Retirement Income and Taxes

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Category: Individual Taxes

Written by Jonah Sparks

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Many things in your life are going to change when you retire but you can count on at least one thing remaining the same. You’ll still have to pay taxes. Let’s face it, taxes are normally the biggest expense in retirement and some of us need every penny of income to make ends meet while ensuring enough of a nest egg to provide income that will last as long as we will.

Consider the types of investments in your portfolio. Not all investments are taxed alike and since cash and bonds are taxed at ordinary income rates, you’ll want to focus on shielding them from taxes in your retirement plans more than others. Similarly, mutual funds with high turnover should be a concern because stocks held for less than a year are also taxed at ordinary income rates.  If you have gold, it’s taxed at a 28% rate.

Payments from ordinary retirement funds are taxed at regular income tax rates upon withdrawal and are added to your total yearly income and then taxed at the rates that apply to your income tax bracket. If you have earned income or significant income from sources other than your retirement plan, your retirement plan distributions may put you in a higher tax bracket than when you were working. To avoid extra taxation consider postponing the receipt of retirement plan distributions until the mandatory age of 70 1/2. Chances are that by then, you’ll be in a lower tax bracket. If you can do this, your retirement nest egg continues to grow tax deferred

If you must draw from your retirement plan before age 70 1/2, then take minimum distributions. Limit the withdrawals to just the amount of cash you need for expenses and the additional taxes. In those years when you have more significant tax deductions against income you can take larger retirement distributions that will be offset by those deductions. For example, if you plan to make large charitable donations or if you have investment losses that can offset ordinary income in a given year, that would be the time to take a larger retirement plan distribution.

Before you consider selling the stocks in your 401(k), make yourself aware of a special rule that allows you to pay the lower capital gains rate on the growth of your employer stock in your 401(k). Be advised however, that you still have to pay tax at regular rates on the total cost of that stock. The key is that you have to take that stock out as an “in-kind distribution,” which basically means that you move it directly into a brokerage account instead of selling it first as most 401(k) distributions are done. 

Should you withdraw first from your IRAs, your 401(k), or your taxable accounts? The answer depends upon timing. If you retire at 55 or older you can take withdrawals immediately from your 401(k) without a penalty. You’ll have to wait until age 59 1/2 to make penalty-free withdrawals from your IRAs. Keep in mind that you can always withdraw from your taxable accounts and the contributions from your Roth IRAs without penalty at any time and for any reason. Finally, when you turn 65, you can also access any HSAs you have for any purpose without penalty.

Another timing factor has to do with tax rates. Are your tax rates going higher or lower in the future? If you think the lower capital gains rate will expire at the end of the year, it may be a good time to take some gains out of the taxable account. If you suspect higher income tax rates then take withdrawals from your pre-tax accounts or consider converting them into Roths, which means you pay the tax now at the relatively lower rate instead of at the higher future rates. Keep in mind that you may need to spread those Roth conversions over more than one year to avoid putting you into a higher tax bracket, which would defeat the whole purpose.

Your tax situation in retirement may become even more complicated than while you were employed. Take the time to understand how the tax code affects your retirement plan withdrawals; it could keep more of your money in your pocket.

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