How Retirement Income is Taxed
Today we look at how the most common types of retirement income are taxed. We look at:
- The common types of accounts retirees use
- The types of income taxed at the highest rates
- Types of income which receive favorable tax treatment
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How Retirement Income is Taxed
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When you retire, you go from earning a paycheck to using your savings to create a paycheck. You will still have to pay income taxes. Today, we look at the common types of accounts retirees use to create income, and how they are taxed.
Retirement Plans and IRA's
This might be a 401k, a 403b or even a 457 deferred compensation plan. Many people roll those over into an IRA.
The taxation of the income generated from those accounts depends on the contributions. If you made pre-tax contributions—meaning you took a tax deduction—the income is taxable. Your contributions, your employer’s contributions, and the earnings are taxed as ordinary income. Tax rates for ordinary income start at 10%. The maximum tax rate is 37%.
If you used the Roth type accounts, the contributions happened on an after tax basis. This means withdrawals from these accounts are not taxed.
Individual and Joint Accounts
The second type of account that retirees use is an individual or a joint account. If you have this type of account, you pay taxes “as you go”. The investments in those accounts often pay dividends or interest. Interest is usually taxed as ordinary income. Dividends paid by a common stock get favorable tax treatment. In most cases, the highest tax rate for qualified dividends is 15%.
You may also have capital gains. A capital gain happens when you or one of the investments you own sells an investment. If you own a mutual fund, that mutual fund may buy and sell stocks and bonds inside the mutual fund. The gains pass to you as a shareholder.
If you own an individual investment, and you sell those shares, you can generate a capital gain as well. If you owned the position for at least a year, the gain is a long-term capital gain. Long-term gains get favorable tax treatment. The highest capital gains rate is 20%. Most people will pay 15%. The full amount of the sale is not usually taxed. Taxes are due on the amount above what you originally paid for the investment.
This can be a factor if you are using a systematic withdrawal. This strategy involves selling shares of your investments to generate monthly income. Part of the income is going to be taxable, and part of it is going to be return of your principal. The taxable part may get taxed at lower rates.
The other type of account used to create income in retirement is a pension plan. If your company offered a pension plan, the income is taxable as ordinary income.
Another common type of account is an annuity. If you annuitize a contract, part of the income is taxable. The balance is a return of your principal.
The last type of income source that’s taxable in retirement is Social Security. We will cover taxes of Social Security benefits next week.
Talk to a Certified Financial Planner™ Professional
Knowing how taxes impact retirement can help you plan for a better future. If you have questions or concerns, talk to a financial planner.
About the Author
Neal Watson is a Certified Financial Planner™ Professional and a Financial Advisor with Fleming Watson Financial Advisors. He specializes in helping hard working, middle class families plan for retirement.