When saving for retirement, how often have you thought about the effect of taxes on your future retirement income? Most people would probably answer, “not often.” But the fact is, you’ll likely owe tax on retirement income — how much depends on several factors. The sooner you start planning, the better.
3 types of accounts
There generally are three types of retirement savings accounts. The first, taxable accounts, consist mainly of brokerage accounts. Taxes are due on investment gains in the year you sell them. If you hold these investments for less than one year, gains are taxed at your ordinary income tax rate. If you hold them for one year or longer, they’re taxed at capital gains rates of 0%, 15% or 20%, depending on your adjusted gross income.
The second, tax-deferred accounts, include traditional IRAs and 401(k) plans. You don’t pay taxes until you withdraw funds in retirement, at which time withdrawals are taxed at ordinary income tax rates. Many people’s tax rates are lower in retirement than during their working years.
Finally, tax-free accounts, including Roth IRAs and Roth 401(k)s, are funded with after-tax dollars. This means taxes have already been paid so funds are withdrawn tax-free during retirement. Tax-free accounts are usually the most beneficial retirement accounts from a tax standpoint.
If you have money in all three account types, you might withdraw funds from your taxable accounts first, tax-deferred accounts second and tax-free accounts last. This will give your tax-deferred funds longer to potentially appreciate. Or you could withdraw money proportionally from all accounts, thus stabilizing your tax bill over time.
Mandatory withdrawals
When you turn 73 years old, you must start taking required minimum distributions (RMDs) from tax-deferred accounts and pay income tax on the withdrawals. Distributions currently must begin by April 1 of the year following the year you turn 73 and for subsequent years, they must be made by December 31. Failure to take RMDs may result in a penalty of 25% of the amount that should have been withdrawn (or 10% if a corrective distribution is made in a timely manner).
Each RMD is calculated based on the balance in a tax-deferred account on December 31 of the previous year. This is then divided by the applicable distribution period or a life expectancy factor based on your age. But RMDs can be minimized, and potentially avoided, by converting a traditional IRA or 401(k) to a Roth account. However, if you make a Roth conversion, you’ll owe income tax on the full value of the account at that time.
Social Security benefits
You may also have to pay federal income tax on a percentage of your Social Security retirement benefits, though never more than 85%. To determine if your Social Security is taxable, add any nontaxable interest you earn to your taxable income and half of your Social Security benefit to arrive at your provisional income.
Talk to a financial advisor or visit the Social Security Administration’s website to learn the tax bracket based on your provisional income. To have tax withheld from Social Security checks, you can specify a withholding percentage or you can make quarterly estimated tax payments to avoid a big tax bill and possible penalty when you file your return.
Current opportunities
It may be possible to reduce tax on retirement income, even if you’re already retired. And if you’re still in the saving stage, consider contributing to different types of accounts so you’ll have flexibility later on. Contact your financial professional for details.
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