IS RETIREMENT INCOME TAXABLE?

By | August 14, 2016

Is our retirement income taxable?  What about social security income? Tax on Retirement Income What happens tax-wise when we retire?

As adults working jobs and earning an income, we know how taxes work.  We work, our employer takes out federal and state taxes based on our income tax bracket, number of dependents, etc.  At the end of the year we get our W-2 that shows our income and amount of tax withheld.

When we retire, our paychecks from our employer end and so does what is familiar about taxes in general.  Now what? How do taxes work on retirement income?  Is retirement income taxable?

First of all, no matter where we live in the world, U.S. citizens pay taxes on our worldwide income … whether retired or not.

However, we are not required to pay or even to file a tax return if self-employment income is less than $400 and

Is Retirement Income Taxable?

In addition, though required to file, we are not required to pay anything if our deductions and exemptions exceed our income.  If your income is greater than this threshold, GIVE THANKS!  Then, consider how best to minimize your tax liability.

Now, let’s look at the different vehicles of income and how those are affected by taxation.  What do you have in your retirement portfolio?  For example, typical sources of retirement income include:

  • IRAs (traditional and Roth) Sources of Retirement Income
  • Savings accounts
  • Pension accounts
  • 401Ks
  • Mutual Funds
  • Stocks & Bonds
  • Social Security

When you retire, you are going to want to be focusing on staying in the lowest tax bracket you can afford to be in (to maintain your lifestyle).  You will want to be wise in managing what you earn (withdraw) and how it is taxed.

The general rule of thumb is: withdraw funds from taxable accounts first.

This may indeed be a helpful “rule,” and it may allow you to “stretch” your retirement portfolio dollars just a bit longer.  For instance, before you reach the magical age of 70-1/2 years old, when mandatory RMDs are required (that is, a required minimum distribution), it is likely that you will have minimal “taxable” income, so it might be in your best interest to withdraw from a traditional IRA, or at least convert funds from a traditional IRA to a Roth IRA, to take advantage of your lower tax rate.  —  However, there are some situations in which this may not be the best strategy.  So, make sure to consult your financial adviser.

Traditional IRAs, Pension Accounts, and 401ks: If these type accounts are in your portfolio, Great!  You and/or your employer have been contributing to them over time.  Traditional IRAs, 401ks, and Pensions are tax deferred – taxed at normal income rates, but only when withdrawn; it is best to try and withdraw funds from these when you are in a low tax bracket.  This could occur early in retirement or later in retirement when medical expenses are high.

Roth IRAs and Roth 401ks: Contributions to these types of retirement accounts are made with after tax dollars; therefore, withdrawals are tax-free.  Be careful though; in the long haul you may pay for early withdrawals.  Let’s look at an example to help understand this:  Bob is retiring at 72.  He has a traditional IRA, and the first year he takes out $18,000.  He is in the 25% tax bracket.  He’ll owe $4500 on that withdrawal ($18,000 x 25%).  If he withdraws $18,000 from his Roth instead, he won’t pay a dime in taxes.  Since Bob is over 70-1/2, he will also be required to take an RMD from a Traditional IRA (not a Roth).  If he leaves his Roth alone, he’ll continue to earn, say 5% annually over the next 10 years, and that could continue to grow, and those growth earning are also tax free when withdrawn later.

If you have a number of different options for withdrawal, it is always best to run the numbers and talk with a tax professional before making any withdrawal.  Unfortunately, we don’t have a crystal ball and cannot predict what the future will hold, either in the market or in our own lives.  Life expectancy tables would suggest we are living longer, and with the medical advances, medications available, etc. that trend should continue.  That means our retirement portfolios need to last longer as well.

Savings Accounts are generally tax free.  Yes, they are interest bearing, but currently at a very low rate of return.  The risk here is minimal.  Withdrawing from a savings account should not be a taxable event.  The interest income you earn, which is taxable, will be reduced by withdrawing from savings.

Mutual Funds, Stocks, and Bonds: These are generally taxable accounts, unless held within another type of vehicle.  Return of principle is not taxable, but capital gains and dividends are taxed.    

Social Security benefits may be partially taxed at ordinary rates if your overall income surpasses certain set thresholds.  In simple terms,

  • Single workers with incomes of greater $25,000 and joint filers earning more than $32,000 face taxes on up to half of their social security benefits above that threshold.
  • Singles workers with incomes greater $34,000 and joint filers earning more than 44,000 face taxes on up 50% of their benefits above the first threshold, plus up to 85% of their Social Security benefits above this second threshold.

Of course, nothing about our tax code is simple.  The actual calculations of tax owed on social security benefits can be quite complex.

CONCLUSION

The conventional wisdom is that retirees should take money from Taxable accounts first, then Tax Deferred, and finally Tax Free.  However, many retirees find that a disproportionate portion of their accumulated wealth is held in one type of account which reduces their flexibility to adapt to future changes in tax codes.  Your financial adviser can provide additional advice on which asset types are best held in each type of account.

6 thoughts on “IS RETIREMENT INCOME TAXABLE?

  1. Andrew Breidenbaugh

    Good information. I would first look at the Taxable and IRA to match the exemptions and deductions, then remainder from the Roths. The Taxable investments should be setup so that you only pay taxes on the dividends, not the gains.
    BTW, IRA stands for Individual Retirement Arrangement.

    Reply
  2. Medu

    I am nowhere near retirement age, just putting it out there. In fact, I am barely working class age. But I do love to know stuff and I did a presentation on the types and benefits of Registered Retirement Savings Plan (RRSP) account. That’s what it is called in Canada, I’m not quite sure what investment assets and savings accounts are called in the US. Is this what you are referring to as IRA, and what’s “roth” by the way?

    This post answers questions I’m sure a lot of people are having. Great work!

    Reply
    1. David Hagstrom Post author

      A traditional IRA (Individual Retirement Account is a vehicle for saving pre-tax earnings for retirement; that money then grows on a tax deferred basic and is taxed upon withdrawal — often at a lower rate than you would have paid during your working years. A Roth IRA is a vehicle for saving after-tax earnings for retirement; that money is tax free upon withdrawal. That’s the basic distinction, although there are more regulations involved regarding how much money can be placed in such plans and when it can be withdrawn without penalty.

  3. Peter Blackman

    Good Information. Are you in financial services? I was in financial services at one time so I know that your information is accurate. Even with my with my knowledge I would still seek out professional help from someone who is currently a tax advisor.

    Reply
    1. David Hagstrom Post author

      Thanks for the vote of confidence. No, my professional background is not financial services — though I have studied this area a bit and have my own financial adviser to check things out with.

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