and could push you into a higher tax bracket. The penalties for not taking RMDs are severe: 50% on the amount of the required distribution.
Quarterly Income Taxes
When you're getting a paycheck, your employer takes care of tax withholding. But when you retire, you're responsible for paying your taxes as you go. Most retirees need to make quarterly estimated tax payments—and do the planning and calculations necessary to correctly estimate quarterly tax bills. Failure to pay estimated taxes, or not paying enough, could result in a penalty from the IRS.
Comprehensive strategies to keep your retirement taxes low
There are many things you can do to manage overpaying taxes when you retire. While everyone's tax situation is different, here are some options:
- Diversify your retirement income sources for more flexibility.
- Take distributions from tax-deferred accounts while you are in a lower tax bracket.
- Convert some tax-deferred dollars into a Roth IRA, if appropriate.
- Hold off selling investments until you've owned them at least 366 days to take advantage of lower long-term capital gains tax rates.
- Ask your financial advisor to use tax-harvesting strategies to offset capital gains with capital losses to manage tax impact.
- Have your broker or financial advisor withhold state and local taxes from any distributions or payments you receive to avoid having to pay estimated quarterly taxes.
Start planning your retirement tax strategy now
Managing your taxes in retirement is complicated—and mistakes can be expensive! Fortunately, you can manage costly missteps with careful planning. The most important thing you can do is to create a retirement tax strategy before you retire. Once you are retired, you'll need to stay on top of withdrawals to make sure you have the money you need while aiming to keep your taxes low.
Financial Advisors* with BECU Investment Services are here to help. They can work with you to develop a detailed retirement tax strategy and withdrawal plan that's appropriate for you. Click here to set up a complimentary consultation or call 206-439-5720.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
iSocial Security Administration. “Understanding the Benefits.” 2018. https://www.ssa.gov/pubs/EN-05-10024.pdf
iiSocial Security Administration. “Benefits Planner.” 2018. https://www.ssa.gov/planners/taxes.html
iiiKimberly Palmer. “Is 70 the New 65?” AARP. March 31, 2017. https://www.aarp.org/work/on-the-job/info-2017/workers-not-retiring-fd.html
ivInternal Revenue Service. “Helpful Facts to Know about Capital Gains and Losses.” April 2018. https://www.irs.gov/newsroom/helpful-facts-to-know-about-capital-gains-and-losses
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