Many investors and retirees can be surprised and shocked by taxes in retirement. One of the foundational pieces for minimizing taxes during retirement is knowing the 3 different ways retirement assets and investments are taxed. When you understand how your retirement assets are taxed it can help you make vital decisions about retirement income, pay less to Uncle Sam, and reduce retirement anxiety.
UNDERSTADING TAX BRACKETS
Depending on how you file your taxes (i.e. single, married filing jointly, etc.) and the amount of income you have, you’ll find yourself paying a percentage of that income in taxes. In the United States, we have a progressive tax system, meaning that every dollar you earn isn’t taxed at the same rate. If you’re filing jointly, for 2021, for example, you’ll pay 10% in tax up to $19,750. Then from $19,751 to $80,250 you’ll pay 12%. Then from $80,251 to $171,050 you’ll pay 22% and $171,051 to $326,600 is 24%. The bottom line is that when you find yourself in a tax bracket, not all your income is taxed in that bracket. Make sense?
This is important because there are a number of strategies that can be employed during retirement to proactively address taxes. Not to make this too complex, but your taxable income (the amount that determines your tax bracket) is figured by taking your adjusted gross income and then subtracting deductions, including your itemized deductions or the standard deduction, whichever is greater. By understanding the basics of taxable income, you’ll be empowered to strategize about how your retirement income will be impacted by taxes.
3 WAYS RETIREMENT ASSETS ARE TAXED
#1 - Taxable Accounts and Investments
Examples: Bank, Taxable Brokerage
Tax Treatment: These are after-tax and tax-as-earned
As you earn interest in a bank account or CD, it will be taxed as interest income, which flows down to your taxable income and will impact your tax brackets.
Taxable brokerage accounts are more complex and have several ways they are taxed. If you earn interest, you’ll pay taxes. If your investments produce dividends, they will be characterized as either qualified or non-qualified. Qualified dividends, which are most common, are taxed at lower long-term capital gains rates and nonqualified dividends will be taxed as ordinary income.
If you own a single stock and it grows, you won’t pay tax until you sell that stock. When you sell the stock, if you own the stock for one year or less it will be taxed as ordinary income but if you hold it more than a year it will be taxed at long-term capital gains rates, which are generally much lower. Mutual funds may report gains or losses that you’ll pay as well as dividend income.
#2 - Tax Deferred Investments
Examples: 401(k)s and IRAs
Tax Treatment: Money is put in these accounts before tax, grows tax-deferred, and is taxed on withdrawal
Tax-deferred accounts don’t make you report gains, dividends, or interest inside an account each year, as long as the money stays inside the account. As you start withdrawing money out of your accounts to create retirement income, this money will be taxed as ordinary income. Even if you don’t need the money for retirement income, at the age of 72 you’ll be required to take RMDs (Required Minimum Distributions). If you don’t take at the least the required amounts each year, you’ll owe a 50% tax on the amount you should have withdrawn. Also, if you have several tax-deferred accounts, you can determine the RMD on each account and you may be able to take it all out of one account in some instances.
#3 - Tax-Free Assets
Examples: Roth 401(k), Roth IRA, Cash Value Insurance
Tax Treatment: Money is put into these accounts after tax, grows tax-deferred, and can often be taken out tax-free
In retirement planning, tax-free investments and financial vehicles are powerful tools. They can allow families to have income, yet pay no tax on the money. This in turn can reduce Social Security taxes, keep you in your current tax bracket, or even reduce your marginal tax rate. Tax-free financial vehicles can also be powerful tools to pass on assets to beneficiaries.
As you better understand how your various investments and retirement plans will be taxed, you can create comprehensive strategies to minimize tax, create peace of mind, and withdraw your assets for income. Determining which accounts to pull from first can be a very important strategic part of your retirement plan.
I’d invite you to act on what you’ve learned and create a retirement income plan that takes into account the taxable, tax-deferred, and tax-free status of your investments and assets. You can do this solo or with a team that includes a fiduciary comprehensive planner like us at Thrive Retirement Planning and a tax professional.
I’d invite you to set up an appointment with us at Thrive Retirement Planning, either in person or virtually, where we can get to know each other. Simply call 801-810-8434 or go to thriverp.com and click on get started to learn more. We can help you make Social Security decisions, create an income plan, create a plan for protecting your investments as you approach retirement, and also help you with your investments.
Do you have questions about when to take Social Security and how to maximize your benefit? Take our free online Social Security Masterclass by going to thriverp.com/ss