Different Types of Taxation in Retirement

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Written by: Wendy Lange
September 1, 2023

Unlike your working years while receiving a single paycheck, in retirement you are responsible for ensuring taxes are paid on your income from various sources.  Surprisingly, your cash flow may exceed your pre-retirement earnings and you may have fewer reductions to help lower your taxes.  A withdrawal strategy placing you in the lowest possible tax bracket will help you manage the impact of taxes in retirement.

The following are common sources of retirement income and how they are taxed:

  • 401(k)/403(b) Distributions:  If your contributions were made with pre-tax dollars, the full amount of the distribution will be taxed at your ordinary income tax rate.  Required Minimum Distributions (RMDs) must be taken annually beginning at age 73.  In 2033, the RMD age will change to 75.
  • IRA Distributions:  The tax impact you will incur depends on the type of IRA you own and if it was funded with pre-tax dollars or after-tax dollars.
    • Traditional IRAs:  Contributions to traditional IRAs are pre-tax and all distributions are subject to tax at your ordinary income tax rate.
    • Roth IRAs:  Contributions to Roth IRAs are after-tax and distributions are tax free (once holding periods are met).
    • Rollover IRAs:  Assuming all contributions to your workplace plan were made pre-tax, distributions are taxed at your ordinary income tax rate.
  • Social Security:  If you are single with provisional income above $25,000 or married filing jointly with provisional income above $32,000, up to 85% of your Social Security benefits can be subject to tax.
  • Annuities:  Contributions made with pre-tax dollars are taxable upon distribution at your ordinary income tax rate.  After-tax contributions are only taxable on the earnings generated by the account.
  • Pensions:  As most are funded with pre-tax dollars, your distributions are taxable at your ordinary income tax rate.
  • Capital Gains and Dividends:  Fully taxable investment options are taxed the same whether you are retired or remain employed.
  • Life Insurance Cash Values:  Cash surrender values of your life insurance policy can generally be accessed tax-free by withdrawing the premiums you paid first.  The remaining cash value can be accessed on a tax-free basis by treating them as loans.  However, keep in mind that tapping into a policy’s cash value will more than likely reduce the available death benefit.
  • Medicare Surtax:  Although this isn’t a source of income, there is a 3.8% Medicare surtax on the lesser of net investment income of adjusted gross income of more than $200,000 for single filers and more than $250,000 for married couples filing jointly.  This surtax applies to dividends, capital gains, taxable interest, annuities, rents, and royalties.  Distributions from IRAs and qualified workplace retirement plans are not subject to this Medicare surtax.

Tax planning can make a big difference within your retirement income strategy and should be considered even if you are years away from retirement.  Any income plan or strategy is incomplete without tax planning.  The financial decisions you make and potential tax implications can be a strain on your retirement income.  This is why it is so important to have a professional assist you in your retirement planning.

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