Understanding Retirement Income Tax
When you retire, you’ll likely draw your income from several sources—such as retirement accounts, taxable investment accounts, and Social Security Benefits. Each of these sources is taxed according to its own rules. So, in order to accurately plan for your retirement, you need to know what these rules are, whether (and when) you’re required to make withdrawals, and how paying taxes on distributions will impact your overall financial goals.
Here’s a breakdown of the most commons sources of retirement income and how they’re taxed:
Traditional IRA and traditional 401(k)
Withdrawals from traditional tax-deferred retirement accounts are taxed at your normal income tax rate. Once you reach a certain age, you must start taking—and paying taxes on—required minimum distributions (RMDs). The IRS changed RMD rules in 2020.[1] If you reached age 70½ in 2019, you should have taken your first RMD by April 1, 2020. If you reached age 70½ in 2020 or later, you are required to take your first RMD by April 1 of the year following the year you turn 72.
Roth IRAs
Because contributions to Roth IRAs are made with after-tax money, withdrawals from these accounts are tax-free. You can withdraw contributions to your Roth account at any age; however, withdrawals on earnings before age 59 ½ are subject to early withdrawal penalties. Roth IRAs do not have RMDs like traditional IRAs, so your money can continue growing in the account. Because withdrawals from Roth IRAs are tax-free, consider making withdrawals from this account last to allow your savings to benefit from tax-free growth for as long as possible.
Taxable investments
Profits from the sale of stocks, bonds, and other investments outside of tax-advantaged retirement accounts are taxed at capital gains rates, which vary depending on how long you’ve owned the investments. Short-term capital gains are taxed as ordinary income and apply to investments you’ve owned for one year or less. Long-term investments, those held for more than a year before selling, are subject to preferential long-term capital gains rates of 0%, 15%, or 20%, depending on your tax bracket.[2]
Social Security
The tax rate for Social Security benefits depends on your provisional income, which is the sum of your adjusted gross income, tax-free interest from other investments, and 50 percent of your Social Security benefits. You’ll have to pay taxes if your provisional income exceeds $25,000 on an individual tax return or $32,000 on a joint return. Only up to 85% of your Social Security Benefits are subject to tax.[3]
Annuities
You typically purchase an annuity with after-tax income. The annuity then pays out income over time. The portion of the payment representing your principal is tax-free, and you’ll pay taxes on any earnings. If you purchased the annuity with pretax funds, such as from a traditional IRA, your entire payment would be taxed as ordinary income.
Making a withdrawal plan
Once you understand how your retirement income is taxed, you can make a tax-efficient plan to support you in your retirement years. You might consider a plan that looks like the following:
- Taking withdrawals from traditional IRA and traditional 401(k) accounts first to satisfy annual RMDs.
- Next, take withdrawals from taxable accounts.
- Take withdrawals from Roth IRAs, and Roth 401(k) accounts last. The longer you can avoid drawing down these plans, which aren’t subject to RMDs, the longer they can benefit from tax-free growth.
A careful withdrawal plan—and keeping your money in tax-exempt accounts as long as possible—can help you maximize your investment returns while minimizing the taxes you’ll owe.
This information, developed by an independent third party, has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Investments mentioned may not be suitable for all investors. The material is general in nature. Past performance may not be indicative of future results. Raymond James does not provide advice on tax, legal or mortgage issues. These matters should be discussed with the appropriate professional. RMD's are generally subject to federal income tax and may be subject to state taxes. Consult your tax advisor to assess your situation.
Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Like Traditional IRAs, contribution limits apply to Roth IRAs. In addition, with a Roth IRA, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits. Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. With variable annuities, any withdrawals may be subject to income taxes and, prior to age 59 1/2, a 10% federal penalty tax may apply. Withdrawals from annuities will affect both the account value and the death benefit. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. An annual contingent deferred sales charge (CDSC) may apply. A fixed annuity is a long-term, tax-deferred insurance contract designed for retirement. It allows you to create a fixed stream of income through a process called annuitization and also provides a fixed rate of return based on the terms of the contract. Fixed annuities have limitations. If you decide to take your money out early, you may face fees called surrender charges. Plus, if you're not yet 59½, you may also have to pay an additional 10% tax penalty on top of ordinary income taxes. You should also know that a fixed annuity contains guarantees and protections that are subject to the issuing insurance company's ability to pay for them.
[1] Source: Internal Revenue Service: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds
[2] Source: Internal Revenue Service: https://www.irs.gov/taxtopics/tc409
[3] Source: Social Security Administration: https://www.ssa.gov/benefits/retirement/planner/taxes.html
