How is My Retirement Income Taxed?
“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
– Judge Learned Hand 
How is My Retirement Income Taxed?
If you have been saving for your retirement by using tax-deferred accounts such as traditional IRA, 401(k), etc., Uncle Sam’s buddies at the IRS will demand a chunk of any withdrawal that you make. Pension payments are most likely subject to federal income tax too. If this weren’t depressing enough, your Social Security benefits might also be taxed.
To avoid tax “sticker shock” in retirement, it’s essential to know what to expect, and then do pro-active tax planning to minimize the portion of your hard-earned retirement going to federal and state taxes. Understanding how your retirement income is taxed is a critical step in the retirement planning process.
Saving for retirement into tax-deferred plans like 401(k)s, 403(b)s, 457 plans, and deductible IRAs are attractive because they result in lower current taxation. But, painful once you’re retired because of the way retirement income is taxed . All withdrawals from tax-deferred accounts will be taxed as ordinary income.
Because withdrawals from tax-deferred accounts are taxed as ordinary income, they can affect how much of your Social Security income is taxed.
The IRS has the formula to calculate how much of your Social Security will be taxed. It’s called Provisional Income. To calculate yours, add up your adjusted gross income without social security benefits, then add tax-free (Municipal Bond) interest and one-half of your social security benefits.
If you are a single tax filer and your Provisional Income is between $25,000 and $34,000, 50% of your Social Security will be taxed. When it’s over $34,000, then 85% of your Social Security benefits will be taxed.
If you file jointly, and your provisional income is between $32,000 and $44,000, 50% of your Social Security will be taxed. When it’s over $44,000, then 85% of your Social Security benefits will be taxed.
Good news to all of you owing investments within a Roth IRA. Since contributions to Roth IRAs are after-tax, you won’t pay taxes on withdrawals in retirement if the distributions are qualified. Also, be aware that the tax code has many complicated rules associated with the taxation of Roth rules.
If you make money on an investment held in a non-tax advantaged account, the IRS will claim a portion. The obligatory amount you’ll pay depends on how long you owned the investment.
The IRS considers profits made by selling an investment held for one year or less as short-term capital gains and are subject to tax as ordinary income. They tax profits made on investments held for more than a year more favorably.
One other important point – there is a preferential rate for qualified dividends.
If a part of your retirement plan includes an annuity funded with after-tax dollars, be aware a portion of your withdrawals will be subject to tax. The requirement is to pay taxes on the piece that’s an investment gain.
“Tax Bucket Diversity” Benefits
By putting a specified portion of your retirement savings into various “buckets” (tax-deferred, Roth, non-tax advantaged); you will benefit from having a flexible plan that can adjust to changing needs and possibly lower your tax bill.
Don’t let unexpected taxes impact your retirement. It’s important to ask yourself, “How is my retirement income taxed?” and develop a plan accordingly. Call 913-393-1000 or schedule a complimentary consultation below. We’re always ready to discuss how much money you could save by having a forward-looking and proactive tax reduction strategy.
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Investment advisory services offered through Modern Wealth Management, Inc., an SEC Registered Investment Adviser.
The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.