Derenda King, CFP®/CSLP®
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There is one commonality that everyone shares in retirement—a price tag. Your price tag may be different from your neighbors’ or your friends’, but we all have one. That price tag or cost will depend on your goals and the lifestyle you desire to have in retirement. It also factors in housing, utilities, health care expenses, inflation, taxes and other expenses.
Building a healthy nest egg to live off of in retirement is probably one of the biggest challenges you may face, especially when you have competing priorities. Identifying the sources of income that you can depend on is one of the first tasks in evaluating your retirement landscape. The bulk of retirement income for most people will come from personal savings and investments, Social Security, and, for some, earnings from continued employment.
Examples of personal savings and investments include employer-sponsored retirement plans, individual retirement accounts (IRAs) and annuities, as well as individual stocks, bonds and mutual funds. Different tax rules apply to each of these income sources. However, there are a variety of tax-advantaged strategies available to help you minimize your tax costs. Having said that, it’s important to recognize that the best solution for you will be based on your specific circumstances. You may need to consider a combination of strategies to minimize or eliminate taxation on your retirement income.
Setting yourself up with a variety of income sources that the IRS can’t tax you on during your golden years involves doing some work in advance. So, it’s important to talk to a financial professional. To help you get a head start, below is a guide to income that is taxable, partially taxable and tax-free.
Taxable Income in Retirement
Traditional Retirement Plans
Contributions to retirement plans, such as a traditional 401(k), 403(b), traditional IRAs and SEP IRAs, offer a number of tax advantages. Since you are funding them with pre-tax dollars, you receive an immediate tax break—tax-deferral on your income and gains until you withdraw your money, assuming you are at least 59½ (there is a 10% penalty on premature withdrawals). However, when you retire, any withdrawals will be taxed at your income tax rate.
Most pensions are funded by employers with pre-tax income. That means that if you are lucky enough to have a pension to depend on, the monthly income will be taxed at your regular income tax rate (unless the payment is a qualified distribution from a Roth account or contributions were made with after-tax dollars). If you take a lump sum payout, you must pay the total tax due in the year you file your tax return, which can also move you into a higher tax bracket.
Non-Retirement or Brokerage Accounts
If you buy stocks, bonds or mutual funds and hold them for more than a year, any gain is considered long-term. The taxation on long-term gains depends on your income and is taxed at either 0%, 15% or 20%. For example, if your taxable income falls below $41,675 for single filers and $83,350 for married filers in 2022, the rate is zero (0%), so you won’t pay taxes on your gains. Those with incomes above these thresholds will pay capital gains tax on the income as it is earned. Investments held for less than a year will be taxed as ordinary income.